Document of The World Bank FOR OFFICIAL USEONLY ReportNO:31485-AZ PROJECT APPRAISAL DOCUMENT ON A PROPOSEDLOAN INTHE AMOUNT OFUS$48MILLION TO AZERENERJI WITHTHE GUARANTEEOFTHE REPUBLIC OF AZERBAIJAN FOR A POWERTRANSMISSIONPROJECT MAY 17,2005 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective March 31, 2005) Currency Unit = Manat (AZM) 1Manat = US$0.0002 US$1 = 4852Manat FISCAL YEAR January 1 - December31 ABBREVIATIONS AND ACRONYMS BCC Backup Control Center (for dispatch of electricity) EBRD European Bank for Reconstruction and Development EIRR Economic Internal Rate of Return EMP EnvironmentalManagement Plan EMS Energy Management System-advanced generation and transmission network management programs operating through the SCADA system FIRR Financial Internal Rate of Return FSU Former Soviet Union Hv HighVoltage IBRD InternationalBank for Reconstruction and Development IDA International Development Association IDP Internally DisplacedPerson IF1 InternationalFinancial Institution ISDS Integrated Safeguards Data Sheet JBIC JapanBank for InternationalCooperation KfW Kreditanstalt fur Wiederaufbau (Germany) MDG MillenniumDevelopment Goal MED Ministry of Economic Development ME Ministry of Industry and Energy NDC National DispatchCenter NPV Net PresentValue PAD Project Appraisal Document PCN Project Concept Note PID Project InformationDocument PIU Project Implementation Unit PLC Power Line Carrier -atype of power system telecommunications equipment PRSC Poverty Reduction Strategy Credit PRSP Poverty Reduction Strategy Paper RTU Remote Terminal Unit- SCADA equipment installedat substations and generating plants SCADA Supervisory Control and Data Acquisition -the computerized system for power generation and transmission network dispatch SPPRED State Program on Poverty Reductionand Economic Development Vice President: Shigeo Katsu Country Managermirector: D-M. Dowsett-Coirolo Sector Manager: Peter D.Thomson Task Team Leader: BiornHamso FOROFTIClALUSEONLY AZERBAIJAN PowerTransmissionProject CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE ................................................................. 1 1. Country and sector issues.................................................................................................... 1 2. Rationale for Bank involvement......................................................................................... 2 3. Higher level objectives to which the project contributes .................................................... 3 B. PROJECT DESCRIPTION ................................................................................................. 3 1. Lending instrument ............................................................................................................. 3 2. Project development objective and key indicators.............................................................. 3 3. Project components ............................................................................................................. 4 4. Lessons learned and reflected in the project design............................................................ 5 5. Alternatives considered and reasons for rejection .............................................................. 6 C IMPLEMENTATION . .......................................................................................................... 7 1. Institutional and implementation arrangements .................................................................. 7 2. Monitoring and evaluation of outcomeshesults .................................................................. 8 3. Sustainability....................................................................................................................... 9 4. Critical risks and possible controversial aspects............................................................... 10 5. Loan conditions and covenants......................................................................................... 10 D. APPRAISAL SUMMARY ................................................................................................. 11 1. Economic and financial analyses...................................................................................... 11 2. Technical........................................................................................................................... 14 3. Fiduciary ........................................................................................................................... 14 4. Social................................................................................................................................. 15 5. Environment...................................................................................................................... 15 6. Safeguard policies............................................................................................................. 16 7. Policy Exceptions and Readiness...................................................................................... 16 This documenthas a restricteddistribution andmay be usedby recipientsonly in the performanceof their officialduties ts contents may notbe otherwisedisclosed .I lwithoutWorld Bank authorization . Annex 1: Country and Sector Background................................................................................... 17 Annex 2: Major RelatedProjects Financedby the Bank and other Agencies .............................. 33 Annex 3: Results Framework and Monitoring.............................................................................. 34 Annex 4: DetailedProject Description......................................................................................... 38 Annex 5: Project Costs.................................................................................................................. 46 Annex 6: Implementation Arrangements...................................................................................... 47 Annex 7: Financial Management andDisbursement Arrangements ............................................ 48 Annex 8: Procurement .................................................................................................................. 55 Annex 9: Economic andFinancial Analysis ................................................................................. 59 Annex 10: Safeguard Policy Issues............................................................................................... 81 Annex 11: Project Preparation and Supervision........................................................................... 82 Annex 12: Carbon Finance Project............................................................................................... 83 Annex 13: Documents inthe Project File..................................................................................... 85 Annex 14: Statement of Loans and Credits .................................................................................. 86 Annex 15: Country at a Glance..................................................................................................... 88 AZERBAIJAN POWERTRANSMISSION PROJECT PROJECT APPRAISAL DOCUMENT EUROPEAND CENTRAL ASIA r Infrastructure and Energy Sector Unit Date: May 17,2005 Team Leader: Bjom Hamso Country Director: D-M. Dowsett-Coirolo Sectors: Power (100%) Sector Manager: Peter D.Thomson Themes: Infrastructure services for private sector development (P);Regulation and competition policy (P);Regional integration (S) Project ID: PO83341 Environmental screening category: Partial Assessment LendingInstrument: Specific Investment Loan Safeguard screening category: N o impact [XILoan [ ] Credit [ ] Grant [ ] Guarantee [ 3 Other: For Loans/Credits/Others: Total Bank financing (US$ million): 48.00 IRECONSTRUCTIONAND I I I DEVELOPMENT Total: 7.87 47.53 55.40 Borrower: Azerenerji (Open Type Joint Stock Company) FY 06 07 08 09 10 11 Annual 9.11 19.42 14.50 4.50 0.47 0 Ciimiilative 9.11 28.53 43.03 47.53 48.00 Project Implementation Period: August 2005 -June 2010 ExpectedEffectiveness Date: August 17,2005 Expected Closing Date: December 31,20 10 Does the project depart from the CAS incontent or other significant respects? [ ]Yes [XI N o Does the project require any exceptions from Bank policies? [ ]Yes [XI N o Have these been approved by Bank management? [ ]Yes [ IN0 I s approval for any policy exception sought from the Board? [ ]Yes [XI N o Does the project include any critical risks rated "substantial" or "high"? [x]Yes [ ] N o Does the project meet the Regional criteria for readiness for implementation? [x]Yes [ ] N o Project development objective The primary objective of the project i s to improve the reliability, quality, and cost-effectiveness of electricity supply in Azerbaijan by financing investments that improve the management and performance o f the high-voltage transmission network. Project description A: Power System Management. Upgrade of the electricity dispatch system (SCADA, Energy Management System, telecommunications, metering) B: Transmission Network Rehabilitation. Rehabilitation of substations and power transmission lines. C: ManagementAssistance. Assistance to company management including assistanceto prepare for a future restructured electricity sector. D: Project Implementation. Assistance inproject management, procurement, training, other. Which safeguard policies are triggered, if any? The project triggers the environmental assessment safeguard. Initialenvironmental category rating: B. Significant, non-standard conditions, if any, for: Board presentation: None Loadcredit effectiveness: None Covenants applicable to project implementation: a The Guarantor (Republic of Azerbaijan) shall provide annual financial and/or in-lund contribution to the Borrower in order to enable it to carry out its operations with due diligence and efficiency and meet its obligations under the Loan Agreement. a The Guarantor shall develop a medium-term tariff policy, satisfactory to the Bank, which shall enable the Borrower (Azerenerji) to achieve full cost recovery of its operations no later than December 31,2010. a Azerenerji will maintain a current ratio of 1.2:1(ratio of current assets to current liabilities), and will refrain from incurring additional debt unless their current annual net revenue exceeds their maximum debt service requirement by a ratio of at least 1.5:1. a Azerenerji will establish a local Project Account and will maintain a balance in this account not less than the expected local cofinancing requirements over the subsequent 3- month period. A. STRATEGIC CONTEXTAND RATIONALE 1. Countryandsector issues Since gaining independence from the Soviet Union, Azerbaijan has experienced many of the same challenges as other CIS transition states. The country's problems were exacerbated, however, by an armed conflict and a large population of refugees and Internally Displaced Persons (IDPs). As a result, Azerbaijan i s today one of the seven lowest income countries of the Europe and Central Asia Region, although its future holds tremendous promise because of offshore oil and gas resources which it i s currently developing in partnership with the private sector. Azerbaijan has succeeded in achieving economic stabilization in recent years as a result of a consistent program of fiscal restraint and prudent monetary policy. Oil and gas developments proceed as planned, and GDP expanded by 10.6 percent in 2002 and 11.2 percent in 2003, reflecting both sound policy adjustments and high oil prices. However, oil production i s expected to peak in 2010 and the Government will need to ensure diversified development of the non-oil sector in order to generate jobs and promote income equity. Significant progress has been made on governance and corruption issues in the years since 1999, although much remains to be done to strengthen the business environment. Poverty i s a serious concern, in part owing to the large numbers of IDPs (nearly a million people) and in part to insufficient investment in labor-intensive sectors and supporting infrastructure. About 47 percent of the population lived in poverty in 2002 and 9 percent lived in extreme poverty. Azerbaijan's Poverty Reduction Strategy Paper (PRSP) identifies six strategic pillars: (i) enablingenvironmentforincome-generatingopportunities; (ii) an macroeconomic stability; (iii) of andequityinaccesstohealthandeducation; (iv) infrastructureimprovements quality (including roads, utility services, and irrigation); (v) social protection reforms to serve the vulnerable more effectively; and (vi) better conditions for refugees and IDPs. Azerbaijan i s making progress in fighting poverty, and pensions and minimum wages were increased significantly in 2004. The power sector has performed poorly in the years since independence. Effective generation capacity has shrunk due to insufficient funds for rehabilitation and capacity addition, and i s currently inadequate to meet the domestic electricity demand. Many areas of the country receive only a few hours of electricity per day. System reliability i s poor, with frequent localized outages and occasional widespread system failures. In addition, the sector i s far from financially viable. Azerenerji (the state power generation and transmission company and beneficiary under this proposed project) depends heavily on the State to provide financial support through payment for power plant fuel (natural gas and mazut) and electricity imports. The underlying causes of poor system performance are similar to those in other FSU countries: (i) inadequate levels of investment and maintenance, especially since independence; (ii)inadequate tariffs and collections; and (iii)system designs originally optimized to function as part of a larger integrated power supply network. The problems have been complicated in Azerbaijan by the war over Nagomo-Karabakh. However, the power sector has seen significant investments from the I international financial institutions (IFIs) in recent years, and Azerenerji's financial dependence on the State i s primarily a matter of political choices relating to the Government's tariff policy and its privatization strategy for power distribution. In 2002, the Government reorganized the power distribution networks into four regional companies and entered into long-term management contracts with private companies (see details in Annex 1). To attract operators and investors, the Government allowed the distributors to defer payments for a portion of the electricity they purchase from Azerenerji while they are building up their end-user payment collections. Payments from the distribution companies to Azerenerji are scheduled to reach 100 percent in 2010. The delivery of affordable electricity and other utility services of acceptable quality is an essential requirement in enhancing the living standards of the population. The Government has established a strategy to address this need, as outlined inthe Letter of Development Policy (LDP) for the Poverty Reduction Support Credit (PRSC-I, 2005). This strategy has five components: 0 Promoting increasedprivate participation inthe provision of utility services; 0 Establishing a medium term tariff policy for Azerbaijan, which incorporates a transition to full cost recovery for utility service providers; 0 Implementinginternational financial reporting standards, through the adoption and implementation of a new Accounting Law which will require, inter alia, that state-owned utilities adopt IFRS no later than January 1,2008; 0 Creating an appropriate regulatory environment; initiallyby establishing an independent regulatory agency covering the electricity, gas, water, and wastewater sectors; and 0 Strengthening competition through a new Competition Law. The elements of the strategy outlined in the LDP are designed to support the Government's vision of a financially viable and self-sustaining utilities sector which i s able to attract a significant level of private sector participation, while providing efficient and cost effective service to the population. Details of the LDP are provided in Attachment 1to Annex 1. The Government, however, i s also fully cognizant of the need to ensure that utility services provided to consumers within Azerbaijan are affordable. As the economy continues to expand, the purchasing power of the population will continue to increase and, with it, the capacity to pay higher prices for utility services. In addition, the development and implementation of a targeted social safety net that i s now underway will ensure that the most vulnerable continue to be able to afford essential utility services as prices rise towards, and eventually reach, full cost recovery levels. Taking into account these considerations, the Government has taken the initial step of increasing prices of gas and water supply as of January 1,2005, but has elected to defer increases inelectricity tariffs until a later date. 2. Rationale for Bank involvement Inthe present international and domestic environment, private sector funding is not available to Azerbaijan on the scale needed for full rehabilitation of the power system. IFIs/donors (EBRD, KfW,Islamic Development Bank, and JBIC) have provided, and continue to provide significant funding to the sector for building new generation capacity and rehabilitating generation and 2 transmission, thereby remedying some of the neglect of the system over the last 20 years. Still, some of the equipment in use i s more than 50 years old, and represents an ongoing risk to system reliability. The Bank can not only help to fill the funding gap, but can also work with the Government to achieve the structural, legal and regulatory framework needed to attract private funding to the sector. The proposed project would complement sector reforms that are being supported by the Bank's adjustment operations by providing needed investment in power dispatch and transmission network rehabilitation. Transmission i s the backbone of the power system, and the current lack of an adequate dispatch system i s both a risk to security of supply, and a cause of inefficient operations. The Bank can offer extensive experience in the design and implementation of transmission rehabilitation projects in FSU countries, with lessons that are directly applicable to Azerbaijan. 3. Higher level objectives to which the project contributes The proposed project to rehabilitatethe power transmission system would contribute to the PRSP inanumber of ways, most notably by: 0 Improving the conditions for economic growth through more reliable electricity supply; 0 Reducing the cost of electricity through improved technical and financial management of the transmission system; and 0 Improving the basis for private participation in energy infrastructure development by upgrading the power transmission system to enable dispatch and transmission o f electricity consistent with contractual arrangements. The project i s included in the Country Assistance Strategy investment program in the context of improving access to services by reversing the decline in social services and infrastructure, which i s one of the four strategic goals of the current CAS. B. PROJECTDESCRIPTION 1. Lendinginstrument Azerbaijan i s a "blend country" positioned to receive IDA credits as well as IBRDloans from the Bank. With only limited IDA funding available, the Government has elected to provide IBRD funding to the revenue-earning sector entity involved in this Power Transmission Project. The proposed project would be a Specific Investment Loan under IBRD lending terms. Given the importance of oil exports in defining the country's inflows of foreign currency, the Government and Azerenerji have opted to have the loan denominated in U S dollars. Azerenerji has informed the Bank that it would prefer a Fixed Spread Loan. 2. Project development objective and key indicators The primary objective o f the project i s to improve the efficiency of the power transmission operation in Azerbaijan through technical and institutional strengthening of the generatiodtransmission utility. The project has as a secondary objective to contribute to strengthening Azerenerji's financial position. 3 The key performance indicators that will be used to assess the fulfillment of the project's development objectives are: 0 Improved efficiency of fuel use per kWh of electricity generated through Economic Dispatch and reduced transmission losses. 0 Improved reliability and quality of electricity supply with respect to frequency and duration of forced outages. 0 Strengthened financial position (i.e. need for Govt. financial support reducedeliminated) as a consequence of (a) tariffs that increase over time to cover full costs, and (b) increased payment collections. See quantitative targets and more details in Annex 3. 3. Projectcomponents The components were selected on the basis of urgent needs of the power system and a division of focus among IFIS, EBRD preparing a power generation project, and KfW financing with transmission components complementary to those to be financed by IBRD. The proposed project has four components, as follows: Component A: Power System Management (Cost: A proportion of US$50.6 million for Components A and B) The first project component includes investments to upgrade the electricity dispatch system in the country, which in turn would support the reliable, secure and economic operation of the electricity sector, and facilitate financial settlements in a future wholesale electricity market. There are three main subcomponents (described in detail inAnnex 4): SCADA/EMS1 system: installation of hardware and software to enable real time acquisition of operational information from generating stations and HV transmission system substations, analysis and monitoring of the network status at the National Dispatch Center, and control and dispatch of the generating plants and the HV transmission system. Telecommunicationsnetwork upgrade: installation of communications equipment to meet the requirements of dispatch, metering, and Hv network operations and maintenance. It will also provide broadband communications facilities between major Azerenerji offices and generating plants to support improvements in Azerenerji financial management and administration. Stationadaptationandmetering: adaptation of generating plant and substation control and metering circuits and equipment to provide alarm, status, and metering inputs to the RTUs and accept control outputs from the RTUs. Fuel meters on each major thermal generating unitwill be providedfor economic dispatch. Supervisory Control and DataAcquisitionEnergy Management System 4 Component B: Transmission Network Rehabilitation (Cost: A proportion of US$50.6 million for ComponentsA and B) The second component would cover priority investments in rehabilitation of high voltage transmission lines and selected high-voltage substations. The investments will enhance system reliability and help protect valuable system assets from costly damage. Subprojects were selected based on priority and economic returns, and include increasing transformer capacity at four HV substations, rehabilitation of 12 transmission line segments, and some low-cost rehabilitation work on four additional substations. Details of the subprojects are provided in Annex 4. Some of the subcomponents may change during project implementation subject to additional studies and a changing system environment (deterioration of existing equipment or emergence of system bottlenecks or weaknesses). Component C: Management Assistance (US$3.6 million) The third component will provide technical assistance (TA) to improve the management systems of Azerenerji and prepare the company for a future restructuredenergy sector. The TA includes (1) assistanceinthe company's transition to International FinancialReporting Standards (IFRS); (2) related development of an integratedmanagement information system; (3) relatedrevaluation of Azerenerji's assets; (4) company and project audits; (5) development of an updated Grid Code; (6) transmission costing (as basis for separate transmission tariff); and (7) a transmission network stability study. This component will also will provide TA to help Azerenerji ensure efficient implementation of the project. The subcomponents include (8) dispatch system procurement support (started during project preparation); (9) project management and technical support; and (10) dispatch system training. ComponentD: Project Implementation (US$0.8million) The fourth component will finance Incremental Operating Costs for the Project Implementation Unit (PIU). This subcomponent will be modest in size given that the PIU is part of the Azerenerji organization, with funding reserved for translation and interpretation work, incremental office equipment, international travel relevant to the project, and incremental office operating expenditures. The total project cost, including contingencies and fees, i s estimated at US$55.4 million. IBRD would provide a loan of US$48 million equivalent; the balance of US$7.4 million would be covered by local cofinancing (see Annex 5). 4. Lessons learned and reflected in the project design The Bank has accumulated substantial experience in implementation of projects and understanding of the problems in the energy sector in Azerbaijan and in other countries in the region. The most important lesson i s that the priority problems include two closely inter-related issues: sector governance and financial performance of the electricity (energy) companies. These are, of course, complex problems with legal, regulatory, structural, economic, financial, 5 and technical aspects. Azerbaijan has only recently embarked on energy sector reform, and the process of restructuring, legal and regulatory reform, and enhancement of utility financial performance i s a progression which i s being supported by IDA adjustment operations (most recently, the PRSC-I (2005)). The proposed project would complement these efforts with needed investment in power system dispatch and transmission network rehabilitation. This integration o f policy and investment support i s designed to maximize their combined effect on the sector's financial position and sustainability of sector reforms. Procurement design and management, bid evaluation, project management and implementation coordination have been difficult challenges for borrowers in similar projects. To minimize these challenges for Azerenerji and its PIU, the procurement strategy i s based on two-stage bidding and a turnkey contract for the integrated dispatch system. Technical assistance by international consultants i s also included to assist the PIU during project implementation and for capacity buildingin operation of the new dispatch system and to enhance project sustainability. Finally, until the financial performance of sector enterprises improves (which will in turn require improvements in collections, tariffs, and social protection systems), the ability of the beneficiary organization to co-finance projects i s limited. Recognizing that the improvements in financial performance will develop only in parallel with the implementation of the reform program, local financing contribution i s kept relatively low in order to reduce the risk of implementation delays. 5. Alternatives consideredand reasons for rejection Consideration was given to whether the proposed financing of high-priority investments in dispatch and Hv transmission represented the best approach at this stage in sector development. The key alternatives considered, andthe reasons for their rejection, are as follows: a Finance investments in capacity expansion: Azerbaijan currently has a power supply deficit and imports power from Russia. Inthe longer term, economics are expected to drive the price of imports above the cost of local supply. A draft Government Power Sector Development Plan includes a number of investments that would increase capacity of both generation and transmission. At the same time, there are clear indications that the current system i s not being operated in an optimal fashion, due to constraints on existing components o f the transmission network, inadequate information on system performance, and lack o f mechanisms to balance the network in such a way as to maximize the capacity of existing facilities. As a result, before investing in additional capacity (which will undoubtedly be needed to accommodate projected load growth), it was decided that the first priority should be to optimize the use of the existing network and generating plants. a Finance investments in generation capacity rehabilitation. An EBRD project i s under preparation in this area, providing funding for the most critical and profitable generation rehabilitation. An additional IBRD lending operation would face issues of providing more electricity into a market characterized by high levels of non-payments and tariffs far below costs. This brings to the forefront the question of real demand at full price/full payment. Investments in the backbone transmission grid are to a lesser degree sensitive to this question. 6 0 Finance investments in energy eficiencyAoad management: Demand management is often accepted as the first course of action in addressing capacity deficits in the power system. However, while electricity i s in many cases used in an inefficient manner, this i s frequently attributable to shortages in the availability of natural gas which, based on both financial and economic considerations, i s the preferred fuel for many applications currently covered by the power sector, such as heating and cooking. Restructuring of the gas supply network to improve accessibility and financial viability, which i s beingaddressed under other initiatives, will help to alleviate the pressure on the electricity system. In addition, the proposed project will provide a tool for load management at the supply level, allowing the National Dispatch Center to quickly identify and address excessive peak loads on the system and minimize the risk of uncontrolled forced outages. A reliable and efficient dispatch, transmission and metering system i s a necessary condition for many energy efficiency measures to work. 0 Finance more transmission system rehabilitation rather than a dispatch system (SCADA/EMS/telecom/metering). KfW projects together with this IBRD project have contributed or will contribute to significant rehabilitation of the transmission system. The SCADA system allows the operator to quickly discover problems in the grid and with the generation units, thereby reducing the chance of outages and cascading negative impacts of a problem, reducing the time of outages, and generally ensure safe operation of the system. The economic rate of return of the SCADA investment i s high based on conservative assumptions, and the Government has expressed a strong preference for investing in the SCADA system. C. IMPLEMENTATION 1. Institutionalandimplementationarrangements 1.1InstitutionalResponsibilitiesand Capacity Executing Agencies: The executing agency responsible for project management and implementation would be the Borrower, Azerenerji OJSC (open joint stock company). Azerenerji i s the state-owned enterprise responsible for operation and management of the high- voltage transmission network and the major thermal and hydroelectric generating stations. The executing agency on the Government's side would be the Ministry of Finance. The Ministry, and in some cases the Borrower, would provide coordination with other Government agencies, notably Ministry of Economic Development (MED), Ministry of Industry and Energy (ME),Cabinet of Ministers, andthe Tariff Council, andwith bilateral andmultilateralfinancing agencies as needed. The Ministry of Finance may delegate some Government coordination and oversight responsibilitiesto other ministries (MEDand/or ME)that these ministries are believed to have the capacity to handle. Azerenerji has established a Project Implementation Unit for the proposed project, reporting to the Chief Engineer (First Deputy President) and staffed by specialists in technical, financial, environmental, and procurement matters, to act as the Bank's counterpart on day-to-day matters. 7 The PIU i s currently responsible for project preparation. Once the loan i s approved and effective, the PIU will be responsible for project implementation, including procurement, contract supervision and management, and project financial management, including project accounting, financial reporting, loan disbursements, and arrangements for external audit. Project Zmplementation Capacity: Azerenerji has been the beneficiary and implementing agency in two major hydro rehabilitation projects financed by EBRD, a substation rehabilitation project financed by KfW, and reconstruction of a combined-cycle thermal power plant financed by JBIC. The capacity of Azerenerji and the PIU to undertake their project implementation responsibilitiesi s considered to be satisfactory, given their experience with previous projects and the technical skills of their staff. However, the project would include financing for additional project management and specialist support during implementation to provide assistance in dealing with the technical complexities of the dispatching system and the new technologies invo1ved. 1.2 Implementation Arrangements Lending and On-Lending: A loan of US$48 million equivalent would be extended to Azerenerji under IBRD terms with a sovereign Guarantee from the Government of Azerbaijan. The loan would be a Single Currency Fixed Spread Loan, denominated in US dollars. Repayment would be over a period of 20 years, including 8 years' grace. The project implementation phase i s expected to be 5 years. Disbursement: (Annex 7) Disbursements from the IBRD Loan will be transaction-based to finance eligible expenditures for goods, works, technical assistance, and recurrent costs consistent with Country Financing Parameters for Azerbaijan. To facilitate timely project implementation, the borrower will establish, maintain, and operate a Special Account denominated in U S dollars, under terms and conditions acceptable to the Bank. The Special Account will be held in a commercial bank acceptable to the Bank. Applications for replenishment of the Special Account will be made on not less than quarterly basis. The Special Account will have an initial allocation of US$l,OOO,OOO. Once cumulative disbursements under the loan have reached US$5,000,000, the allocation will increase to US$2,000,000. Payments in excess of 20 percent of Special Account will be made through direct disbursement from the Loan Account. Financial Management and Reporting Arrangements: (Annex 7) The PIU will prepare and submit to the Bank quarterly Financial Monitoring Reports (FMRs) in a format agreed with the Bank. The PIU would also be responsible for coordinating the annual audits of the Project Financial Statements, as well as the corporate financial statements that will be carried out by independent auditors under terms of reference acceptable to the Bank. The audit fees for both the project andthe corporate audits would be financed from the Loan. 2. Monitoringand evaluation of outcomedresults The PIU, with the assistance of Azerenerji and the relevant Government ministries, will monitor progress against agreed performance indicators specified in Section B2 and Annex 3. The PIU will provide, on a quarterly basis, 45 days after the end of each quarter, consolidated reports on 8 project implementation progress in the Bank's Financial Management Report (FMR) format. Draft annual action programs for the upcoming year will be included with the December reports for IBRD's review and comment. The Govemment of Azerbaijan and IBRD will conduct joint reviews annually during supervision missions. The PIU will prepare a detailed mid-term report within 27 months of project effectiveness to serve as the basis for a project mid-term review, to be undertaken not less than 3 months later. In addition to the topics covered under the quarterly reports, the mid-term review will include a review of the economic viability of the project, based on actual costs and benefits achieved to-date as well as any revised estimates. Based on the outcome of the mid-term review, measures will be taken to ensure efficient completion of the project. The PIU will also help prepare a Borrower's contribution to an Implementation Completion Report (ICR), so that IBRD could complete the ICR within six months of the closing date of the Loan. The ICR would include an assessment of project costs and benefits, project execution, and performances of involved parties. 3. Sustainability The project enjoys strong support from the Government. Assistance in improving the reliability and effectiveness of the high voltage transmission system was a key component of a request by the Government for sector investment funding. The project i s specifically noted in the agreed FY03-05 CAS, and the Govemment has taken a PHRDGrant for project preparation. Over the longer term, the sustainability of the project will depend on: 0 increasingAzerenerji's tariffs to cost-recovery level; 0 the financial performance of electricity distribution companies and their orderly payments to Azerenerji for supply of electricity; and 0 capacity building for the Azerenerji dispatchers; continuous SCADA computer system support; maintenance personnel and resources for the transmission system. The LDP attached to the PRSC-I lending operation includes the Government's commitment to a medium-term tariff policy that would bring electricity tariffs to cost recovery levels no later than by 2010. The path to such cost recovery i s not yet laid out in detail, and will depend on progress with developing social protection programs and systems (as supported by an IDA credit) and the development in pensions, minimum wages, and other. In the legal agreements for this project, the Government has agreed to the mentioned tariff policy framework and to continue to provide financial support to Azerenerji sufficient to make up shortfalls in cash flow as a result of contractually-mandated non-payments by distribution companies and/or non-compensatory tariffs until such time as these conditions no longer pertain. The financial performance of electricity distribution companies i s essential to the sustainability of the entire power sector, and of Azerenerji in particular, since Azerenerji's revenues depend almost exclusively on payments from distribution companies. The distribution companies have been transferred to private management, and their payments to Azerenerji are specified in the concession contracts. Inor before 2010, all distribution companies are contractually obligated to provide timely payment for their full supply of power from Azerenerji. Technical assistance for capacity buildingi s included in the scope of the Project. 9 4. Critical risks and possible controversial aspects CriticalRisks Risk Risk Rating Risk Mitigation Measure From Outputs to Objective Inadequate tariffs for sector S Technical assistance to Government in enterprises due to failure to establish establishing and implementing independent suitable institutions and rules for utility regulation provided by donors (PPIAF, independent regulation. USAID). Loss of Government commitment to S Government performance to be supported by the principles of cost-recovery tariffs. adjustment lending, as well as donor-financed TA. The Government has committed in the Guarantee Agreement to establish cost- recovering tariffs by 2010 and to provide financial support to compensate Azerenerji for non-compensatory tariffs. Failure to establish adequate social M Pension and Social Assistance Project (IDA, protection systems on a timely basis. 2004). Future energy price increases mitigated by recent substantial increases in pensions and minimumwages. Distribution companies' payment to S Government commitment to provide necessary Azerenerji for power supply falls financial support to Azerenerji even if private short of their contractual obligations. distributors do not meet their contractual obligations. From Components to Outputs Meter reading and dispatch rules and M Privatization of distribution and strengthening procedures not followed. regulation. Inadequate system maintenance. S Financial strengthening of Azerenerji through tariff increase andfull collection of payments. Project implementation delays due to S Local financing requirement minimized. PTU lack of local financing and poor to be assisted by TA for project management project management. duringimplementation. Overall Risk Rating S Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligib1eor Low Risk) Possible ControversialAspects: None. 5. Loan conditions and covenants The Government will budget and provide annual financial support to Azerenerji sufficient to cover the differences between the company's annual revenues (net of non-payments) and its annual cash flow requirements (including operating and maintenance costs, self-financing 10 of capital investments, and debt service) until such time as tariffs shall reach cost-recovery level and distribution companies are required to make timely payment for 100% of the electricity received from Azerenerji. The need for financial support i s expected to last until 2010. The Government has also agreed, by May 31, 2005, to develop a medium-term tariff policy, satisfactory to the Bank, which shall enable the Borrower to achieve full cost recovery o f its operations no later than December 31, 2010; and thereafter, implement the tariff policy in accordance with its defined timetable. In addition, Azerenerji will maintain a current ratio of 1.2:1, and will refrain from incurring additional debt unless their current annual net revenue exceeds their maximum future debt service requirement by a ratio of at least 1.5:1. Azerenerji will establish a local Project Account, in US dollars, and will maintain a balance in this account not less than the expected local cofinancing requirements over the subsequent 3-month period. D. APPRAISAL SUMMARY 1. Economicand financial analyses 1.1 Benefit-Cost Analysis: Potential benefits of the proposed project include (i)reduction in the cost of electricity supply through more economic dispatch of power plants and reduced line losses; (ii)increased reliability of supply to industrial, commercial and household customers; (iii)reductioninmaintenance andrepaircosts through the prevention of forced outages and ancillary damages; (iv) greater opportunities to participate in regional electricity trade through better understanding and monitoring of system status and requirements; and (v) potential to defer new investments in generation and transmission through more efficient use of existing resources. The primary beneficiaries of the project will be the electricity customers in Azerbaijan, who will enjoy reliable electricity supply at prices lower than would otherwise be required. Fiscal impacts of the project would include medium-term reductions inthe level of state support required for the power sector (in terms of financing for power plant fuel supply), reduction in the cost of electricity used by budget organizations, and reduction in the future level of subsidies to low income customers as a result of reduced need for tariff increases. The economic analysis looked at the benefits associated with reduced line losses, more economic dispatch of power plants, net savings in system operating and maintenance costs, and deferred investment as a result of more efficient use of existing resources. While increased reliability of supply and regional electricity trade are no less important, it is more difficult to anticipate the value of these impacts given the degree to which they rely on factors outside the control of the project. However, a conservative allowance has been made inthe calculations for benefits of the SCADA/EMS component related to the ability to reactivate the system more quickly in the event of an outage and for benefits of the transmission and substation rehabilitation projects accruing from reduced frequency and duration of outages, and removal of capacity constraints at substations. 11 Based on the assumptions outlined in Annex 9, the economic internal rate of return (EIRR) the SCADA/EMS component i s estimated at 35.8 percent. Net present value (NPV) at a 10 percent discount rate would be US$73.2 million. The ERRSfor the transmission line subcomponents that have been proposedfor Component B are very high, ranging from 53 percent to 441 percent. The overall EIRR for the 12 subprojects i s 76 percent. EIRRs for the proposed transformer replacement at Imishli, Gandja and Gala are also high (46 percent, 64 percent, and 51 percent respectively), since these stations are operating at or near capacity duringpeak loads. . While the proposed replacement of the transformers at Mushvig cannot bejustified on the basis of capacity constraints, the Mushvig substation i s located in a high-profile area of Baku, serving the presidential palace and a number of major government facilities, and may be justified on the basis of reliability and security of supply. In addition, Azerenerji plans to use the existing transformers to replace transformers at other substations that are either nearing capacity or nearing the end of their economic life. Replacement of switchgear and batteries at three additional substations i s regarded as a "must-do" project in order to protect the integrity of the entire substation. Overall, the ERR for Component B i s estimated at 48 percent, and the NPV at $83.8 million. The ERR for the project as a whole i s estimated at 38 percent, and the NPV at $143.7 million. The project's financial internal rate of return (FIRR) was also evaluated usingfinancial prices for the benefits and costs. At current tariffs and fuel prices, the FIRR for the SCADA/EMS component i s estimated at 30.2 percent, and the NPV at US$53.7 million. For the proposed investments in transmission network rehabilitation, the FIRR for Azerenerji i s less attractive owing to the Govemment's current tariff policy. At current tariff levels, the ability to serve additional load (through reductions in forced outages and removing capacity constraints) makes little contribution to the company's profitability since the variable cost of supply (mostly fuel) i s very close to the tariff level. The main financial benefit of carrying out the rehabilitation works at the present time i s the ability to avoid an equal or potentially greater investment in the future when the facilities can no longer function. However, as tariffs increase to full cost recovery levels, reduced outages and the associated increase in electricity sales will yield financial benefits equal to the difference between the full and variable cost of supply for the additional units of electricity supplied. Assuming that tariffs reach full cost recovery in 2008, and also assuming that, absent the current project, the equipment would have to be replacedrehabilitated at an equal cost not less than 5 years hence, the FlRR of the transmission rehabilitation component would be 9.1 percent. If tariffs do not reach full cost recovery until 2010, the FIRR would be 8.7 percent. The low financial retums to Azerenerji are not considered a problem (beyond the problem of low tariffs), since the high EIRR reflects the consumers' willingness to pay to avoid outages and load shedding. Details of the economic and financial analysis and the underlying assumptions are contained in Annex 9. The project also offers substantial environmental benefits related to reduced greenhouse gas emissions. A portion o f these benefits may translate into additional financial returns to the Borrower through the sale of carbon credits. The Bank i s currently preparing a Carbon Credit Finance Project based on the emission reductions associated with anticipated savings in fossil fuel consumption (see Annex 12). 12 1.2 Financial Viability of Azerenerji: At current tariff levels, Azerenerji is unable to meet its operating costs and cash flow requirements even with full collections - which infact were only 30 percent in 2002, and 36 percent in 2003. As a result, the State i s providing the necessary liquidity by financing the purchase of fuel and imported electricity. The company had an operating loss of AZM 421 billion (US$ 84 million) through 9 months of 2004. Duringthe same period, the government transferred in excess of AZM 2 trillion (US$400 million - equivalent to the value of fuel purchases for the last 2 quarters of 2003 and the first 2 quarters of 2004) in order to offset the cash flow problems associated with operating losses, debt service obligations, and less-than-full collections. Collections are scheduled to increase under the concession contracts with the operators of the four distribution companies; however, payments by the distributions companies are not scheduled to reach 100percent until 2010. The company has external loans equivalent to US$375 million, with a balance owing of approximately US$310 million as of the end of 2003. Approximately one half of the borrowings are on terms similar to IDA. The remainingloans have terms of 11-12 years with repayment obligations starting between 1999 and 2003. Inaddition, the company's capital investment program calls for additional borrowing of approximately US$940 million (including the proposednetwork rehabilitationproject) over the 2005 - 2006 period. Debt service costs over the 2005- 2010 period, including the new borrowings, are estimated to total approximately US$515 million. Projections of financial viability, debt service capacity, and the transition to cost-recovery tariffs were developed for a number of scenarios which incorporated various options for the transition to cost recovery tariffs for electricity supply within the framework of reaching full transition by 2010, and examined the required level of government financial support associated with each scenario. Because of the cash flow problems associated with deferred payments by the distribution companies and high debt service obligations, financial recovery of Azerenerji will have to be achieved by a combination of tariff increases and interimfinancial support. There are significant advantages, however, to accelerating the timing of tariff increases. First, higher tariffs would encourage customers to use electricity more efficiently, thereby moderating growth in demand and hence the need for Government financial support. Second, tariff increases would reduce the need for government financial support, freeing up additional funds to provide support for low- income households. Finally, moving to cost recovery tariffs at a time when the distribution companies have some leeway in terms of enforcing payment provides a de facto form of social support for low income households while more formal mechanisms for social protection are put inplace. O f the alternative scenarios for tariff increases and government support which were developed and reviewed, the option which was deemed to offer the best balance between the Government's affordability concerns and the need to move quickly to economically efficient pricing of electricity supply would entail a 50 percent increase in wholesale electricity tariffs (from 71 AZWkWh to 106.5 AZMkWh) effective January 1, 2006, with equal annual percentage increases thereafter in order to reach full cost recovery (estimated at 174 AZWkWh) by the end of 2010. The proposed option would require government financial support totaling AZM 6.7 trillion over the 2005 - 2010 period. Details of the analysis and of the projected corporate financial position are provided inAnnex 9. 13 Duringthe period to 2010 while tariffs are increased and the distribution companies' contractual rights to defer part of the payments for received wholesale electricity are eliminated, the Government will continue to provide financial support to Azerenerji as part of the terms of the Guarantee Agreement. The support shall be sufficient to make up the difference between the company's revenues (net of non-payments) and its cash flow requirements (including operating and maintenance costs, self-financing of capital investment, and debt service). In addition, Azerenerji will conform with the current ratio, debt service and project pre-financing covenants outlined in Section C.5. 2. Technical The technical components of the proposed project were identified and evaluated as part of a detailed feasibility study carried out by Azerenerji with the assistance of international consultants. The technical solutions for the dispatch, telecommunications, and station adaptation and metering subcomponents are based on standard concepts and proven technologies, accepted and applied worldwide. At the same time, they are particularly suitable and adaptable to the needs of the Azerbaijan grid where wide variances in plant characteristics, as well as technical and capacity constraints in the grid, make comprehensive and timely information and control systems essential. Technical solutions for rehabilitation of transmission substations include standard components such as transformers, circuit breakers, switchgear, batteries, and chargers. Rehabilitation of transmission lines includes replacement of damaged conductors, replacement and reinforcement of towers, tower foundations and anchoring, conductor spacers, insulators and line armatures, grounding rods, and vibration dampers. Some of the subcomponents may change during project implementation subject to additional studies and a changing system environment. However, most of the proposed subcomponents have been characterized as "must do" components, thus appropriate to Azerenerji and the sector's urgent needs. Technical assistance will be necessary for the successful project management, design, procurement, and installation of the dispatch system, and to a lesser degree for the system rehabilitation (procurement and environmental assistance). The Project will also finance a transmission network study (including a system stability and relay coordination analysis and software), dispatch training, an updated Grid Code, and assistance relating to financial management and other management, as described under Components C and D of the Project Components section further above. 3. Fiduciary A Financial Management Capacity Assessment (FMCA) was carried out during project preparation and updated at Appraisal. The assessment indicated that the PIU and Azerenerji meet financial management requirements for the project. The PIU and their consultants have implemented recommended improvements to the Project accounting system, including automatic generation of required Financial Monitoring Reports (FMRs). 14 A procurement capacity assessment was carried out in October 2004, which confirmed that the PIU and Azerenerji meet minimumrequirements for the project. Given the prior experience of Azerenerji staff in implementing donor-financed projects, capacity shortcomings are confined to the specifics o f Bank procurement procedures. Provision has been made under Component D of the project for TA to address the needs for procurement support and capacity building. 4. Social The project will have a positive social impact by improving the reliability and quality of electricity supply, and there are no direct negative social impacts of the project. While proposed increases in electricity tariffs will lead to higher costs for customers, the State Budget resources currently used to support Azerenerji can be targeted to better protect vulnerable households. A new credit, "Pension and Social Assistance Project" (IDA, 2004) will support the Government in improving the social protection system. The Government has committed to a targeted social assistance program that will, inter alia, protect low-income families from the negative effects of tariff increases. In 2004, the Bank undertook a Poverty and Social Impact Analysis (PSIA) of reforms in the power sector, notably the impact of tariff increases. In Baku, households spend about 2 percent o f their income on electricity. A 50 percent tariff increase would cause an increase in the monthly electricity bill of about US$2, which i s significant but probably bearable for most families, considering substantial increases in pension levels and minimum wage levels in 2004. Data outside Baku i s lacking, but if higher tariffs and collections can improve the currently poor service level, the social impact would be positive. While the Project will not explicitly monitor its social impact, cost savings and quality of supply improvements (at the transmission level) will be monitored. The SCADA system creates opportunities for Azerenerji staff to learn new, advanced skills. The system may in a 5-year perspective reduce staffing needs at HV substations, although very modestly compared to the size of the company (9500 employees). Azerenerji reduces staff mainly through attrition. 5. Environment The project i s conservatively expected to lead to a 1.5 percent reduction in gas and fuel oil use at power plants because of more economic dispatch, with a corresponding effect on emission of greenhouse gases. An estimated 0.5 percentage point's reduction in transmission losses (from 5 percent to 4.5 percent) has a corresponding positive impact on emissions from the power plants. Insofar as the project contributes to increased and more reliable electricity supply, it will help to reduce the need for households to consume wood and kerosene in order to meet their demands for heat and lighting. Savings of power plant fuel will be monitored under the project, and thus also emission reductions. Future household surveys will monitor developments in electricity supply vs. wood and kerosene use (as well as natural gas). At the same time, it i s anticipated that the tariff increases which form a key part o f government strategy for the utilities subsectors will encourage more efficient use of energy, and hence reduce future growth in greenhouse gas emissions. 15 6. Safeguard policies Safeguard Policies Triggered by the Project Yes N o Environmental Assessment (OP/BP/GP 4.01) [XI [I Natural Habitats (OP/BP 4.04) 11 [XI PestManagement (OP 4.09) [I [XI Cultural Property (OPN 11.03, being revised as OP 4.11) [I [XI Involuntary Resettlement (OP/BP 4.12) [I [XI IndigenousPeoples (OD 4.20, being revised as OP 4.10) [I [XI Forests (OP/BP 4.36) [I [XI Safety of Dams (OP/BP 4.37) [I [XI Projects inDisputed Areas (OP/BP/GP 7.60) [I [XI Projects on International Waterways (OP/BP/GP 7.50) [I [XI The project has been given an environmental category rating of B since proposed investments under the project will be confined to existing facilities and rights of way and as such are unlikely to trigger major environmental impacts or other safeguard policies. As part of the EA, an Environmental Management Plan (EMP) was prepared to define procedures for mitigation of local impacts of the project during construction (e.g. repair of lines, replacement of transformer equipment) and disposal of waste materials and procedures for mitigation during operation (e.g. maintenance activities). Consultations about and disclosure of the EMP has taken place. There will be no subprojects indisputed areadconflict zones. 7. Policy Exceptionsand Readiness The project complies with all applicable Bank policies. The Feasibility study for the project has been completed and approved by Azerenerji. A Procurement Plan has been developed and agreed with the Borrower. Prequalification bids for Component A, Power System Management, have been received and evaluated. Documentation for two-stage biddingi s under preparation. The Borrower has hired a consulting firm (consortium) to provide procurement and technical assistance through the biddingstages and contract negotiations. 16 Annex 1: Country and Sector Background AZERBAIJAN: Power Transmission Project Azerbaijan has experienced many of the same challenges as other CIS transition states since gaining independence from the Soviet Union. However, armed conflict, and a large population of refugees and IDPs have exacerbated problems. Thus, Azerbaijan i s today one of the seven lowest income countries of Europe and Central Asia. On a more positive note, however, Azerbaijan's future holds tremendous promise because of oil and gas resources that it i s currently developing. How the country manages the exploitation of these finite natural resources and the associated revenue boom will determine the success of its medium-term poverty reduction goals, set out in its PRSP. 1. Macroeconomic and Governance Trends. After hyperinflation and severe recession, the economy grew at nearly 9 percent a year during 1997-2002 while annual inflation droppedto 0.1 percent. Azerbaijan by now has an impressive track record of stabilization with fiscal restraint and prudent monetary policy. External indebtedness i s modest and sustainable. Oil and gas developments proceed as planned, and GDP expanded by 11.2 percent in 2003, reflecting both sound policy adjustments and high oil prices. However, oil production i s expected to peak in 2010 and decline rapidly after 2013, absent other major discoveries. The role of the Oil Fund will be crucial in managing the boom, and securing growth that i s more equitable across current and future generations. Diversified development of the non-oil sector i s key for generating jobs and equity. A joint EBRD and World Bank Business Environment and Enterprise Performance Survey showed significant progress on governance and corruption issues during 1999-2002, although much remains to be done to strengthen the business environment. 2. Poverty Reduction. Despite some progress in recent years, about 47 percent of the population lived in poverty in 2002 and 9 percent lived in extreme poverty. The incidence o f income poverty i s greatest among households in provincial towns, although rural areas have more limited access to services and there are significant regional variations in poverty rates. Appropriate management of oil resources offers promising prospects for meeting the Millennium Development Goals. 3. Azerbaijan's PRSP, known as the State Program on Poverty Reduction and Economic Development (SPPRED), identifies six strategic pillars: (i) an enabling environment for income- generating opportunities; (ii) macroeconomic stability; (iii) of and equity in access to quality health and education; (iv) infrastructure improvements (including roads, utility services, and irrigation); (v) social protection reforms to serve the vulnerable more effectively; and (vi) better conditions for refugees and IDPs. The SPPRED and the Millennium Development Goals (MDG) serve as the organizing framework for the CAS, whose four strategic goals are designed to underpin the six SPPRED pillars. Generally, Azerbaijan i s on track to realize most MDGs by 2015, with the caveat that health indicators are difficult to measure due to data uncertainties that needto be addressed. The primary issues in the Azeri power sector are typical for countries of the FSU: (i) inadequate levels of investment and maintenance, especially since independence; (ii) inadequate tariffs and collections; and (iii) designs originally optimized to function as part of a larger integrated system 17 power supply network. The problems have been complicated in Azerbaijan by the war over Nagorno-Karabakh, which displaced a large percentage of the population, and led to the loss of many key facilities in the southwestern part of the country. However, the power sector has seen significant investments from the IFIs in recent years, and Azerenerji's financial dependence on the State i s mostly a matter of political choices relating to the Government's tariff policy and its privatization strategy for power distribution. The Government's strategy for addressing these issues generally corresponds to the sector reform program implemented in a number of Bank member countries. The key steps are: (i)sector restructuring to separate the ownership/management of generation, transmission and distribution; (ii)development of a regulatory framework and institutions to promote competition and ensure the financial viability of sector enterprises; (iii)introduction of targeted social protection programs to mitigate the impact of higher tariffs on vulnerable groups; and (iv) involvement of the private sector in the operation andor financing of generation and distribution facilities. In line with the above, the Government has separated and reorganized the power distribution network into four regional companies, and entered into four long-term management contracts with private companies (Barmek for Baku and the northeast, Baiva for the western and southern parts of the country) which have the character of being concession contracts due to the management companies' investment obligations and the 25 year duration of the contracts. To attract operators and investors, the Government allowed the distributors to defer payments for a portion of the electricity they purchase from Azerenerji while they are building up their end-user payment collections. Payments to Azerenerji shall reach 100 percent in 2010. This arrangement i s one of the two main causes of Azerenerji's dependence on State financial support in a transition period. The other main reason i s the non-compensatory wholesale tariff which i s to increase to full cost recovery by 2010, as described further below. 4. The FY03-05 CAS strategy comprises four interrelated strategic goals, aiming to: (i) manage the oil windfall and maintain macroeconomic stability; (ii) generate jobs and non-oil growth (iii)improve access to services by reversing the decline in social services and infrastructure and (iv) help realize the oil potential to the extent and in the timeframe envisaged by Azerbaijan's poverty reduction program. These would be supported by a carefully balanced combination of policy-based assistance (PRSCs) and investment projects, institution building and technical assistance, as well as analytical support. The proposed Power Transmission Rehabilitation Project i s specifically noted in the CAS as a mechanism to support the third strategic goal of improved access to services. 5. Power Sector Institutional Reforms Supported by PRSC. The Government's Letter of Development Policy (LDP) associated with the Poverty Reduction Support Credit (PRSC-I, 2005), includes a commitment to consolidate reforms in the utilities and infrastructure sectors through financial restructuring of the large natural monopolies; separation of commercial and regulatory functions; and introduction of proper regulatory frameworks. Inan attachment to the LDP (see full text inAttachment 1to Annex l), Government outlines the how it will ensure the sustained viability of the utility services sector. The Government recognizes that the delivery of affordable utility services of acceptable quality i s an essential 18 requirement in enhancing the living standards of the population. Consequently, the Government has established a strategy to address this need. This strategy has five components: 0 Promoting increased private participation inthe provision of utility services; 0 Establishing a medium term tariff policy for Azerbaijan; 0 Implementing international financial reporting standards; 0 Creating an appropriate regulatory environment; and 0 Strengthening competition through a new Competition Law. According to the strategy, the Government will significantly increase the level of private sector participation in the provision of utility services within the next five years, including power generation. A medium-term tariff policy i s outlined in the mentioned attachment to the LDP, albeit not in detail. Most importantly, the Government commits to eliminate by 2010 all financial support for the provision of electricity (as well as gas and water services) and to achieving full cost recovery tariffs. Tariffs will be raised in a staged fashion that gives full consideration to the affordability of these tariff increases. On or before January 1, 2005, the Government significantly increased tariffs for natural gas, water supply in Baku, and raised prices on gasoline and diesel. The Government, however, has elected to defer increases inelectricity tariffs. The Government has developed draft legislation, satisfactory to the Bank, for the establishment of an independent regulatory agency covering electricity, gas, water and wastewater sectors. This legislation is on the Parliament's legislative agendafor AprilMay 2005. 6. Power Sector Structure. Azerbaijan's power generation capacity i s comprised of a mixture of thermal and hydro generation facilities. The transmission and distribution networks were designed to provide almost universal access. Azerbaijan has transmission interconnections and i s able to trade power with Russia, Georgia, Iran, and Turkey. A direct line to Armenia i s partly dismantled. Table 1,below, summarizes the capacity inthe sector. Azerenerji, a state-owned enterprise, manages both generation and transmission. Distribution activities are grouped in four regional distribution companies and the Government has transferred management of these activities to two private companies under what are, in effect, concession arrangements, as described further below. Barmek Holding AS manages the Baku and Sumgayit power distribution networks, and the Baku High Voltage Electrical Equipment Company manages the Ali-Bayramli and Gandja networks. The sector, however, has suffered from inadequate funding to perform essential maintenance functions and to introduce new technology. The result has been a distinct deterioration in the quality of the infrastructure and an associated deterioration in the quality of service. Rolling blackouts are now commonplace and the sector i s becoming increasingly exposed to the risk o f systemic collapse. Rehabilitating and upgrading generation facilities and investing in a modem transmission management system could significantly reduce the risk of system failure, and this Power Transmission Project i s a central part of the Government's effort inthat respect. 19 With the deterioration in the sector's infrastructure, the country i s now no longer self sufficient in terms of electricity supplies. While it has the capability of providing the primary fuels for power generation from its natural resource base - in particular, its hydrocarbon resource base, significant investment in generation facilities will be required if self sufficiency in terms of electricity supply i s to be re-established. Annex 1- Table 1: Transmission and Distribution Network I'ransmission 500kV 330kV 220 kV 110kV Total Line length- km. 693.6 961.2 1,225.9 2,283.4 5,164.1 Number of substations 1 4 9 23 37 Distribution Network 110kV 35 kV 20 kV 6-10kV 0.4 kV Line lengthkm. Baku 0 727 72 1,271 6,490 Gandja 0 1,925 0 12,519 20,659 Ali-Bayramli 934 1,951 0 11,534 20,529 Sumgayit - 0 527 - 0 3,672 6,807 Total 934 5,130 72 28,996 54,485 Cable line length km. Baku 0 111 9 1,653 1,330 Gandja 0 171 0 0 280 Ali-Bayramli 0 0 0 15 132 Sumgayit - 0 6 - 0 297 535 Total 0 288 9 1,965 2,277 Substations Baku 11 217 57 3,674 Gandja 87 192 0 6,129 Ali-Bayramli 66 272 0 6,290 Sumgayit - 60 29 -0 2,087 Total 193 741 57 18.180 Source: Report prepared for thi Yorld Bank - -~ y Dr.Vilayat Valiyev (2( l). The isolated Nakhchivan ;rid is not included inthe numbers above. 20 Annex 1- Table 2: Power Generation Plants and Capacities Name Type ## Unit Total Total Real Units Nominal Nominal Capacity Capacity Capacity MW MW MW Fuel Oil Azerbaijan Thermal 8 300 2,400 1,383 1981-1990 Ali-Bayramli Thermal 7 155-160 1,100 785 NG(4) 1962-68 FO (3) Shimal Thermal 1 150 150 100 Baku-1 Thermal 2 55 110 93 Total Major Thermal 18 3,760") 2,361 Thermal I I I I I Mingachevir Hydro 6 60 360 250 Shamkir Hydro 2 190 380 380 Yenikend Hydro 3 37.5 112.5 112.5 Varvara Hydro 3 5.5 16.5 Other Plants Hidro 132 Total Major Hydro 1,001 742.5 Hydro GrandTotal 1 4,761 I 3,103.5 *) Total Nominal Thermal Capacity is 4234 MW when units are~includedthat are rated with 0Real Capacity (Baku- - . 12, Sumgayit-1, Sumgayit-2) 7. InvestmentRequirements. As Table 2 above indicates, available generation capacity is substantially less than installed capacity, representing a little less than 60 percent of installed capacity. Available capacity i s not sufficient to meet peak winter domestic demand when there i s extensive use of electricity for heating, and the reserve margin, which would be expected to be around 20 percent to 25 percent, i s non-existent at current consumption rates2. Options to meet peak demand include (i) expanding and upgrading existing generation facilities; (ii) increasing regional trade; (iii)improving the performance o f existing facilities; and (iv) demand-side management. In 2003, Burns and Roe Inc. completed a least-cost planning study3, funded by EBRD, to identify optimal expansion plans to meet Azerbaijan's future power needs. The study covered the period 2003 to 2020 and forecasted a 4 percent increase in gross consumption o f electricity in 2004 and 2005, followed by annual increases in consumption in the range o f 1.2 percent to 1.6 percent, see details in Attachment 2 to this Annex 1. The study concluded that, in order to meet In2002, billed consumption was 18,031 MWh. BurnsandRoe Inc.: "Republic of Azerbaijan: Prioritization of InvestmentNeeds for Power Generation and Transmission", November 2003. 21 projected demand levels, new generation capacity would be needed from 2007 and the required additions to capacity by 2020 would exceed 2,000 MW. Investment requirements to address these generation and transmission needs exceed $475 million, almost $280 million of which are critical near term items. (These estimates exclude the planned installation of a 400 MW combined cycle unit at Shimal. They also exclude any investment in distribution). The investment requirements are briefly summarized inTable 3. Annex 1- Table 3: Power Sector InvestmentNeeds TotalCost 2004 -2007 Needs 2003 US$ millions 2003 US$ millions Generation: Least cost planning study base case 246.7 74.1 rehabilitation and upgrade Transmission: Transmission system reinforcement plan 231.7 205.6 And replacement of Central Dispatch Total 478.4 279.7 With these investments, Azerbaijan would be on track to meet the generation profile required to cover its projecteddemand through 2020. This profile i s shown inTable 4 below. Annex 1- Table 4: Installed Generation Capacity Forecast -Base Case 12,000- I 10,000- IAzgres 1OShimal CC New CC - OHydro 0 s3 8,000- 1 6,000- 8 4,000- 2,000- 0 - 2004 2005 2006 2007 2008 2009 2010 2011 2012 2015 2020 Source: BurnsandRoe Priority investments are required to upgrade and rehabilitate existing generation facilities to meet the near term demand and to allow time for the financing and construction of new capacity. At a 22 minimum, emergency facilities should be enhanced to reduce the risk of large-scale failure. EBRD is preparing a loan4 to support emergency and capacity enhancing investments in generation. The transmission grid represents the largest risk o f systemic, catastrophic failure and overloading and protective relay operations have been major contributors to winter blackouts5. There i s a highrisk that availability could be further reduced due to the sub-optimal location of generation compared to demand and the consequent reliance on long transmission lines. Investment in a modem transmission control system such as SCADA6 under this Power Transmission Project, could reduce the risk of failure and improve economic dispatch. The Least Cost Expansion Plan also identified replacement of the Central Dispatch Center as a priority investment. KfW i s supporting the upgrade mainly of substations'. 8. Power Distribution Management Contracts. Private firm Barmek Holding AS manages the Baku power distribution network since 2002 and the Sumgayit distribution networks since 2003. Private firm Baku hgh Voltage Electrical Equipment Company ("Baiva") manages the Ali-Bayramli and Gandja distribution networks since 2003. With the transfer of the distribution facilities to the private sector, responsibility for investment indistribution has also beentransferred. These arrangements havebeen established on a contract basis essentially equivalent to a 25-year concession arrangement (although described as a "management contract"). The contracts include an obligation on the part of the private sector enterprises to develop investment plans. Since availability of funding to meet future investment requirements will be dependent on the margins available to the distribution companies, the Government will need to work closely with these companies to ensure that appropriate incentives exist to allow adequate investment in distribution. The management contracts for the four regional distribution and retail companies include the following requirements: To make at least certain annual minimumlevels of investment in specified areas; To install meteringfor defined customer groups; To meet the technical and operational standards proposed by the operator and agreed with the MED; To meet or exceed specified performance targets for technical losses (or suffer reduced profit levels); To propose within the first year a new detailed investment program and feasibility study which will set out a forward loolung business plan for the company; and Restrict operations to "constant margin" for the first three years of the contract. The EBRD loan is expected to be about US$lOO million. This was clearly demonstrated inJuly 2002, when a combination of fire on the ground and poor transmission line maintenance caused short-circuits of both the 500 kV and the parallel 330 kV power lines between the Azgres thermal power station at Mingachevir and Baku, ultimately causing the whole power system to trip and blackout the entire country. Including an Energy Management System, metering and telecommunication upgrades. KfW'scredit is 15millionEuros. 23 The management contractors took over the distribution assets at a time when collections from end consumers were low. Thus, the management contractors have a right in the initial years of their contracts to pay for less than the amount of wholesale electricity that they receive from Azerenerji, starting from a level between 35 percent and 50 percent and stepping up the levels over several years. For the network in Baku, the contractor i s obliged to pay in full for the energy early in the second half of the current decade, and for the other networks late in the decade. Thereafter, their payments will exceed 100 percent of current consumption in order to pay for past, unpaid deliveries. 9. Energy Sector institutions, Laws and Regulation. The Ministry of Economic Development (MED) and the Ministry of Industry and Energy (ME)were established in 2001' and are the primary agencies responsible for energy sector policy making. MED has broad functions and responsibilities including policymalung, regulation, pricing and tariffs, licensing, and management of fixed assets. MIE i s responsible for formulating and implementing State policy for oil and natural gas production, transport and processing, electricity generation and transmission, district heating, and gas transmission and distribution. The Tariff Council, chaired by the Minister of Economic Development, addresses monopoly services for the electricity, natural gas and water sectors. It has authority to propose tariff adjustments to the Cabinet of Ministers, define customer categories, and adopt cost-reflective tariff designs. MED has a pricing and tariff policy function that provides technical and administrative support to the Council. The Council i s also supported by Working Groups that include industry representation. The Council has adopted rules and procedures' that outline the principles and process for tariff determination. However, they do not address sector-specific issues. Tariffs for the utility sectors include large subsidies particularly to residential consumers. The Government has developed draft legislation for the establishment of an independent Utility Regulatory Agency covering the electricity, gas, water, and wastewater sectors. This legislation i s on the Parliament's legislative agenda for AprilMay 2005. Government plans call for establishing the regulatory agency in 2005 and make it fully operational by mid 2006. The World Bank mobilized consulting resources in 2003-2004 through PPIAF to assist the Government in developing the legislation and regulatory base for the new agency. Consultants funded by USAID provided continued support to the Government in the regulatory area since mid2004. The key legal provisions affecting the energy sector are embodied inthe laws inthe table below: MEDwas establishedby Presidential Decree No.475 (April30, 2001). MFEwas establishedby Presidential Decree No. 458 (April 18,2001). Rules for Formation and State Regulation of Prices (Tariffs) of the Products (Works, Services) of Natural Monopoly Subjects, MED Order No. 67, September 20, 2002. These rules are registered with the Ministry o f Justice. 24 Annex 1- Table 5: Legislative Framework Law on Power Engineering (1998)- This provides the legal basis for electrical and thermal power generation, transmission, distribution, purchase, sales and consumption. It governs the activities of State power engineering companies, power supply companies, independent power producers and consumers. The relevant State authorities are responsible for licensing, transmission and distribution contracts, pricing, de-monopolization, performance criteria, rules and standards. Law on Energy (1999) - This covers energy policy objectives; ownership of resources; control of exploration, development of fields and the construction and maintenance of transport systems. The law includes a strong commitment to energy efficiency and contains significant licensing provisions. Law on Use of Energy Resources (1996) - This provides the legal, economic and social policy basis for the efficient use of energy resources. The State has the power to control the use of energy resources by State enterprises and organizations, to set policy for efficient energy resource use, and to use a range of mechanisms to promote energy saving technology and equipment. Registration o f plans for energy resource use i s also addressed. Law on the Protection of Foreign Investments (1992)- This includes a number of safeguards for foreign investors and allows the acquisition of exploration and development rights. Revisions to this Law are planned. Relating specifically to other energy sub-sectors than power, central laws are the Law on Gas Supply (1998), Production Sharing Agreements (PSAs), and an Oil Law under preparation. 25 Attachment 1to Annex 1: Country and Sector Background Azerbaijan: Power Transmission Project Attachment to the Government's Letter of DevelopmentPolicy for PRSC-I Azerbaijan Utility Services Sector Medium Term Tariff Policy for Utility Services Current Situation The Government of Azerbaijan in close cooperation with international financial institutions has started reforms in the utility services sector, new relationship have been formed between the utility service providers and consumers, achieved some progress and currently continues activities inthis direction. Overall, the accelerated economic growth, increasingnumber of service and productive facilities, stricter requirements sought on the volume and quality of the utility services, necessitate new and more radical actions and implementation of additional measures to address the problems that impact on the socio-economic development of the country. This notwithstanding, it i s required to take cautious steps in ensuring the efficiency o f utility services, since the utility services share common and closely inter-relatedproblems, which requires a comprehensive approach, while the resolution of these problems could potentially give rise to economic and social consequences. Hence, the Resolution of the President of Azerbaijan Republic approving "The Program for Enhancing Financial Discipline in the Energy and Water Sectors" dated March 25th, 2002, #: 893, identified a timeline of initiated works as well as the respective implementers and gave a substantial impetus to acceleration of reforms in the utility sector. These tasks were further specified in subsequent Decrees "On Measures to accelerate socio-economic development in Azerbaijan Republic" dated November 24th, 2003, #: 4, "On Approval of the Law of Azerbaijan Republic on State Budget for 2004" dated December 27th, 2003, #: 9, "On Approval of the State Program for Socio-Economic Development of Regions of Azerbaijan Republic (2004-2008)" dated February 1lth, 2004, #: 24. Nevertheless, the situation still remains as severe, despite the implementation of relevant measures to partially improve technical and technological state (rehabilitation of pipelines, installation of meters, repairing purifying and transmission devices, start of exploitation of new generation and transmission capacities, etc.) of economic units providing services in important areas of the utility services sector, such as gas, electricity, water supply, wastewater services, etc. The continuous increase of prices of energy resources in the world markets enhances those problems further. Significance of transition to new tariffs Among the problems of the utility services sector (technical, technological, economic etc.) a move towards economically justified tariffs, while of paramount importance, serves as a 26 principal criteria for establishment of financial discipline in the sector. The problems like a low purchasing and paying power of the population, high level of technical losses of entities providing utility services, inadequate accounting, lack of meters for most subscribers, cause difficulties in intensifying decision-making, while delaying the move to economically justified tariffs. Generally speaking, the fact that the tariffs of most of the utility services for the population are less than their respective costs by several folds, results in setting the tariffs for other consumer groups at much higher levels, thus, leading to cross-subsidization, and eventually, deviation from the principles of fairness in the economy. This, in tum, constrains the endogenous investment opportunities and leads to a loss of resources otherwise to be used in the state budget, violation of financial discipline, higher production costs of enterprises and other shortcomings. In this respect, the analyses reveal drastic differences between the current level of cost recovery and the actual prices in effect. As such: Currently the wholesale tariff of Azerenergy i s AZM 71 per kWh. Taking into account the increase of the price of imported gas to US$ 60 per 1,000 m3 starting from the beginning of 2005, in accordance with initial calculations the wholesale tariff per 1kWh of electricity will be in the range of AZM 120-122 including 5% profitability, that is 69-72% higher than the current tariff. Based on the information from AzerSU, the full cost of recovery of 1m3water and wastewater are AZM 00.99 and AZM 1.28, respectively. In the revenues and expenditure plan of Azerigaz for 2004, which was approved by the Azerbaijan Republic Cabinet of Ministers, the cost of delivery of gas to consumers was established as AZM 40,991 per 1,000 m3. There i s also a large difference between the costs of heating energy and the current tariffs. For the past years, heating energy tariffs were not changed despite of the significant increase of prices of mazut, natural gas, water, wages and stock that affects the costs of heating energy. In accordance with the decree of Baku Executive Committee dated July 22, 1999 No. 621, the monthly heatingenergy tariffs inBaku were established as follows for groups o f consumers. Consumer Groups Quantity Tariffs,AZM Residentials . Per 1m2 of apartment 250 Budget institutions Per 1m2 of building 600 Other consumers Per 1m2 of building 1,100 Lower residential tariffs than recovery costs of utility services lead to significant subsidization of consumers of utility services (electricity, gas, water, and wastewater) every year. However, the fact that these subsidies are provided implicitly results in further worsening of the viability o f the utility companies, which are unable to obtain a minimumof required resources for maintenance 27 and investments. Infrastructure maintenance i s substantially deferred, the risk of systemic collapse increases, and therefore, the quality of utility services declines. Long-term sustainability and viability of utility companies depend on the ability to cover costs from their revenues, which i s possible only through elimination of subsidies in the sector, tariffs enabling the recovery of the full cost incurred by these companies, enabling financial viability by providing for sufficient resources for investment. Measures currently under implementation The issues to be addressed are economic regulation of electricity, natural gas, water, wastewater and heating services, a need to increase the reliability and quality of services provided to the consumers of these services and to ensure the protection of their rights, implementation of institutional adjustment andrestructuring measures, which meet the international standards. The Presidential Decree dated December 29, 2004 on the State Budget of the Republic of Azerbaijan for the year 2005, paragraph 6, subparagraph 3, instructs to prepare proposals on the introduction of an improved tariffs system to ensure effective use of energy resources, increase the reliability of power supply to consumers and enhance the financial situation of the energy sector. The Government o f Azerbaijan Republic has embarked on a program of economic reforms in the framework of the program to reduce poverty and resolve current and future problems. This program includes improving the utility services sector, enabling the private sector participation in this area, enhancing the financial discipline in the utility sector, increasing the service quality and establishing the efficient regulatory legal framework. The Government of Azerbaijan communicated a Letter of Intent to the World Bank in this regard, where it elaborated its principles. The Letter of Intent covers objectives and principles on the utility services and aims at preparation and approval of the Program on developing institutional mechanisms, which would ensure submission of the relevant draft legislationto Parliament. "Nexant, Inc." provided consultancy services to the Government of Azerbaijan on developing the regulatory legal framework and institutional capacity in electricity, natural gas and water sectors funded through the Public-Private Infrastructure Advisory Facility (PPIAF), multi-donor technical assistance agency aiming at supporting the developing countries to improve the quality of infrastructure with private sector participation. Proposals on institutional adjustment in the sector, on establishing a new regulatory agency and revising the legal framework have been developed and submitted to relevant organizations. In addition, it is currently necessary to develop and implement a medium-term tariff policy embracing the immediate timeframe and consolidating the stages of transition to economically justified tariffs, which would ensure financial discipline, higher service quality as well as investment sources. In recent years, while increases in wages (including the minimum wage) and pensions have improved the ability of the population to pay higher prices for utility services, however, there i s need to ensure that utility services provided to consumers within Azerbaijan are affordable. As 28 the economy continues to expand, the purchasing power of the population will continue to increase and, with it, the capacity to pay higher prices for utility services will increase. In addition, the development and implementation of a targeted social safety net as well as the installation of meters will allow implementing the tariff policy that i s aimed to reach cost recovery for provided services. The establishment of a targeted social safety net will ensure that the most vulnerable continue to be able to afford essential utility services as prices rise towards, and eventually reach, full cost recovery levels. Takmg into account these considerations, the government has taken the initial steps of increasing prices of gas and water. Inorder to prevent the drastic increase of price the delivery costs of Azerigaz was approved to be at the level of AZM 30,000 per 1000 m3.The overall cost of recovery of natural gas, including the operational costs of production, processing and delivery of natural gas i s in the range of AZM 140,000- 150,000. Gas Tariff IncreasesEffectiveas of November2nd,2004 1Customer Groups I AZMper 1000cubic meters Old Tariff I Approved Tariff 1 (includingVAT) Residential Customers 35,560 81,000 83,200 Other (Budget, SOEs, commercial users, etc.) 106,103 194.700 236,000 236.000 1 The increase of tariffs will lead to improvements inthe financial-economic activities of Azerigaz JSC and elimination of subsidies extended to the joint-stock company. Starting from January 1,2005 the Government, after the review of water prices, established new tariffs of AzerSU for the areas of the former ARWC as follows: Customer group Old New (wlo VAT) (wlo VAT) Domestic 185 370 Budgetfundedentities and equal to those 900 1,200 Other customers 2,500 5,300 2,700 Producersof bottled water 42,000 42,000 Technical water 1,200 1,200 For new tariffs the customer groups of "Trade and services" and "Industry" were merged in one group "Other customers". Future increases in water tariffs will be linked to improvements in the performance of AzerSU and regulations of the power energy tariffs. 29 At the same time, the government i s cognizant of the importance of accurately measuring the quantities of electricity, gas and water delivered to state consumers. Currently, actions to approve and start the implementation of a program to install meters for all consumers of electricity, gas and water are initiated. Accordingly, there are precise instructions to the relevant institutions: (i) to prepare proposals on the costs of installation of meters required for electricity, gas and water supply services as per the Presidential Decree dated December 29, 2004 on the State Budget of the Republic of Azerbaijan for 2005 year, paragraph 17; and (ii) to ensure the installation of meters, advance these efforts in accordance with the established completion dates as per the Resolution of the Cabinet of Ministers dated January 10,2005, No. 8 and January 12,2005 No. 13. Medium Term Tariff Policy and Envisaged Measures It is provisioned to resolve the following problems through the approval of the Medium Term Tariff Policy with implementationperiod of 2005-2010: 0 The implementation of the Medium Term Tariff Policy taking into the consideration the problems stated above in his document; 0 Untilthe end of the implementation period for the Medium Term Tariff Policy, increase tariffs for utility services in a staged fashion that gives full consideration to the affordability of these tariff increases; 0 Recognize the connections between the costs of the various utility services (for example, talung into account that the costs for water and wastewater services are heavily influenced by the cost of electricity), increase of electricity tariffs together with the tariffs for water and wastewater in order to ensure that the objective of full cost recovery can be achieved; 0 Discontinue financial support to utility entities from the State Budget; 0 Ensurethe sufficiency of tariffs for all utility services to allow full cost recovery, and the financial viability of the utility entities; 0 Motivate restructuring of various utility entities and enterprises, improvement of corporate governance, enhancement of quality of services, reduction of losses and savings on consumption from the perspectives of resolution of tariffs issues; 0 Introduce on the basis of successful experience of similar reforms in other countries the mechanism for targeted social assistance to low-income families and appliance of such mechanism to eliminate the negative impact of tariffs increase; 0 Review tariffs for power supply until January 2006 in case o f the establishment of targeted social assistance mechanism; including: 30 0 Regulation of wholesale prices and transmission tariffs for Azerenergy; 0 Regulation of retail prices for BARMEK and BAYVA; 0 Regulations of heating energy tariffs. 0 Implement the review of tariffs in the following areas on the basis of the economic justification and cost recovery: 0 Regulation of tariffs for drinking water (by various regions); 0 Regulation of tariffs for wastewater (by various regions). 31 i--t+-i 6 I , , , mi a 3 rt Annex 2: Major Related Projects Financed by the Bank and other Agencies AZERBAIJAN: Power TransmissionProject Sector issue Project Implementation Development Progress (IP) Obiective (DO) Bank-financed Power Sector Restructuring PPIAFSupport for Power Sector na na Restructuring Gas Sector Restructuring PPIAF Support -Gas Sector na na Restructuring Reform of Social Protection Second Institution Building S S System Technical Assistance (2002, SDR 7.47 mill.) Gas Infrastructure Rehabilitation Gas System RehabilitationProject S U (2002, SDR 14.1mill.) Power Sector Restructuring SAC I1(2002, SDR 48.4 mill) S S IndependentUtility Regulation PRSC-1(2005, SDR 13.1mill.) na na PPIAF Support for Development of Regulatory Framework and Institutional Capacity inElectricity, Natural Gas, and Water (2003-04) Improvement inEffectiveness Pension and Social Assistance S S and Transparency of Provision Project (2004, US$10mill.equiv.) of Pensions and Social Assistance Other development agencies EBRD YenikendHydroelectric Plant Rehabilitation (1994, EUR42 mill EBRD Mingachevir Hydroelectric Plant Rehabilitation (1997, EUR 17 mill JBIC Reconstruction of Shimal GRES Power Plant (1998, JPY 20.2 trillion) KfW Substation Rehabilitation Project (1998 EUR 12 mill.) KfW Second Substation Rehabilitation Project (2003, EUR 12mill.) USAID Technical Assistance for Utilities Regulation 33 Annex 3: ResultsFramework and Monitoring AZERBAIJAN: Power Transmission Project ResultsFramework PDO Outcome Indicators Use of Outcome Information Improvethe efficiency of the power Improved efficiency of fuel use per zontinued high fuel consumption transmission operation in Azerbaijan kWh of electricity generatedthrough 3er kWh may indicate that rules of through technical and institutional Economic Dispatch and reduced xonomic dispatch are being ignored strengthening of the generation/ transmission losses. ndeference to other considerations transmission utility. which need to be addressed in an Improved reliability and quality of institutional context. Alternatively it Secondary objective: Contribute to electricity supply with respect to nay signal a need for additional strengthening Azerenerji's financial frequency and duration of forced investment in transmission capacity. position. outages. Zontinued forced outages related to Inline with legal covenants, line failures may help to identify Azerenerji's financial position xitical problems in other parts of the would be strengthened (i.e. need for network, signaling a need for Govt. financial support reduced additional investment in network eliminated) as a consequence of (a) rehabilitation. tariffs that increase over time to cover full costs, and (b) increased Lack of increased payment payment collections. collections (in accordance with contracts with distributors) should (a) trigger actions to ensure that distributors fulfill contractual their obligations and (b) trigger increased financial support to Azerenerji as necessaryto meet its financial needs until the problem is solved. Lack of tariff increase according to agreed plan should trigger a dialogue between the Government and the I Bank, and if necessarytrigger the use of remedies available to the Bank inlegal covenants. 34 Intermediate Results Results Indicators for Each Use of Results Monitoring One per Component ComDonent I ComponentOne: Component One: Zomponent One: SCADA and Telecommunications Average fuel consumptionper kWh 'ailure to achieve at least initial generated will decreaseby 1.5%. mprovement in fuel consumption Reduced cost and improved quality indquality of supply may signal that 3f electricity in Azerbaijan. Gridvoltage and frequency will be ;ome of the features of the SCADA maintained within defined ranges ;ystem are not being used correctly (voltage within +5%, -10% of indthat additional training is nominal at bulk supply points; .equired. frequency within 50 Hz k 0.5 Hz). ?oor performance with respect to Transmission losses will decline .ransmission loss targets may from 5.0% to not more than 4.5%, .ndicate the existence o f non- with corresponding savings infuel :ethnical losses which need to be cost. identified and eliminated. Component Two: Component Two : Component Two: TransmissionNetwork [frehabilitated lines continue to fail, Rehabilitation work may not have been carried out Forced outages on rehabilitated inaccordance with specifications Reduction of forced outages. transmission lines decline and work crews' performance will significantly. needto be reviewed and monitored more carefully. Overall network outages decline. Component Three: Component Three: Component Three: TechnicalAssistanceand Training Delays in the implementation of Projects are implemented ina timely project components may mean that Improved technical and financial manner. additional implementation support i s operation of the Azerenerji grid. required. Azerenerji staff are confident intheir ability to manage the SCADA Continued uncertainty on the part of system without outside assistance. dispatch staff with respect to the use of the SCADA system may mean GridCode drafted and adopted. that additional training i s needed. Azerenerji has inplace a qualified Delays indrafting and adopting a team and competently reports GridCode may signal either a accordingto IFRS. misunderstanding with respect to its purpose or a more fundamental resistance to the concepts of open network access. IfAzerenerji at end of parallel accounting period still incurs a high number of errors, extended and intensified training may be warranted. 35 s8 - ch 0 P3 g g 8 L" 4 0 0 e - g g m o o * * * * * * * 5% * * * s8 o\ 0 - 8 N \o 0 - 0 N vi 0 8 .* *h ** ,- C * * * n* Annex 4: Detailed Project Description Azerbaijan: Power Transmission Project 1. Project Overview The proposed project has four main components, as follows: ComponentA: Power System Management The component provides an upgrading of Azerenerji's dispatch system and includes the following subcomponents: 0 SCADALEMS system implementation. This subcomponent includes installation of the necessary hardware and software to enable real time acquisition of operational information from generating stations and HV transmission system substations, analysis and monitoring of the network status at the National Dispatch Center, and control and dispatch of the generating plants and the HV transmission system, to maintain a reliable, secure and economic operation, and facilitate financial settlements in a future wholesale electricity market. The main elements of the system include the Supervisory Control and Data Acquisition (SCADA) system and the Energy Management System (EMS) at the National Dispatch Center (NDC), a Backup Control Center (BCC) in Baku, and Remote Terminal Units (RTUs) at the generating plants and HV substations. SCADA system elements provided under KfW financing will be incorporated into the full-scale SCADABMS system. 0 Telecommunications network upgrade. This subcomponent includes installation of the necessary communications equipment - fiber optic cable systems, power line carrier systems (PLC), and telephone systems - to meet the communication requirements of dispatch, metering and HV network operations and maintenance. It will also provide broadband communications facilities between major Azerenerji offices and generating plants to support improvements inAzerenerji financial management and administration. 0 Station adaptation and metering. This subcomponent covers adaptation of generating plant and substation control and metering circuits and equipment to provide alarm, status and metering inputs to the RTUs and accept control outputs from the RTUs. Since this i s the first installation of a SCADA system on the Azerenerji generation and transmission network and the majority o f the stations and equipment are very old, it will be a long and difficult task to design and install modifications to the station control circuits and equipment that will provide inputs to the RTU that will support basic monitoring and remote control SCADA functions, plus sequence-of-events recording, disturbance analysis and real-time load flow features on the SCADABMS system. It will also include installation of remote access facilities to existing and new energy meters at all interconnecting points to the bulk power transmission grid from the generating plants, HV interconnections with neighboring networks and each 110 kV and lower voltage supply point to the privatized distribution networks to enable accurate control and settlement of power sales and impodexport contracts. 38 0 Fuel meters will also be provided for each major thermal generating unit for economic dispatch operations. The station adaptation work to design, install and test each modification to the existing substations and generating plants must be performed by a team of Azerenerji engineers and technicians attached to the PIU. The Azerenerji personnel assigned to this task must be well- experienced with the existing protection and control systems and be authorized to obtain assistance from engineers and technicians at each substation and generating plant as and when required for this task. Azerenerji must begin the station adaptation work immediately, due to the amount of work involved and the needfor the station adaptation work to be completed before the RTUs can be connected and the SCADA system put into service. Delays in completion of this work are the most common and severe cause of delays in completion of SCADMEMSprojects. ComponentB: TransmissionNetwork Rehabilitation This component covers the most urgently needed replacement and repair of high voltage transmission line elements and rehabilitation measures in selected high-voltage substations. Sub- components originally proposed by Azerenerji included: 0 repairs to one 500 kV and two 330 kV transmission lines; 0 replacing damaged conductors with higher rated conductors and replacing porcelain insulators with glass insulators on eight 220 kV transmission lines; 0 replacing towers and conductors on three 110kV transmission lines; and 0 replacing seven transformers with higher capacity units at one 330 kV, one 220 kV and two 110 kV substations, adding a transformer at one 330 kV substation and replacing miscellaneous power system apparatus at three other substations. The network development plan study and associated protection relay coordination analysis under Component C may also identify high priority, least-cost solutions to improve voltage control, reactive power support and network stability. These items could also be eligible for financing under the Loan if considered of higher priority than the components identified during project preparation, or if funds otherwise are available. Availability of funds for transmission network rehabilitation will be known after the dispatching system contract price i s determined and that contract i s awarded. Component C: Management Assistance This component consists of technical assistanceto assist with: Azerenerji's transition to International Financial Reporting Standards (IFRS) 0 IntegratedManagement Information System (MIS) 0 Assets Revaluation 0 Development of revised GridCode 0 Transmission costing 0 Transmission Network Study Company and project audits 0 Dispatch System Procurement (started duringproject preparation) 39 0 Project Management and Technical Support a. Project management b. Procurement assistance c. Technical Specialist assistance d. Environmental management 0 Dispatch Training One of the objectives of this component i s to assist Azerenerji in developing core accounting systems to meet the requirements of the new Law on Accounting and the company's transition to InternationalFinancial Reporting Standards (IFRS) no later than by January 1, 2008. In order to substantially improve the management of the company, the new financial system will be one of the core components in an Integrated Management Information System, which would have functional modules expected to include (but not be limited to) General Ledger, Accounts Payable, Accounts Receivable, Fixed Assets Management, Materials Management, Personnel and Payroll, and Report Generator. Revaluation of Assets, to be financed under this component, i s a precondition for auditors to conclude audits based on IFRS. Technical Assistance (TA) would also be provided to prepare Azerenerji for a future restructured energy sector, including the development of a revised Grid Code, and the development of transmission costing as basis for a separate power transmission tariff. A Transmission Network Study will incorporate a protection relay coordination study and address issues o f system stability as well as development plan for the network. The study may point to high value rehabilitation work and investments that might influence prioritization of system rehabilitation subcomponents to be financed under this project, although many of the identified subcomponents have been characterized as "must do" investments. ComponentD: Project Implementation This component includes the incremental costs associated with the establishment and operation of a Project Implementation Unit created by Azerenerji specifically for implementation of this project. Items to be financed from the loan include incremental office furnishings and equipment, incremental office operating expenses; accounting and office software; interpretation and translations; overseas travel expenses for PIU team members for project-related meetings, training, and to witness in-plant tests. Azerenerji has not chosen to use this project for developing corporate capacity in environmental issues. Environmental TA will be made available as required to ensure implementation of the project in accordance with Azerbaijan and World Bank environmental standards. 2. Detailsof TechnicalInvestments The following sections provide additional detail on the items that will be included in Components A and B. 40 2.1 DispatchSystem Technically satisfactory operation of a generation and HV transmission grid means unimpeded, reliable, and efficient flow of electricity from generating plants to the distribution utilities supplying the consumers. To achieve this, the generation and transmission grid must have adequate transmission lines and substations as well as means to continuously plan, control and monitor the operation of the complex HV transmission network. Given the nature of the physical processes involved, grid operation must be centrally monitored and controlled in real time. This requires continuous collection of information from geographically dispersed facilities (generating plants and HV substations) and transmission of this information to the National Dispatch Center and Backup Control Center and communication of dispatch control commands (either automated or executed by personnel manning the facilities) to locations where action must be taken. For this reason, a modem power grid dispatch system includes an elaborate system of data acquisition and metering devices, data transmission and communication channels, computers and software, physically and functionally integrated to ensure secure and reliable operation of the grid. The transmission network in Azerbaijan, with its associated dispatch and communications facilities, suffers from years of neglect, maintenance backlogs, and lack of investment in upgrades and new equipment. Many of the main substations are over 40 years old. The substations had previously been well maintained, but maintenance has suffered over the past 10 years or more due to the lack of spare parts and the age of the installations. At present, most of the problems are the result of insufficient maintenance (lack of funds for spare parts and/or unavailability of spare parts) and extreme operation conditions (e.g. large number of on-and-off switching of circuit breakers because of grid overloads and instability). The existing dispatch system, with its present telemetry equipment and massive, detailed static mimic diagram board, was installed over two decades ago. It i s based on old Soviet technology, which i s difficult to maintain, due to unavailability of spare parts. The telemetry system covered only 450 out of an estimated 5,800 measurement values required from generating plants and substations in Azerbaijan. Other real-time data (e.g., equipment alarms, circuit breaker and transformer tap-changer positions, power flows and bus voltages, energy meter values, etc.) are not available to the dispatchers and there i s no capability for remote control. Dispatchers rely on their many years of experience at the NDC in directing operation of the generating plants and HV network plus an obsolete dispatcher telephone system to obtain updated information on the status of the grid and issue verbal commands to station operators. This lack of adequate real- time data and grid overview faculties at the N D C makes an already difficult and complex job very stressful and frustrating for the dispatchers. Repair and upgrading of the existing, outdated dispatch and telemetry equipment to meet the requirements for safe, reliable and economic operation of the generation and HV transmission grid i s not possible. A new SCADA/EMS system will be provided, including a dispatcher training simulator at the N D C and Remote Terminal Units (RTUs) at each generating plant andHV substation. The dispatch system will utilize the following major components, all combined into an integrated dispatch system: 41 SCADAEiMS system consisting of a master station at the National Dispatch Center (NDC) and Backup Control Center (BCC) and Remote Terminal Units (RTUs) at substations and generating plants, plus a small master station and RTUs for the isolated gridin Nakhchivan; Telecommunication system, and Station control and metering system adaptation at substations and generating plants. SCADA/EMSSystem Functional performance technical specifications for the SCADAEMS system will be prepared by consulting firm KEMA Engineering (in partnership with Dar A1 Handasah, the consortium hereinafter called KEMA) together with its client Azerenerji. The SCADAEMS system will be located at the NDC; however, in accordance with industry best practices, a backup control center (BCC) will also be established (in Baku). The initial SCADA master station provided under KfWfinancing will be integrated into one of the master stations at the NDC or BCC. KEMA shall ensure that the following subsystems are adequately defined for the SCADAEMS system: a) SCADA system, including, but not limited to data acquisition, supervisory control, data processing, full graphics man machine interface, alarming, logging, tagging, trending, sequence of events recording, disturbance data recording, historical data collection and reporting, and data links. b) Generation Management System, including, but not limited to load frequency control, tie-line interchange control, reserve monitoring, economic dispatch, unit commitment, hydro scheduling, hydro-thermal coordination, production costing, energy accounting and penalty factor calculations. c) Network Management System, including, but not limited to network status processor, network model builder, state estimator, power flow, contingency analysis, transmission loss penalty factor, dispatcher power flow, optimal power flow, voltage/MVAr scheduler, short-circuit calculation, dynamic security assessment and available transmission capacity. d) Operations Planning System, including, but not limited to outage scheduler, short-term load forecast and transaction evaluation. e) Dispatcher Training Simulator. f> Uninterruptible power source for the NDC andthe backup control center. Telecommunications Network The existing Azerenerji telecommunications network i s based on power line carrier (PLC) links, some communication cable carrier systems, a dispatcher telephone system and mobile radios that are almost entirely obsolete and cannot support the new SCADA/EMS system. The new 42 telecommunications network will incorporate digital communications technology and utilize fiber optic cables for a high-capacity telecommunications backbone to major generating plants and substations and PLC links to smaller substations. A new dispatchers' telephone system will also be provided, together with new PABXs at major Azerenerji sites. The requirements for dispatcher voice, SCADA data, mobile radio, teleprotection signaling, and other operational communications services were discussed by KEMA with Azerenerji and analyzed during preparation of the Feasibility Study. Based on these requirements, KEMA developed a recommended telecommunications network topology. This takes into consideration the bandwidth requirements to each substation and generating plant, types of equipment suitable for use in electric utility telecommunications networks, and the costs of the equipment and installation and testing services. Telecommunications facilities available in Azerbaijan from other major utilities were also investigated, including Aztelkom, Azerbaijan Railways, and the BTC oil pipeline, but these organizations had no interest in cooperating with Azerenerji injoint use or development of communications facilities. KEMA also analyzed the existing Azerenerji telecommunications network of power line carrier, cable carrier, mobile radio and other facilities. The mobile radio system in use by Azerenerji i s new and i s considered adequate by Azerenerji. The telecommunications network will be based on a fiber optic cable backbone consisting of three interconnected rings; two short rings (Rings 1 and 2) totaling 43 km in the Apsheron peninsula and a 988 kmring (Ring 3) westward to the major thermal and hydro generating plants and Ganja regional office. Fiber optic cable (and power line carrier to smaller stations) spurs will be established between nodes on the rings and outlying stations to provide required capacity to these stations. Rings 1and 2 will utilize 24 strand fiber optic cables in underground ducts and optical ground wire (OPGW) on HV transmission lines. Ring 3 will utilize 12 strand OPGW, rather than 24 strand, since 12 additional strands would cost about $2 million and there i s no realistic Azerenerji requirement or other market for this additional capacity. The existing obsolete dispatchers' telephone system, PABXs and PBXs will be replaced with a new dispatchers' telephone system andinterconnected PABXs. The telecommunications network required for the Nakhchivan grid will likely utilize powerline carrier and a small dispatcher telephone system with a thin route data link to the NDC. Functional performance technical specifications to be prepared by Azerenerji and KEMA for the telecommunications network equipment shall ensure that the following subsystems are adequately defined: Dispatcher telephone system; SCADA data network; Teleprotection signaling channels between HV substations; Azerenerji operations and administration telephone system; Broadband Wide Area Network (WAN) linking major Azerenerji offices and generating plants on the fiber optic network; Telecom quality 48 Vdc battery and charger plants for the RTUs and telecommunications equipment at substations, generating plants and major offices; and 43 (g) Other telecommunications facilities required by Azerenerji for efficient and effective operations. Station Adaptation and Metering Station adaptation and improvements to the energy metering equipment are required at generating plants and substations. This will involve adaptation of the station control and metering circuits and equipment for interconnection with the RTUs. Due to the age of the stations and equipment and the large number of RTU input and output points required, this will be a difficult and lengthy task. KEMA discussed the size of SCADAEMS system with Azerenerji and identified the types of input and output points for a typical RTU and the transducers and station adaptation work required for each type of point to provide the real-time data required for proper operation of the SCADA andEMS functions. Energy meters were installed at HV substations in 2001/2002 at the interconnection points with the privatized distribution utilities and generating plants. The meters record real and reactive power flows and are presently read manually by Azerenerji station personnel, however the meters are equipped for interconnection with SCADA RTUs. Azerenerji and KEMA estimate that 160 additional meters will be required to replace other existing but obsolete meters used for both commercial and operational metering. The existing voltage transformers (VT) and current transformers (CT) associated with the energy meters and SCADA telemetry varies in age and accuracy. Some will need to be replaced, but the quantities required will only be determined during detailed design of the station adaptation works. Fuel meters will be provided for the 17 major thermal generating units at the three major thermal generating plants to enable accurate on-line modeling and economic dispatch of these units. Technical specifications are to be prepared by KEMA for required transducers, meters, cables and other material required for station adaptation by Azerenerji personnel. The Bill of Material for the cables and other material required for station adaptation will be prepared by the Azerenerji PIU, based on designs prepared by the Azerenerji project team responsible for designing and implementing the adaptations required at each generating plant and substation. 2.2 Rehabilitationof SubstationsandTransmissionLines Rehabilitation of transmission facilities (HV transmission lines and equipment at substations) will improve system reliability and efficiency and enable better integration with the neighboring networks. Consulting firm Burns and Roe performed load flow and short circuit studies in 2003 as part of the Prioritization of Investment Needs for Power Generation and Transmission report funded by EBRD. The Burns and Roe study identified transmission line and substation rehabilitation items required in 2006/2007 and beyond to relieve transmission network overloading, primarily on the 110kV network and also transmission network additions that would be requiredfor the proposed 400 MW generating plant at Shimal on the Apsheron peninsula. The report also attributes the 44 causes of the major power system outages during the winters of 2001 and 2002 and the blackout in June 2002 to insufficient generation capacity, transmission line overloads and protection relay settings. The system has suffered from a lack of regular maintenance, due to non-availability of spare parts, and due to the age of the installations. Most of the equipment i s more than 40 years old and in some substations even older than 50 years, which i s well beyond the expected physical lifetime. Azerenerji identified a list of the most urgently needed transmission rehabilitation measures, based on their knowledge of the network and the rehabilitation items beingfunded by KfW. The items can be summarized as follows: a) replacing 1,980 corroded anchor bolts with preformed concrete anchors on guyed towers, replacing 17 and adding 3 towers, replacing 13,950 porcelain insulators with glass insulators and installing various transmission line hardware on one 500 kV and two 330 kV lines, b) replacing damaged ACSR (AluminumConductor Steel Reinforced) conductors with higher capacity ACSR conductors and replacing 29,300 old porcelain insulators with glass insulators, installing various transmission line hardware and reinforcing tower cross arms on eight 220 kV transmission lines, c) replacing copper conductors with higher capacity ACSR conductors, replacing porcelain with glass insulators and installing various transmission line hardware on three 110kV transmission lines, and d) replacingfour autotransformers with higher ratedunitsat one 330 kV and one 220 kV substations, adding a transformer at one 330 kV substation, replacing three 330 kV circuit breakers at a substation, replacing three transformers with higher rated units at two 110 kV substations and replacing a station battery and a bank of 10 kV switchgear at two 110kV substations. Discussions with Azerenerji regarding the items proposed indicated that Azerenerji will have competent and adequate construction and maintenance personnel to handle installation and testing of the rehabilitation items, rather than having the work done by international or local contractors. The PIU will be responsible for arranging for procurement of the material and equipment involved and for coordination of the tasks within the rehabilitation items. Azerenerji have also requested an Asset Management software package to improve network reliability and reduce the costs of maintenance and asset renewals and additions. Azerenerji also propose purchase of insulator washing equipment and note that some of the existing current transformers and voltage transformers may require replacement to meet the requirements of the upgraded energy metering system, if adequate funds are available from the loan. Cost estimates are based on the Feasibility Study conducted by KEMA, an international consultant firm with broad experience in this type of project. The estimates are consistent with similar projects in the region. Physical contingencies were estimated at 5 percent. Price contingencies for locally procured goods and services were based on the I M F N o r l d Bank projections for Azerbaijan, and for imported equipment were based on World Bank projections for the international manufacturers' unit value (Muv)index. 45 Annex 5: Project Costs AZERBAIJAN: Power Transmission Project Project Cost By Component and/or Activity Local Foreign Total US$000 US$ 000 US$000 Transmission Network Rehabilitation * * * Sub-total 6,476 39,338 45,814 Management Assistance 295 2,988 3,283 Project Implementation 361 338 699 Unallocated 0 240 240 Total Baseline Cost 7,132 42,904 50,036 Physical Contingencies 366 2,199 2,564 Price Contingencies 366 2,199 2,565 Total Project Costs' 7,864 47,301 55,165 Front-end Fee 0 240 240 Total Financing Required 7,864 47,541 55,405 * Detail suppressed. 'There are no identifiable taxes or duties; the total project cost, net of taxes, i s US$55.41 million. Therefore, the project cost net of taxes i s 100percent of the project cost. 46 Annex 6: Implementation Arrangements AZERBAIJAN: Power TransmissionProject The executing agency responsible for project management and implementation would be the Borrower, Azerenerji OJSC (open joint stock company). Azerenerji i s the state-owned enterprise responsible for operation and management of the high-voltage transmission network and the major thermal and hydroelectric generating stations. On the Government's side (the Government providing sovereign guarantee), executing agency would be the Ministry of Finance. The Ministry, and in some cases the Borrower, would provide coordination with other Government agencies, notably Ministry of Economic Development (MED), Ministry of Industry and Energy (ME),Cabinet of Ministers, and the Tariff Council, and with bilateral and multilateral financing agencies as needed. The Ministry of Finance may delegate some Government coordination and oversight responsibilities to other ministries (MED and/or ME)that these ministries are believedto have the capacity to handle. Azerenerji has established a Project Implementation Unit for the proposed project, reporting to the Chief Engineer (First Deputy President) and staffed by specialists in technical, financial, environmental, and procurement matters, to act as the Bank's counterpart on day-to-day matters. The PIU i s currently responsible for project preparation. Once the loan i s approved and effective, the PIU will be responsible for project implementation, including procurement, contract supervision and management, and project financial management, including project accounting, financial reporting, loan disbursements, and arrangements for external audit. 47 Annex 7: Financial Management and Disbursement Arrangements AZERBAIJAN: Power TransmissionProject 1. Summary and Conclusions-Financial Management An assessment of the adequacy of the project financial management systems at the Azerenerji and the PIU within Azerenerji was carried out during project preparation, and updated at appraisal, to ensure the systems can provide to the Bank accurate and timely information regarding project resources and expenditures. The Project's financial management systems meet Bank requirements for project implementation. Such systems include accounting, financial reporting, staffing, internal controls, auditing, and loan disbursements arrangements. The PIU has installed a LOGO system for accounting and financial reporting for both the company and the Project. The Project system has been customized to automatically generate the quarterly Financial Monitoring Reports. The LOGO systedsoftware has multi-currency and multi-language capacity and would be used for general accounting and reporting to local authorities and to the Bank. The accounting books and records are maintained on accrual basis and project financial statements presented in U S Dollars and in local currency (Manat). The PIU will prepare and submit to the Bank quarterly Financial Monitoring Reports comprised of financial reports, project progress reports and procurement management reports. The PIU would also submit monthly, quarterly and annual reports on sources and uses of funds to the Ministry of Finance, the Ministry of Industry and Energy, and the National Bank. In addition, the PIU would be required to submit statistical accounting statements to the Ministry of Taxes and the Department of Statistics. The accounting policies and procedures that are an integral part of internal controls are considered adequate, and are documented in an Accounting and Financial Management Manual. The key staff of the PIU (director, accountant and procurement specialist) are employees of Azerenerji selected from various departments. The project accountant i s the deputy chief accountant of Azerenerji who i s a qualified and experienced accountant. H e i s currently the accountant for an ongoing EBRD loan and the PHRD Grant used for preparing the Power Transmission Project. The proposed project includes a TA component to further develop Azerenerji's (the company) integrated accounting system and assisting the company in the implementation of International Financial Reporting Standards and related management information systems. Overall financial management risk for the Project i s considered moderate. 2. Country Issues The Azerbaijan Country Financial Accountability Assessment diagnostic work carried out in 2002 recommended accounting and auditing regulatory and institutional reforms to increase accountability and good governance inthe country. Most of the key CFAA recommendations on legal and regulatory reforms and institutional capacity building are addressed in the proposed three Poverty Reduction Strategy Credits (PRSCs), and the recently approved Institutional Development Fund Grant on Accounting and Auditing Reforms. A new Accounting Law and related secondary regulation mandating use o f International Financial Reporting Standards 48 (IFRS) for public interest entities and governmental enterprises, and International Public Sector Standards (IPSA) for the public sector has been approved by Parliament. The Accounting Law would assure greater transparency and accountability of public funds. In parallel, the enactment of the new Audit Law currently under preparation, and establishment of regulatory and institutional frameworks for the Chamber of Accounts, the Country's Supreme Audit Institution and the Chamber of Auditors, the audit profession regulator and standard-setter would provide greater transparency and comparability of financial Reporting. 3. RiskAnalysis-Financial Management Risksassociated with the Project's financial management systems are summarized below, and outlined in a report available in the Project files. accountability and governance. PricewaterhouseCoopers. 7. Reportingand Monitoring Moderate Quarterly FMRs to be agreedat negotiations 8. Information Systems Moderate Upgraded systeminplace and operational. Overall Control Rxk IModerate I H-High S - Substantial M-Moderate N-Negligible or Low 4. Strengthsand Weaknesses Although the PIU has not implemented other World Bank financed projects, the staff have experience in implementing EBRD and KfW funded projects. The timing of the ongoing accounting and auditing reforms in the country and policy reforms under planned PRSCs would mitigate risks and benefit the Azerenerji in capacity building and in the transition from National Accounting Standards to International Financial Reporting Standards (as supported financially under this project). 49 5. Implementing Entity The project will be managed and implemented by Azerenerji through the PIU established with overall responsibility for procurement, contract supervision and management, and project financial management, including financial reporting, loan disbursements, and arrangements for external auditing b y independentauditors. Ministry of Finance would be the formal counterpart in the Government (the Guarantor), but some coordination responsibilities may be delegated to the Ministry of Economic Development (MED)and or the Ministry of Industry and Energy. 6. Staffing The key staff o f the PIU include: Project Director, Finance Officer, Project Accountant/ Disbursement Officer and Procurement Specialist, all selected from technical units within Azerenerji, and with experience in implementing other international donor-funded projects. The Project Accountant i s the Deputy Chief Accountant of Azerenerji. Focused local and international training in financial management, disbursements, international accounting and auditing standards will be provided through the project to the PIU accounting and financial management staff. The selected accountant for the PIUhas already taken training offered by the EUTACIS on international accounting and auditing standards, and Bank workshop on the new Audit Policy. 7. Flow of Funds The Bank Loan of US$48.0 million and Government counterpart funds of US$7.4 million will finance the project costs estimated at US$55.4 million. The funds will be disbursed through the Bank's traditional disbursement procedures described in the disbursement arrangements paragraph of this PAD. The Bank Loan will be provided directly to Azerenerji and the Government will provide a sovereign guarantee. Disbursements from the IBRD Loan will be transaction based to finance eligible expenditures for goods, works, technical assistance, and recurrent costs based on the disbursement percentages agreed in the Loan Agreement. To facilitate timely project implementation, the borrower will establish, maintain, and operate a Special Account denominated in US dollars, under terms and conditions acceptable to the Bank. The Special Account will be held in a commercial bank acceptable to the Bank. Other methods of loan disbursements will include reimbursements, disbursements on the basis of Statements of Expenditure (SOEs), and direct payments. 8. ExistingAccounting Structure, Systems, and Controls The current Azerenerji organization structure within the financial management and accounting function consists of three departments segregated along the following lines: (i) Finance; (ii) Accounting; and (iii) Planning. The Accounting Department i s responsible for recording and summarizing transactions, and reporting the results periodically to management and relevant Government entities. Currently, the Accounting Department at the Head Office uses an in-house designed accounting system for consolidating financial accounts and information received from the subsidiaries. The accounting i s decentralized at the subsidiary level. Statutory forms are 50 prepared quarterly by the subsidiaries and submitted to the Head Office for consolidation of the accounts and financial reporting to various Government entities. Each of the subsidiaries has a Chief Accountant who in turn reports to the Chief Accountant at the Head Office. Consolidations and financial reporting i s based on modified accrual accounting applying National Accounting Standards. 9. Accounting Policiesand Procedures The existing accounting policies and procedures that are an integral part of the internal control environment, and have been updated and documented in an Accounting and Procedures Manual (the Manual) to enable management to monitor accounting transactions at all levels of project management. 10. ProposedAccounting Systemand Financial Reporting Greater centralization of accounting functions and full automation of the accounting and financial reporting system would allow financial information to be collected and reports generated off source data in the general ledger, and allow for uniform policies and procedures. The upgraded system would be used for accounting and financial reporting for the Project, instead of inventing a stand-alone system for the project. Delays and loss of data will be minimized, and adequate controls put in place compared to the current decentralized system. Books of accounts and financial reporting would be based on modified accrual basis of accounting. Azerenerji i s required under the new Accounting Law to apply International Financial Reporting Standards issued by the International Accounting Standards Board (IASB). 11. Reporting and Monitoring Quarterly Financial Monitoring Reports (FMRs) will be prepared for the Project and submitted to the Bank no later than 45 days after end of each quarter. The FMRs will comprise of: (i) Financial Reports; (ii)Project Progress Report; and (iii)Procurement Management Report. These reports will provide information on the progress of the project in terms of financial activity, key output measures and procurement for the relevant quarter. The reporting and format of the F M R s was confirmed at negotiations. Azerenerji's financial statements comprising of balance sheets, income statements, statement showing changes in equity, cash flow statements and notes to the financial statements, will be prepared in accordance with International Financial Reporting Standards. 12. Auditing Arrangement External Audit. The World Bank New Audit Policy will be applied. Although a single audit for Azerenerji financial statements will be issued, the selected auditor will however review arrangements surrounding use of the Special Account and the Statements of Expenditure. The audit will be carried out by independent auditors in accordance with standards and terms of reference acceptable to the Bank. The audit report for Azerenerji financial statements, including Project financial statements, will be submitted to the Bank within six months of the end of each 51 fiscal year, and also at the closing of the project. As agreed with Azerenerji, and on condition the Bank procurement agrees, Azerenerji will retain the current auditors of PricewaterhouseCoopers as auditors for the Project. The contract for the audit would be awarded during the first year of project implementation and extended subject to satisfactory performance. The cost of the audit will be eligible for financing under the Loan. The auditing arrangements were confirmed at negotiations. Zntemal Audit. A proper internal audit function being an appraisal to examine, evaluate and monitor the adequacy and effectiveness of the accounting and internal control systems, i s rather weak in Azerbaijan. A strategy to develop an internal audit function in the country i s being addressedunder the PRSC. 13. FinancialCovenants. Azerenerji and the PIU will be required to maintain a financial management system, including records and accounts, and prepare financial statements in a format acceptable to the Bank, adequate to reflect the operations, resources and expenditures related to the Project. Quarterly F M R s will be submitted to the Bank no later than 45 days after end of each subsequent calendar quarter. The accounts and financial statements would be audited each year by independent auditors, and audit submittedto the Bank no later than six months after end of each year audited. Other financial covenants are elaborated inthe financial analysis section of the PAD. 14. Impactof ProcurementArrangements Based on diagnostic work carried out under the Country Procurement Assessment Report (CPAR) issued in June 2003, the legal framework, enforcement regime and procurement capacity were identified as areas that require strengthening. Azerbaijan has introduced a new Public Procurement Law (PPL) that i s based extensively on the United Nations Commission for International Trade Law (UNCITRAL) model. The PPL has set up a three-tier review system that consists of an internal administrative review by the State Procurement Agency (SPA) and judicial review. Perception of the courts' ability to deal with procurement disputes i s poor, thus jeopardizing the SPA'Slevel of confidence and overall transparency in the review process. The SPA has been vested with the procurement regulatory functions and has shown a willingness to ensure compliance with the Public Procurement Law (PPL). 15. SupervisionPlan During project implementation, the financial management staff would conduct risk-based financial management assessment to ascertain that: (i)financial accounting and reporting i s adequate; (ii) flow arrangements of the project effectively support the project's objectives; funds and (iii) the quarterly FMRs and the annual audit reports (with accompanying Management Letters) are submitted on time, and meet legal requirements. 52 16. Disbursement Arrangements The table below sets forth the Categoriesof itemsto be financedout of the proceedsof the Loan, the allocation of the amounts of the Loan to each Category and the percentage of expenditures for items so to be financedineach Category: Allocation of Loan Proceeds: Amount of the Loan Allocated (Expressedin Category Dollars) % of Expendituresto beFinanced 160,000 80% 44,5 10,000 100%of foreign expenditures, 100%of local expenditures(ex- factory costs), and 80% of local expendituresfor other items procuredlocally (3) Consultants' Services 2,470,000 75% of local expendituresfor and Audits individual consultantsdomiciled within the territory of the Guarantor, 95% of local expenditures for consultingfirms domiciled within the territory of the Guarantor, 85% of foreign expenditures for services of other consultants, and 100%of eligible socialcharges (4) Training 100,000 100% (5) Incremental Operating 280,000 75%, and 100%of eligible social costs charges (6) Front-endFee 240,000 Amount due under Section2.04 of this Agreement (7) Unallocated 240,000 TOTAL - 48,000,000 53 Disbursements from the IBRD Loan will be transaction-based to finance eligible expenditures for goods, works, technical assistance, and recurrent costs consistent with Country Financing Parameters for Azerbaijan. To facilitate timely project implementation, the borrower will establish, maintain, and operate a Special Account denominated in U S dollars under terms and conditions acceptable to the Bank. The Special Account will be held in a commercial bank acceptable to the Bank. Applications for replenishment of the Special Account will be made on not less than quarterly basis. The Special Account will have an initial allocation of US$l,OOO,OOO. Once cumulative disbursements under the loan have reached US$5,000,000, the allocation will increase to US$2,000,000. Payments in excess of 20 percent of Special Account will be made through direct disbursement from the Loan Account. Available Loan disbursement methods include reimbursements with full documentation, reimbursements on basis of Statements of Expenditure (SOEs) for small expenditures within agreed threshold'*, and payments against Special Commitments. The main contract under Component A (Power System Management) will be paid by direct payment from the Loan Account. l1Reference small contracts thresholds established inthe Procurement section of the PAD. 54 Annex 8: Procurement Azerbaijan: Power TransmissionProject 1. General Procurement for the proposed project would be carried out in accordance with the World Bank's "Guidelines: Procurement under IBRD Loans and IDA Credits" dated May 2004; and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" dated May 2004, and the provisions stipulated in the Legal Agreement. The general description of various items under different expenditure category are described below and summarized in Table 1. For each contract to be financed by the Loan, the different procurement methods or consultant selection methods, the need for prequalification, estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank project team in the Procurement Plan. The Procurement Plan would be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. Procurement of Works: Works procured under this project, would include: contracts procured under NCB procedures. The procurement would be carried out using the National SBD agreed with the Bank. Procurement of Goods: The majority of the equipment to be procured requires installation. Therefore, most of the Goods will be procured through World Bank Standard Supply and Installation Bidding Document. Procurement for the transmission system and other miscellaneous equipment will be procured through International Competitive Bidding (ICB). Hardware and Software for the Management Information System (MIS) will be procured through Shopping. The Bank's Standard Bidding Documents (SBD) will be used for all International Competitive Bidding (ICB). Goods through National Competitive Bidding (NCB) will be procured in accordance with the Borrower's NCB procedures, agreed with the Bank. Shopping of Goods under a specific threshold will be carried out by comparing price quotations obtained from at least three suppliers. Goods and works which the Bank agrees meet the requirements for Direct Contracting may be procured in accordance with the provisions of said procurement method. Selection of Consultants: Consultants' services would include Transmission Network Study, Development of Grid Code, Accounting and Management Information System and Project Management (firms selected under Quality- and Cost-Based Selection (QCBS) and Consultant Qualifications (CQS) procedure). A few Project Management individual consultants will be selected by comparison of at least three CVs. Incremental Operating Cost: The project will finance the incremental operating costs of about US$380,000 to oversee and manage the project, including: (a) PlU and other professionals' travel expenses locally and internationally; (b) communications, maintenance and operation cost 55 for equipment procured or used under the project, and (c) training expenses locally and international1y. 2. Assessmentof the ProjectImplementationUnit'scapacityto implementprocurement The project activities would be implemented by the PIU, consisting of full time Azerenerji staff dedicated for the proposed project. It would include the Head of the Technical Department, as well as specialists in Procurement, Financial Management, and IT. The PIU would ensure that procurement of goods, works and services will be carried out in a timely manner, in accordance with World Bank guidelines, manage project funds, maintain accounts, get the accounts audited, ensure adequate budget provisions for the PIU, facilitate the work of consultants and workmg groups, review consultant outputs, organize acceptance testing of SCADNEMS system etc. The head of the PIUwould ensure that the PIU has access to decision-makers at the appropriate level and can bring emerging implementation or coordination problems to their notice in a timely and proactive manner. An assessment of the capacity of the PIUto implement procurement actions for the project was carried out by Mr. Gurcharan Singh, Sr. Procurement Specialist, on October 18, 2004. The assessment reviewed the organizational structure for implementing the project and the interaction between the project's staff responsible for procurement and the relevant central unit for administration and finance in the Ministry of Energy and Azerenerji. Most of the risks concerning the procurement component for implementation of the project have been identified. The PIU, including the procurement officer, has some experience in procuring goods under EBRD, ADB and Islamic bank loans. The PlU has no experience in carrying out procurement under an IBRD/IDA loan or credit. The corrective measure which has been agreed i s to send the procurement officer and head of the PIU for World Bank procurement training in L O or any other suitable institute. Further, TA for procurement support will be contracted as required under the project. The overall project risk for procurement i s ratedhigh. 3. ProcurementPlan The Borrower's consultant KEMA developed a Procurement Plan for project implementation that provides the basis for the procurement methods. This plan has been further developed in discussions with the Bank. The Procurement Plan will be updated annually or more frequently if required to reflect the project implementation needs. The Procurement Plan will be available in the Project's database and on the Bank's external website, without indicating the estimated costs ifrequiredbythe borrower. 56 Table 1:Project Costs by Procurement Arrangements (US$ million equivalent) Expenditure Category Procurement Method' ICB NCB Other2 N.B.F. Total Cost 1. Works 0.20 5.7S3 0.00 5.98 0.00 (0.16) (0.00) (0.00) (0.00) (0.16) 2. Goods 43.6 0.70 0.9 0.00 45.3 (42.9) (0.8) (0.00) (0.00) (44.5) 3. Consultant Services 0.00 0.00 2.87 0.00 2.87 (0.00) (0.00) (2.46) (0.00) (2.46) 4. Operating Cost 0.00 0.00 0.77 0.00 0.77 (0.00) (0.00) (0.38) (0.00) (0.38) 5. Front End Fee 0.24 0.24- (0.24) (0.24) 6. Unallocated 0.24 0.24 (0.24) (0.24) Total 44.4 6.48 4.05 0.00 55.4 (44.3) (0.00) (3.70) (0.00) (48.0) Figures inparenthesis are the amounts to be financed by the Bank Loan. All costs include contingencies. Includes civil works and goods to be procuredthrough shopping, consulting services, training, technical assistance services, and incremental operating costs related to managingthe project. The entire amount of US$5.78 mill. less US$40,000 i s inkindcontribution from Azerenerji 4. BankReview of Procurement Decisions a) ICB Contracts estimated to cost above US$ equivalent 600,000 per contract and all Direct Contracting will be subject to prior review by the Bank. b) ICB for Works contracts estimated to cost above US$lmillion or equivalent per contract and all direct contracts will be subject to prior review. c) First contract through NCB and Shopping. 57 1 Table 2: ConsultantSelection Arrangements (US$ million equivalent) (3rmmt I QCBS ISFB Expenditure ILcs (b) Consultancy services estimated to cost above US$ equivalent 100,000(Firms)per contract or above US$50,000 equivalent (Individual consultants) will be subject to prior review by the Bank. (c) Short lists of consultants for services estimated to cost less than US$200,000 equivalent per contract, may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. 5. Procurement Strategy for Component A: Power System Management The procurement strategy i s to procure the required Azerenerji SCADABMS system, telecommunications network, and metering equipment in a single, turnkey contract. This contract will be awarded through a two stage bidding process in accordance with World Bank standard bidding procedures. Prequalification of bidders took place during project preparation. The first stage bidding documents will contain functional specifications. On this basis the bidders will develop a complete technical proposal and include both technical and commercial statements of compliance, but will not include any prices or pricing data. The technical proposals of each qualified bidder will then be evaluated and discussed with the bidders to establish a common baseline for the second stage bids. The qualified bidders will be invited to submit second stage bids in accordance with the modified technicalkommercial conditions, together with complete prices. These bids will then be evaluated for compliance with the revised technicalkommercial conditions and ranked in accordance with the stated bid evaluation criteria (technical bidprice bid formula). The highest ranked bidder will then be invited to negotiate a contract. 58 Annex 9: Economic and Financial Analysis AZERBAIJAN: Power TransmissionProject 1. Economic and Financial Rates of Return 1.1 Component A: Power SystemManagement (SCADAEMS System) Capital cost: The overall capital cost of the SCADA/EMS system i s estimated to be $[detail suppressed] million including contingencies of 10%. The system i s expected to take four years to install, with expenditures beginningin the first quarter of 2006. Benefits: The installation of a modern SCADALEMS system will fundamentally improve the operational work of Azerenerji in almost all its aspects. In some instances, the degree of improvement i s difficult to quantify or to value (for example, the effects of better maintenance scheduling, extension of asset life and improved billing resulting in lower commercial losses). Other benefits, however, can more readily be quantified and valued. Specifically, the types of benefits considered inthe IRR analysis were as follows: 1) improvements inpower plant scheduling resulting inlower overall fuel costs; 2) lower transmission losses; 3) lower operational costs in administration, data logging and reporting; 4) improved systemrestoration time after unplanned outages; and 5) deferred expenditure on new generation. Zmproved Scheduling: The Azerenerji generating system consists of seven thermal plants comprising 27 units. Some of these are combined-heat-and-power units, some are power only. There are also four hydro-stations with 15 units. The location of the main thermal plants i s not optimal as they are situated far from the main demand centers. They are designed to bum both natural gas and fuel oil though their performance i s less efficient when using oil. Additionally, there i s an active connection to Russia that i s usedto import electricity, and a connection to Iran that i s usedfor wheeling power to the Azerbaijan enclave of Nakhchivan. There are also plans to re-establish a 330 kV link to Georgia. The Azerenerji system i s relatively complex for its demand load. It i s controlled currently by a central dispatch center in Baku that i s of obsolete design and suffers from poor maintenance and lack of spare parts. As a consequence, station dispatch operates at below optimal levels resulting in losses due to lower overall system efficiency. With the proposed SCADA and communications system, scheduling of thermal plants could be improved so as to make better use of those with higher efficiency. The improvement in scheduling would also include a more optimal use of the hydro resource whose operation i s made more complex by the fact that some of the dams are also used for irrigation and drinkmg water supply. At the margin, the variable costs saved as a result of improved scheduling of generating plants are primarily fuel, either in the form of fuel saved or in the form of scheduling lower-cost plants at higher loads. The average fuel costs of Azerenerji have been rising steadily in recent years as the natural gas used in power generation i s increasingly imported from Russia. Thus, while the 59 average cost of gas in 2002 was $34.10 per MCM, it i s likely in the future to approach the price of imports (approximately $53 per M C M in 2004, rising to $60 per M C M in 2005). Assuming a 75/25 mix between gas and mazut (measured in GJ equivalent), the average cost of fuel per kWh i s expected to rise from the 2002 level of $0.0138/kWh to $0.0217/kWh in 2004. At the margin, the cost per kWh would be $0.0268 based on the price of imported gas. Using these estimates, the projected financial fuel bill for Azerenerji in 2005 would be $563 million (based on average fuel costs per kWh). The economic cost, based on the marginal cost of imported gas, would be approximately 24 percent higher (US$696 million). Given current data limitations, it i s impossible to forecast with any accuracy the improvements that can be achieved by a modern SCADAEMS system installed on the current Azerenerji network. A conservative estimate based upon international experience i s that overall fuel use will be reduced by 1.5%. The total projected fuel cost was calculated based on the 2005 average and marginal costs described above, and assumed to increase in proportion to forecast growth in demand as postulatedin the Burns & Roe12base case forecasts. The resultant savings associated with the installation of the SCADA system in 2010 (the first year of full operation of the system) were estimated at $9.1 million for the financial analysis, and $11.2 million per year for the economic analysis. These savings would increase on an annual basis in proportion to demand growth. Lower Transmission Losses: The electricity system inAzerbaijan was reported to have technical losses in 2002 of 11.8%, a significant reduction on losses up to 2000 when around 16% was lost annually. It i s not clear whether this drop was a result entirely of technical improvement as commercial losses increased in 2002 to 5.2% from a claimed 0% in 2000. The transmission system i s reportedto have technical losses of about 5%. The introduction of SCADA will allow more efficient use of the national transmission system and, consequently, lower overall transmission losses. As with improvements in scheduling, such improvement i s difficult to quantify although experience with other systems suggests that it will occur. An improvement of 0.5% was assumed for this analysis; that i s transmission losses were assumed to decline from the current 5% to 4.5%. The resultant benefits were measured as the value of avoided fuel consumption expressed in both financial and economic terms. In 2010, the financial benefits to Azerenerji are projected at $3.0 million while the economic benefits are projectedto be $3.7 million. Lower Operating Costs: Logging and transmitting data presently consumes a significant amount of resources within the Azerenerji organization. The company prepared an estimate of the operational savings likely to arise as a result of SCADA installation, which totaled $315,400 annually. The areas of savings included accounting and financial reporting, preparation of techno-economic data, computerized preparation of financial data, human resources management, computerization of O&M data, reduction in communications expenses, and investment planning. l2l2Burns andRoeInc.: "Republic of Azerbaijan: Prioritizationof InvestmentNeedsfor Power Generationand Transmission", November 2003. 60 At the same time, there will be additional O&M costs for the new SCADAEMS system. Based on international experience with such systems, the incremental O&M costs are estimated at 1.5% of the capital cost per annum - approximately $[detail suppressed]. Improved Outage Times: The introduction of a modem SCADA system would allow much faster restoration times following transmission system outages as the overall system operating conditions will be provided more quickly and more accurately to the dispatchers. In such situations, although the fault causing failure may only be transient, the process of restorationmay take some time, particularly if failure has occurred over a wide area. Typically, restoration times can be reduced from an average of three hours to only one hour, resulting in large economic savings interms of outage time. Data on large-scale regional or national outages show that these are rather rare. In 2003, there were 16 such outages with a load-shed of between 97 and 845 MW. These were clearly severe incidents but the longest lasted less than 20 minutes, a period that would not have been significantly shortened by a SCADA system. In 2002, there was a major national outage as a result of a cascade collapse of the system. It took over 22 hours to fully recover the system from this event with power being restored gradually throughout the day. The total system loss from this event i s estimated at 6 181 MWh with a financial value of approximately $125,000 at an average tariff of $20/MWh. For Azerenerji, however, the benefit i s lower since they would lose only the margin between the selling price of the electricity and the variable cost of generation. Given the low level of tariffs, the financial benefit i s negligible. The actual economic loss to the economy was estimated in terms of customer willingness-to-pay for the power that was lost during the outage. Willingness to pay was estimated, for this analysis, based on the premise that when power i s cut off, consumers will turn to alternatives to provide the services provided by electricity and these alternatives will usually be higher cost. There are a wide range of possibilities for such alternatives including gas, oil and wood for heating, kerosene for lighting and the use of diesel-powered generators for industrial consumers and, possibly, for household and commercial consumers to provide an alternative source of electricity. There i s only limited data available on which to base an assessment of willingness to pay in Azerbaijan, though recent data suggests that it may be quite high. Estimates of the price elasticity of demand in the country13 are that it i s about -0.2, that i s a 10% rise in prices produces a 2% drop in consumption if income remains constant. This i s rather lower figure than has been found in many other countries. For example, a similar elasticity in India i s between -0.29 and - 0.51, whilst in developed countries such as the UK and USA, a figure of about -0.5 i s usual. Such statistical estimates can be misleading but a low negative price elasticity does suggest that residential consumers are prepared to pay rather higher prices without altering their consumption greatly. However, such statistics, whilst indicative, do not provide the key price numbers. Willingness-to-pay will vary across different consumers so, in principle, a weighted average of the range of consumers should be used. Based upon estimates for other Caucasus and Central l3Short-term social, rural and environmental implications of residential electricity tariff rebalancing in Azerbaijan, July 142004 61 Asian countries, a figure of $0.16/kWh for diesel generation, the normal alternative for industry and commerce, and $0.25/kWh for kerosene lighting i s reasonable. About 60% of power sales are to household and commercial customers so a weighted average of $0.215/kWh was used as the economic value of electricity. On this basis, the cost of the 2002 outage would have been approximately $1.32 million. A modern SCADAEMS system would have allowed a much faster recovery from such an outage, probably at least cutting it in half. The problem with estimating the value of the SCADA system i s in estimating the frequency of such relatively rare events. It was assumed for this analysis that one would occur every four years and that a SCADAEMS system would save half the cost of the 2002 outage, that i s $0.66 million ineconomic terms. Deferred Generation Expenditure: Reduction in transmission losses and improvements in generation scheduling including power import will enable the current generating system to operate for a longer period without additional capacity. The benefit would be equivalent to the capital cost savings of such deferral measured in equivalent interest charges (financial and economic). In their system study, Burns and Roe proposed that a new 400MW combined-cycle plant should be built in 2007. The cost of this unit i s assumed to be approximately $200 million. A one-year deferral of such expenditure would also defer between $10 million and $30 millionin financing charges (depending on whether the financing was concessionary or commercial) for that year. The implicit economic benefit of this is, in effect, the interest that would be gained by investing such a sum for one year, which would be a one-time benefit of between $1- 3 million at 10%. Given the relatively small value of the benefit, as well as the uncertainty with respect to i t s timing (a number of other factors, including tariff increases, end-user efficiency improvements, and access to less-costly fuels for heating and coolung could substantially defer the need for new generation capacity), it was decidedto omit this from the IRR calculations. Overall Rate of Retum to SCADNEMS System: The quantifiable costs and benefits of the SCADAEMS system over a 20-year period are shown in financial and economic terms in Tables 1and 2 below. Because installation will be substantively completed by the end of 2008, 75% of the expected full benefits were assumed to accrue in 2009. Financial intemal rate of retum (FZRR): The benefits of improved scheduling and lower transmission losses are calculated as a percentage of forecast average fuel cost (assuming a 75:25 mixture of gas and mazut). The benefits of lower outage time are based on tariffs. The base- case FER of the SCADAEMS system over a period of 20 years i s estimated to be 30.2%. The NPV of the base-caseat 10%is $53.7 million. Economic internal rate-of-return (EIRR): The estimate of the economic rate of return (EIRR) of the project uses border prices for the fuel cost savings. The latter is assumed to be based on a cost of US$60 per M C M for natural gas - approximately 20% higher than the projected average fuel prices paid by Azerenerji. Benefits of reduced outage times are based on customer willingness to pay. Under base case assumptions, the EIRR of the project i s 35.8%, and the NPV at 10% discount rate i s $73.2 million. 62 5 Lo - 0 2 g (D 0 m a 0, 0 0 I I cv b c U c -f (II a, v) .-m v) v) c a, S a - a, a S 3 S a c g 0 b 3 a, z 0 n w v ) 3 W N - N O j 9 7- 9 0 3 w !n m d m a N c o a O 3- N co l- m - 0" a" a 3 Q O 9 d 2 y cwom a u- N b 0 9 u o E N -Uc oWr -d 0- N b .9 u o _. h 3 3 -9cwo wm N 4 .9N b v o - Do 0 0 N The sensitivity of the base-case results was tested against the following changes in key assumptions: 50% increase incapital cost; use of the "low" electricity demand forecasts (see Attachment 2, Annex 1); smaller improvements in efficiency (through improved scheduling, reduced transmission losses) The results of the sensitivity analysis are shown in Table 3. In all instances, the rates of return remain satisfactory despite significant adverse changes in the base case assumptions. Table 3: Sensitivity Analysis of SCADAEMS None 30.2% 35.8% Increase in capital cost by 50% 21.4% 26.1% Low electricity demand forecast 27.7% 33.0% Overall efficiency improvement of 1.5%' 23.9% 28.7% 1.2 Component B: Transmission Network Rehabilitation Azerenerji has proposed a number of relatively small projects related to improving the reliability of transmission lines and substations, all of which are considered to be high priority. The total estimated cost of these subprojects i s US$ [detail suppressed] million, including US$[detail suppressed] million for transmission lines, US$[detail suppressed] million for transformer replacement, and US$[detail suppressed] million for voltage control and installation equipment. Rehabilitation of Transmission Lines: Improvements to the existing high-voltage transmission system can bejustified intwo ways: e the lines have reached capacity, and capacity increase will result in increased power supply as demand grows; 0 faults on the line can be reduced leadingto improved outage times. The first of these does not apply to any of the projects currently being proposed. Although no system analysis was carried out, the Bums and Roe appraisal of the system identifiedthose lines that are currently at capacity. All were inthe 110kV lines and none were the projects named as part of this project. Data supplied on present peak currents in these lines confirmed that none approached design maximum. In addition, it can be noted that the kind of improvement described, typically replacement of towers, i s not such as to increase capacity. 65 The benefits o f the proposed projects accrue primarily from reduction in outage times as a result of recurring faults in the equipment. It i s known that the lines to be rehabilitated have had faults resulting in outages over the past three years. Table 4 shows data on outages in 2003, and demonstrates that outages on the project lines were frequent and of considerable duration. Table 4: TransmissionLinePerformance:OutagesandDuration Line Number of TotalDuration outagesin2003 (Hours) 2ndApsheron 500 kV 12 47 lSt 330kV Apsheron 16 138 lSt 220kV Ali-Bayramli 15 83 Sangachal220 kV 13 71 3rdApsheron 220 kV 9 45.5 4thApsheron 220 kV 8 45.5 lSt 220kV Mingachevir 17 131.5 2ndMingachevir 220 kV 10 93 2ndAli-Bayramli 220 kV 6 60 Agsu 220 kV 8 54 4thAli-Bayramli 330 kV 6 32 lSt110kV Alat ' 5 17 lSt110kV Barda ' 5 624 lSt 110kV Kurdamir 20 148 The available data did not specify (i) whether the outages resulted in load-shedding equal to the power that would have been transmitted by the line; (ii) what this power level was; or (iii)how many of the faults occurred in equipment that would be replacedrehabilitated. However, inspection of the dates of outages suggests that they occurred throughout the year and at various times of day. It was assumed, therefore, that the outages occurred on average when the lines were carrying base load power, that it i s 62% of the peak current carried and that 50% of this power was actually lost to consumers, that i s that 50% was transmitted via an alternate route. If outages occur during higher load periods then losses will be greater. The resultant estimates of total MWhlost are shown inTable 5. Table5: Estimatesof OutagesandLossofPower Line Peak Baseload Total Power current current' Outage lost 1"Apsheron 330 kV 700 434 138 15,387 lstAli-Bayramli 220 kV 950 589 83 8,373 Sangachal220kV 800 496 71 6,03 1 3'd Apsheron 220 kV 600 372 45.5 2,899 4" Apsheron 220 kV 600 372 45.5 2,899 1'' Mingachevir 220 kV 550 341 131.5 7,680 66 Line Peak Base load Total Power current current' Outage lost = (A) (A) (Hrs) (MWh) 2ndMingachevir 220 kV 600 372 93 5,925 2"dAli-Bayramli 220 kV 800 496 60 5,097 Agsu 220 kV 550 341 54 3,154 4&Ali-Bayramli 330 kV 950 589 32 4,842 lst 110kV Barda 250 155 624 8,283 1) 62% o f peak current 2) 50% of base current multiplied by voltage times 1.73 times power factor assumed @ 0.9 times duration of outages Note: Azerenerji data on M W h lost on 2003 were significantly higher than the computed values. For conservatism, the computed values have been used in the analysis o f benefits. As noted above, valuation of the electricity lost to consumers at the average wholesale tariff will show little or no financial benefits to Azerenerji as a result of the proposed improvements since Azerenerji's current tariff i s arguably less than the variable cost of supply. Financial losses would accrue to the distribution companies, and could be valued at the average distribution margin, insofar as the consumption i s truly foregone and not simply deferred to another time period. In economic terms, however, the losses associated with outages have a much higher value. The final assumption relates to the degree to which the proposed improvements would reduce outages. It i s likely that Azerenerji have diagnosed the most common causes of failures, but not all. It was therefore assumed that 60% of the outages in 2003 would be eliminated by the proposed improvements. Table 6 shows the EIRR of the various transmission projects based on these assumptions. Table 6: Estimated Economic Return by Transmission Line I cost Benefit EIRR @ l o % $'OOO* $'OOO (20 years) $'OOO ~ 2nd Apsheron 500 kV 1,352 62% 6,067 1st Apsheron 330 kV 1,985 68% 9,058 4th Ali-Bayramli 330 kV 625 441% 3,082 1st Ali-Bayramli 220 kV 1,080 53% 4,662 Sangachal220 kV 778 61% 3,876 3rd Apsheron 220 kV 374 91% 2,126 4th Apsheron 220 kV 374 64% 1,873 1st Mingechevir 220 kV 991 162% 4,838 2nd Mingechevir 220 kV 764 176% 3,744 2nd Ali-Bayramli 220 kV 658 69% , 3,339 Agsu 220 kV 407 65% ' 1,885 1st Barda 110 kV 1 1,068 116% 5,566 ~ Total Transmission Line Component 10,456 76%1 26,273 *) Cost details suppressedat Borrower's request 67 It can be seen from Table 6 that the proposed improvements offer high EIRRs particularly for the smaller investments (lst and 2ndMingachevir, 4thAli-Bayramli). It i s possible that for these small investments the degree of reduction in outage time would be less than the 60% assumed in these calculations, as this estimate i s not securely based. However, the ERR for the larger investments are also high and in these cases, the replacement of towers known to be the cause of many failures i s likely to lead to improvement of the order of that assumed. Overall, the high cost of power failures based upon the economic cost of electricity combined with the clear deficiencies of these lines suggests that investment i s likely to show a highEIRRin all cases. Given that there i s always room for debate regarding "willingness to pay" estimates of the value of electricity supply, a sensitivity analysis was also carried out assuming that the economic value of the avoided outages was equivalent to the minimum observed value -i.e. the average retail tariff. This drastically reduced the ERR of the transmission rehabilitation components. However, only 3 of the 12 subprojects fell below a lo%, return (lst Ali-Bayramli 220 kV line, Sangachal 220 kV, and 4" Apsheron 220 kV), and the weighted average returnfor the total package was 13.8%. Transformer Replacement: Four transformer replacement projects are included in this component, of which 3 relate to sub-stations whose transformers are at or close to capacity utilization. The fourth, Mushvig, has relatively less urgency as the current transformers have sufficient capacity to deal with load growth for at least another 10 years. However, it i s located in a high-profile area of Baku, serving the presidential palace and a number of major government facilities, and may be justified on the basis of reliability and security of supply to these important facilities. The sub-station transformers effectively act as a bottleneck through which power supply to consumption districts must pass. When the transformers reach capacity, downstream supply i s necessarily restricted at first to a limited number of consumers at peak load times, then increasingly to larger number of consumers for longer times. When the capacity of the transformer i s only about 62% of peak demand, which i s the national base load level, there will effectively be a state of permanent load-shedding downstream of the substation which will gradually increase as potential demand increases. The result of this i s that until capacity i s reached, the benefits of increased transformer capacity are small, amounting to no more than improved efficiency in the transformer itself. However, once capacity i s reached and incremental load must be shed, benefits will accrue which will increase annually as load increases. A precise calculation of the rate of return for each of the proposed projects requires data on the load-demand curve for the district served by the particular sub-station and also a demand forecast for that district. Inthe absence o f these, the national load-demandcurve was assumed to apply as well as the national base-case demand forecast. Examination of this national load- demand curve suggests that there i s a reasonable approximation to a linear change in load between the base load level (62% o f peak demand) and the peak load. The base-case demand forecast of 1.4% per annum growth rate increasing to 1.6% per annum after 2010 means that full load-shedding of incremental demand (the point at which base loads on 68 the transformers are equivalent to the present-day peak loads) will not be reached in the absence of new transformer capacity for over 20 years. In order to make estimate of the economic rate-of-return of each proposed project, the following assumptions were made: replacement transformers installed in 2006; load shedding in 2006 because of insufficient capacity i s zero with existing transformers on full load; demand increases at 1.4% per annum for five years, and at 1.6% thereafter; initially, 5% of this incremental load will be shed, increasingthereafter by 1% each year (except for Mushvig which i s not yet operating at capacity); and a ten-year evaluation period i s used. Table 7 shows the results of this evaluation for each substation project. Table 7: Economic Returns for Transformer Replacement NPV @lo% Benefit (10 years) US$'OOO US$'OOO 5.043 16.067 2,521 64% 8,536 1,765 51% 4,990 - NA (3.487) \ I I Total Transformers 9,329 35% 15,021 Comnonent *) Cost details suppressedat Borrower's request The EIRR of the transformer replacement projects are sensitive to the economic value of outages assumed. For example, if customer willingness-to-pay i s reduced from $0.215 to the existing average tariff (US$.02l/kWh), the EIRR of the four subprojects falls to minus 3%. At a willingness to pay of $O.l/kWh, the EIRR of the package would be 20%. Other substation rehabilitation projects: It is believed that the proposed switchgear replacement projects at Yashma and Yevlakh and replacement of batteries at Alat are `must-do' projects to protect the integrity of the sub-stations. While the risks of equipment failure are difficult to predict, in all cases the equipment i s well beyond its economic life. Total failure of supply from these stations would produce extremely high costs interms of outages and ancillary damages. Financial Rates of Return: The previous sections have focused on the economic rates of return associated with the proposed transmission line rehabilitation and transformer replacement subprojects on the premise that, at under present conditions, the projects offer only limited financial benefit to Azerenerji. At current tariff levels, the ability to serve additional load (through reductions in forced outages and removing capacity 69 constraints) makes little contribution to the company's profitability since the variable cost of supply (mostly fuel) i s very close to the tariff level. The main financial benefit of carrying out the rehabilitation works at the present time i s the ability to avoid an equal or potentially greater investment in the future when the facilities can no longer function. However, as tariffs increase to full cost recovery levels, reduced outages and the associated increase in electricity sales will yield financial benefits equal to the difference between the full and variable cost of supply for the additional units o f electricity supplied. This amount would vary on an annual basis with fluctuations in the ratio of fixed to variable costs and with load growth. Indicative numbers for 2010 would value the annual financial benefit of the transmission rehabilitation component at AZM 4.2 billion (approximately US$810,000). Assuming that tariffs reach full cost recovery in 2008, and also assuming that, absent the current project, the equipment would have to be replacedrehabilitated at an equal cost not less than 5 years hence, the FIRR of the transmission rehabilitation component would be 9.1 percent. If tariffs do not reach full cost recovery until 2010, the FIRR would be 8.7 percent. The low financial returns to Azerenerji should not be considered a problem (beyond the problem of low tariffs), since the high EZRR reflects the consumers' willingness to pay to avoid outages and load shedding. Table 8: Summary ofProjectRatesof Return EIRR NPV FIRR NPV $million $million SCADAIEMS 36% 73.2 30% 53.7 Network Rehabilitation 48% 83.8 -9% (0.7) Transmission Line Rehabilitation 76% Transformer Replacement 35% TotalProject (ComponentsA -D) 39% 145.1 21% 41.7 2. CarbonFinanceProject The project offers significant global economic benefits in the form of reduced greenhouse gas (GHG) emissions related to the reductions in thermal fuel use accruing through the installation of the SCADAEMS component. There i s a possibility of converting a portion of these benefits into financial returns through a Carbon Finance Project which i s currently under preparation wherein emission reductions from the investment project would be sold as carbon credits to an entity in another country. With such Carbon Finance Project in place, the FIRR for the project would increase b y 0.8 percentage points to 21.6%, and the Net Present Value of the investment project at 10% discount rate would increase by US$2.8 million to US$44.5 million. This only includes carbon trading for the period 2010-2012, i.e. to the end of the Kyoto Protocol period. There are, however, possibilities that agreements could be extended for several years more. See comments on the Carbon Finance Project in Annex 12. 70 3. FinancialViability of Azerenerji 3.1 Current Financial Position Azerenerji has been accumulating significant cash flow shortfalls for the past several years. The main reasons are three-fold: (i)wholesale tariffs are inadequate to cover the fully allocated cost of operations; (ii)undercontractual agreements signed with the private operators of the distribution companies, collections are mandated at well below 100 percent; and (iii) fixed assets, which are carried on the books at original cost, provide insufficient cash flow from depreciation to cover the levels o f investment required, even with significant concessionary borrowing from external financial institutions. As a result, the company has accumulated in excess of AZM 15 trillion (over US$3 billion) in accounts payable to suppliers, and i s dependent on cash transfers from the Government to purchase fuel and meet other cash obligations such as debt service. Table 8 below summarizes the company's balance sheets (expressed according to local accounting standards) as of the end of 2002 and 2003. It should be noted that while a significant portion of accounts receivable (and a corresponding amount of accounts payable) were "frozen" in 2001 as part of agreements reached between the Government, new management of the distribution companies, and Azerenerji's creditors, by 2003 receivables and payables on current operations had grown to represent more than one half of the total trade-related14 indebtedness. In addition, the gross value of fixed assets (including work in progress) i s valued at only AZM 3.9 trillion, or approximately US$920 million. The minimum replacement cost of the 5,500 Mw of generating capacity alone would be in the order of US$2.75 billion (assuming a cost of US$500 per kW). Total depreciation charges in 2003 were approximately AZM 100 billion (US$25 million). Consequently, new investment has been financed primarily by external loans. The balance outstanding on these loans, as of the end of 2003, was AZM 1,535 billion, or approximately US$310million. l4 Accounts payable with respect to purchases of materials and equipment, and accounts receivable related to sales of heat and electricity. 71 Table 9: Azerenerji Balance Sheet (AZM billions) ISSETS 2002 2003 LIABILITIES & EQUITY 2002 2003 FixedAssets Shareholders'Equity Plant,propertyandequipment 2,652.3 3,898.5 InitialCapital 635.0 483.3 AccumulatedDepreciation (1,372.8) (1,475.1) CapitalContributions 2,524.9 3,498.2 CapitalWork inProgress 1,703.8 640.4 RetainedEarnings (1.1) (425.5) Net Plant & Equipment 2,983.3 3,063.7 Plus current periodprofit (424.3) (1,005.3) Other reserves 0.2 0.2 3ther LongTerm Assets Total Equity 2,939.3 2,702.5 Deferred Debts of Distcos (frozenreceivables) 7,422.4 7,422.4 Other 0.0 0.0 Long-TermLiabilities Total Other 7,422.6 7,422.6 Domestic Borrowings 286.3 598.2 ExternalLoans 1,374.8 1,535.4 DeferredDebts to SOEs Current Assets (frozenpayables) 7,422.4 7,422.4 Cashand Bank Accounts 70.4 112.3 Total Long-TermLiabilities 9,083.4 9,556.0 Accounts Receivable - Retailers 7,762.1 9,288.4 Other Current Assets 1.3 1.4 CurrentLiabilities Total CurrentAssets 9,094.6 10,753.0 Accounts Payable- Trade 6,709.3 7,896.2 Other CurrentLiabilities 0.8 1.1 rota1Assets 19,500.5 21,239.3 Total CurrentLiabilities 7,477.7 8,980.8 TotalLiabilitiesand Equity 19,500.5 21,239.3 3.2 Financial Projections Assumptions: Financial projections for Azerenerji were prepared based on 2000 - 2004 operating and financial statistics, and on load forecasts taken from the Burns & Roe system planning study. Other assumptions include the following: Financial projections include proposed capital investments which are currently being negotiated with financiers. Specifically, these are (i) the proposed IBRD project including all transmission subprojects identified by the Borrower (total cost US$55.6 million with US$48 million in IBRD financing), (ii)a substation rehabilitation program that has been agreed with KfW (total cost US$15 million), (iii) rehabilitation of generating units at AzGres (estimated total cost of US$118 million, with a US$lOO million loan from EBRD). In addition, the Government and Azerenerji are currently discussing financing arrangement for three other major capital projects: (i) a 500 MW generating plant at Sumgayit (estimated cost Euro 300 million, to be financed by Bayerische), (ii) a 400 MW thermal plant at Shimal (estimated cost US$300 million to be financed by the Japanese Bank for International Cooperation); and (iii)a new HV transmission line to Iran (estimated cost US$75 million to be financed by the Iranian Development Bank). These investments were also included in the analysis, using financing assumptions provided by the Government and Azerenerji. 72 0 It was assumed that Azerenerji would also invest a share of each year's depreciation in capital projects - 25 percent in each of 2004 and 2005, 50 percent in 2006 and 100 percent in 2007 and thereafter. Beginningin 2005, depreciation on fixed assets was assumed to be 4 percent of gross book value for generation and transmission equipment and 6 percent of gross book value for other assets. 0 Prices for natural gas were assumed to increase to US$60/MCM in 2005 and to US$61 in 2006. Thereafter, they were assumed to increase with international inflation. 0 Operating costs were assumed to increase in proportion to the growth in electricity sales, and were adjusted annually based on forecast local inflation (2.5% per annum). Cost savings associated with the proposed IBRDproject were included in the forecasts. However, potential cost savings associated with other capital investment projects were not included. 0 The schedules of payments by the distribution companies were taken from their management contracts. The assumed weighted average collection rates are shown below. 2004 2005 2006 2007 2008 2009 2010 2011 2012 50% 58% 69% 71% 82% 90% 101% 115% 115% 3.3 Optionsfor AchievingFinancialViability The financial projections indicated that, absent any increase in wholesale electricity tariffs,, Azerenerji will continue to accumulate cash flow shortfalls in excess of AZM 2 trillion per year (approximately US$400 million) over the next 10 years. These shortfalls derive in part from operating losses, but are exacerbated by non-payments by the distribution companies, debt service obligations, and self-financing of capital expenditures. If tariffs are maintained at current levels, the Government will need to provide ongoing financial support in order to maintain the company's financial viability. Between 2005 and 2010, a total of approximately AZM 13.8 trillion would be required. Alternatively, the government could reduce the amount of financial support required by increasing wholesale electricity tariffs to levels which would allow Azerenerji to fully recover its prudently incurred costs of operations. "Full cost recovery" tariffs would cover operating costs (fuel, materials, repair and maintenance, administrative expenses, taxes, and interest on debts), as well as depreciation expenses and a 5 percent per annum return on net fixed assets. Based on the financial assumptions described above, full cost recovery wholesale tariffs for Azerenerji are estimated to be approximately AZM 132/kWh for 200515. By 2010, the required wholesale tariff to achieve full cost recovery l5 Because Azerenerji also serves some customers at the distribution level, the weighted average tariff is slightly higher. 73 would be AZM 174/kWh. However, even if the Government moved immediately to full cost recovery tariffs, Azerenerji would continue to have a cash flow shortfall - and hence a need for financial support - totaling approximately AZM 3.7 trillion over the 2005 - 2010 period owing to (a) contracted nonpayments by distribution companies and (b) the relatively low level of depreciation as compared with capital investment commitments. The above analysis suggests that tariff increases alone will not fully resolve the weak financial position of Azerenerji. Additional actions are required in order to achieve sustainable financial viability. Among the measures that have been considered are the following: (i) Improve operating efficiency: B y the standards of the region, Azerenerji's operating costs are not excessive. Even the "full cost recovery" wholesale tariff i s less than 3 US cents per kWh - although as noted above, the depreciation component of this tariff i s not representative of net replacement value of the assets. Still, there i s room for improvement in areas such as more cost-effective dispatching of generation plants, reduction in line losses, reductions in outages, improvements in scheduled maintenance to prevent more serious equipment failures, better financial management and planning, and staff reductions through better management, communications and automation. The proposed project will help to address some of these issues. Ongoing technical assistance provided under the USAID program of assistance to the power sector will assist in addressing other efficiency concerns. (ii) Improve collections: Improvement in collections would help to alleviate the company's cash flow problems and the associated build-up of debts. However, under contracts signed with the private managers of the distribution companies, Azerenerji's collection rates are restricted to well below 100 percent until 2010. The company can, however, ensure that the mandated collections are received. Inthis regard, it will require the support of the Government in enforcing the contracts with the distribution companies. This support should include, inter alia, steps on the part of the Government to withdraw the licenses of distribution companies who are in significant arrears on payments to Azerenerji, and also granting Azerenerji the right to restrict supply to those distribution companies until such time as they meet their payment obligations. (iii) Revalue fixed assets: As noted in the previous section, even a "full cost recovery" tariff i s inadequate to cover the cash flow requirements o f the company - largely owing to the low level of depreciation included in the calculations. One mechanism for addressing this issue would be to base depreciation on a more realistic estimate of net replacement value of the plant and equipment. A comprehensive technical review of the existing asset base, its remaining useful life, and its current replacement cost i s needed in order to better understand and manage the investment requirements of the company and ensure that adequate funding i s available through the tariffs. Provision has been made in the technical assistance component of the project to finance an asset revaluation exercise. 74 (iv) Provide financial support to operations: The final option for ensuring the financial viability of the company i s additional injections of equity by the Government. This can take a number of forms, including direct equity injections, Government loans and/or deferral of payments owing to the budget, or equity injections tied to specific parameters such as collection rates or fuel expenditures. While financial support tend to be counter-productive in that they generally discourage efficiency improvements on the part of the recipient, in the present case it would appear that some level of support i s needed until such time as tariffs are adjusted to full cost recovery levels. It i s believed that, in the near and medium term, financial recovery of Azerenerji is best achieved by a combination of tariff increases and ongoing Government support, rather than solely by Government transfers as i s the current situation. This would have three key advantages. First, a move towards cost recovery tariffs would encourage customers to use electricity more efficiently, thereby moderating growth in demand and hence the need for Government support. Second, providing financial support to Azerenerji to cover contracted nonpayments by distribution companies rather than addressing the company's cash flow problems through tariff increases i s more consistent with long term tariff principles which would not normally allow the inclusion of nonpayments as part of revenue requirements. Finally, moving to cost recovery tariffs at a time when the distribution companies have some leeway in terms of enforcing payment provides a de facto form o f social support for low income households while more formal mechanisms for social protection are put in place. In the longer term, it i s expected that financial support can be phased out as efficiency improvements are introduced, collections improve, and asset values are adjusted to provide adequate cash flow for debt service and new investment. A number of alternative scenarios for tariff increases and financial support were developed and reviewed, including a range of dates for the move to full cost recovery tariffs. The option which was deemed to offer the best balance between the Government's affordability concerns and the need to move quickly to economically efficient pricing of electricity supply would entail a 50 percent increase in wholesale electricity tariffs (from 71 AZWkWh to 106.5 AZWkWh) effective January 1, 2006, with equal annual percentage increases thereafter in order to reach full cost recovery (estimated at 174 AZWkWh) by 2010. The proposed option would require government support totaling AZM 6.7 trillion over the 2005 - 2010 period - and a single-year maximum of AZM 1.7 trillion in 2005. The figures below show the annual and cumulative levels o f cash flow deficits, and hence of financial support required under this scenario. For comparison, the figures also show the supplemental financing that would be required if full cost recovery tariffs were introduced in 2005,2006,2008 and 2010. 75 3000 2500 2000 ElCost Recovery 2005 E 2 Cost Recovery 2006 1500 Cost Recovery 2008 I1000 8 Cost Recovery2010 E 50% 2006, CR 2010 500 0 2006 2007 2008 2009 2010 -500 Figure2 Azerenerji Cumulative Cash Flow Deficit 12000 r - - - - l0000 +Cost Recovery 2010 8000 -A- Cost Recovery 2008 6000 -0- Cost Recovery2006 -B- Cost Recovery2005 4000 +50% 2006, CR 2010 2000 0 2005 2006 2007 2008 2009 2010 Highlights of the company's financial performance under. 1the proposed scenario are provided inTable 10. Pro forma financial statements are given in Table 11,Table 12 and Table 13. 76 3 3 3 'I 0 + VI > U B L1 -m +- dam (0 U .- a m % 0 Annex 10: Safeguard Policy Issues AZERBAIJAN: Power Transmission Project The proposed investments under the project will be confined to existing facilities and rights of way and as such are unlikely to trigger major environmental impacts or other safeguard policies. The project has been given an initial environmental category rating of B. As part of the EA, an Environmental Management Plan has been prepared to define procedures for mitigation of local impacts of the project during construction (e.g. repair of lines, replacement of transformer equipment) and disposal of waste materials and procedures for mitigation during operation (e.g. maintenance activities). There will be no subprojects in disputed areadconflict zones. The impacts associated with the project are for the most part related to potential noise and dust during construction. PCB i s not expected to be found on the sites (substations), but testing for PCB will be undertaken and any necessary remedial action taken. Replaced batteries will be disposed of safely. Ecological reshaping by filling holes, soil leveling, and re-vegetation will take place if the ground i s impacted by the operations. No pesticides will be used for any land clearing operations (e.g. new tower platforms, access roads preparation, etc.). All land clearing will be done by manual or mechanical methods. No potentially large scale, significant, and/or irreversible impacts of the project have been found. Thepositive environmental impact of the project i s as follows: The project i s expected to leadto a conservatively estimated 1.5 percent reduction in gas and fuel oil use at power plants because of more economic dispatch, with a corresponding effect on emission of greenhouse gases from the plants. An estimated 0.5 percentage point's reduction in transmission losses (from 5 percent to 4.5 percent) has a corresponding positive impact on emissions from the power plants. Insofar as the project contributes to increased and more reliable electricity supply, it will help to reduce the need for households to consume wood and kerosene in order to meet their demands for heat and lighting. Savings of power plant fuel will be monitored under the project, and thus also emission reductions. Future household surveys will monitor developments in electricity supply vs. wood and kerosene use (as well as natural gas). The project requires that the Government ensure that Azerenerji i s kept financially viable. In order to curtail direct financial support to the company, the Government plans to increase electricity tariffs to ultimately reach cost recovery. Such higher tariffs will have a dampening impact on demand and therefore also on emissions from thermal power plants. 81 Annex 11:Project Preparation and Supervision AZERBAIJAN: Power TransmissionProject Planned Actual PCNreview 07/21/2003 09/03/2003 Initial PID to InfoShop 09/29/2003 09/30/2003 Initial ISDS to InfoShop 09/29/2003 09/30/2003 Appraisal 03/15/2004 02/11/2005 Negotiations 03117/2005 BoardBVP approval 05/17/2005 Planneddate of effectiveness 08/17/2005 Planneddate of mid-term review 10/31/2007 Plannedclosing date 12/31/2010 Key institutions responsible for preparation of the project: State power generation and transmission company Azerenerji, supported by consulting firm KEMA,Inc. (consortium), financedby PHRD. Bank staff and consultants who worked on the project included: Name Title Unit Bjom Hamso Task Manager ECSIE Andrina A. Ambrose-Gardiner Sr. Finance Officer LOAGl Bernard Baratz Environmental Consultant EASEG Junko Funahashi Sr. Counsel LEGEC Gurcharan Singh Sr. Procurement Spec. ECSPS Surekha Jaddoo Operations Analyst ECSIE Josephine Kida Program Assistant ECSIE Farid Mamedov Operations Officer ECSIE Ida N.Muhoho Financial Mgmt Specialist ECSPS Neal Patterson Sr. Power/SCADA Engineer Consultant Vladislav Vucetic Lead Energy Spec./Engineer ECSIE Margaret A. Wilson Sr. Financial Analyst Consultant Bank funds expended to date on project preparation: 1. Bank resources: US$379,000 2. Trust funds: US$57,000 3. Total: US$436,000 Project implementation (some procurement stages for the main component SCADA/EMS/ Telecom/Metering) has been undertaken in parallel with project preparation and i s included in the above costs (estimated to US$30,000). Estimated Approval and Supervision costs: 1. Remaining costs to approval: US$4,000 2. Estimatedannual supervision cost: US$120,000 82 Annex 12: Carbon Finance Project AZERBAIJAN: Power Transmission Project Azerbaijan Electric Power Transmission CarbonFinance Project. The Azerbaijan Electric Power Transmission Carbon Finance Project i s potentially eligible under the Kyoto Protocol's Article 12. which establishes the Clean Development Mechanism (CDM) allowing public and private sector parties in industrialized countries to invest in greenhouse gas mitigation projects implemented in developing countries. The C D M enables investors to receive a credit toward their emission reductions target under the Kyoto Protocol and associated regional agreements, such as the European Union Greenhouse Gas Emission Trading Scheme (EU ETS), which entered into force on January 1, 2005. Azerbaijan has ratified the Kyoto Protocol on 28 September, 2000, and the Kyoto Protocol came into force on February 16,2005. The primary objective of the project i s to improve the reliability, quality, and cost-effectiveness of electricity supply in Azerbaijan by financing investments that improve the management and performance of the high-voltage transmission network. In addition, improving the management of the high-voltage transmission system will facilitate expanded energy trade inthe region. Some of the IBRD project activities are eligible Clean Development Mechanism activities and the emission reductions from the eligible C D M activities will result in greenhouse gas emission reductions which would be purchased by the Netherlands Clean Development Facility. The key performance indicators that will be used to assess the fulfillment of the project's development objectives are: 0 Reduction in the per kWh fuel consumption o f thermal plants due to improved, economic dispatch: 1.5 percent; 0 Reduction in transmission losses: 0.5 percent; and 0 Reduction in the frequency and duration of forced outages within the HV transmission system. The project's increase of the overall efficiency of electricity generation in Azerbaijan will reduce local air pollutants in Azerbaijan and abate C02 emissions responsible for global climate change from burning of fossil fuels (mazut and natural gas) in thermal power plants. Azerbaijan has ratified the Kyoto Protocol and the Ministry of Ecology and Natural Resources has been selected as the Designated National Authority (DNA). Azerbaijan i s thus eligible to act as host country for greenhouse gas mitigation projects implemented under the Clean Development Mechanism of the Kyoto Protocol and the power transmission project offers a good opportunity for creating additional income by selling the C02 emissions reductions generated by the project. In order to assess and ascertain the C02 emission reductions from the proposed project, two baseline studies are currently being prepared. It is preliminarily estimated that increased electricity generation from existing hydropower stations though Decision Support System would generate about 2 million tons of C02, and improved efficiency in power system generation 83 through advanced SCADA and an Energy Management System i s expected to generate approximately 2.5 million tons of C02 over a ten-year period. The Dutch government has agreed to include the project inthe portfolio of the Netherlands Clean Development Facility (NCDF), which i s one of the carbon funds managed by the World Bank. They NCDF will buy 100percent of the amount of emission reductions generated by the project till 2012. The exact amount to be purchased will be determined after the study to estimate the emission reductions i s completed and due diligence on the carbon finance project has been performed. The Azerbaijani DNA i s well informed about the project and approves of it. It i s expected to formally approve the project in 2005. It is expected that negotiations on an emission reductions purchase agreement (ERPA) between the World Bank and the project sponsor Azerenerji will be completed in 2006. The ERPA will determine the exact amount of C02 emission reductions that would be purchased by the World Bank, the unit price, and the delivery over time. The amount of carbon finance revenue earned by the project sponsor would depend upon the amount of greenhouse gas emission reductions generated by the project and the unit price(s) agreed between the buyer(s) and seller. Assuming a price of US$4/tC02, the project could potentially generate an income of up to US$18 million. Within the first five-year commitment period under the Kyoto Protocol (2008-2012) the project would generate about US$5.4 million (in the 2010-2012 period). The income from selling COz emission reductions would raise the project Internal Rate of Return (IRR) by 0.8 percent, and the project Net Present Value (NPV) would increase by US$ 2.8 million. If the government parties to the Kyoto Protocol agree to renew the five-year commitment period (i.e., 2013-2017), or other post-2012 regional or international emissions treading schemes are to emerge, it will become possible for Azerenerji to sell a substantial amount of the GHG emission reductions generated by the project. The carbon finance income will increase significantly as a result. Due to the World Bank's experience with the C D M and the global carbon market, Bank involvement in the carbon finance project would be very significant in terms of carbon asset development and inbuildingrecognition of Azerbaijan as a C D M country. The World Bank has as a pioneer in the early carbon market acquired valuable methodological experience and expertise that would benefit this carbon finance project. Because it would be the first CDM project implemented in Azerbaijan, the project would be significant, as it would help demonstrating Azerbaijan's capacity to participate successfully in this emerging market. The poor conditions of the existing power plants in Azerbaijan offer considerable potential for other carbon finance projects. A detailed description of carbon finance component of the project will be made available in the Carbon Finance Document (CFD) and the Project Design Document (PDD), respectively, during the first half of 2005. 84 Annex 13: Documentsinthe Project File AZERBAIJAN: Power Transmission Project KEMA Inc., Dar a1Handash, "Azerenerji Joint Stock Company, FinalFeasibility Study Report, PartI, Transmission Project", October 2004 Power KEMA Inc., Dar a1Handash, "Azerenerji Joint Stock Company, FinalFeasibility Study Report, Part11,Rehabilitation Assessment" (Environmental Assessment), October 2004 Azerenerji, "Power Transmission Project (IBRD): Environmental Management Plans", 2005 Burns& RoeEnterprises, "Republic of Azerbaijan, Prioritization of Investment Needs for Power Generation and Transmission", November 2003 Dr.V. Valiyev, "Review of the ExistingPower andGasNetworksinAzerbaijan", June 2002. World Bank, "Azerbaijan: Issues and Options Associated with Energy Sector Reform", November 2004 World Bank, "Azerbaijan Raising Rates: Short-Term Implications of Residential Electricity Tariff Rebalancing", December 10,2004 Nexant: "Azerbaijan: Development of the Regulatory Framework and Institutional Capacity in Electricity, Natural Gas, andWater", August 13, 2004 Website for further information about Azerenerji: www.azerenerji.com/ 85 l:l 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 w 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0151 22 :I ~ ~ 9 90909 0 0 9 9 90909 0 0 9 9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 9 9 0 0 9 9 0 0 0 0 z 49 v) 3 .E + < m 0 0 0 0 l n ~ 0 0 0 0 0 0 0 0 0 N 9 9 9 9 ? 9 ? 9 9 9 9 ? 9 9 g N ~ m ~ l n m m m c N O c t - 0 - m * * m m N w m 'z-cz9090 0 0 0 0 0 0 0 0 0 0 0 0 0 8 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 9 9 9 9 9 9 9 9 9 9 9 9 9 8 E . z o o o o o o o o o o o ~ 0 0 0 0 0 0 0 0 0 0 8 9 9 9 9 9 9 9 9 9 9 0 u . $ 8 ? 8 8 8 8 7 8 8 8 1 3 a $ 0 0 0 0 0 0 - o o o r i Annex 15: Country at a Glance AZERBAIJAN: Power Transmission Project ` Europe 8 POVERTY and SOCIAL Central LOW- Azerbaljan Asia income Development diamond* 2002 Population, mid-year (millions) 8.2 476 2,495 Lifeexpectancy GNIper capita (Atlas method, US$) 710 2,EO 430 GNI(Atlas method, US$ billions) 5.8 T 1,030 1,072 Average annual growth, 1996-02 Population (77) 0.9 0.1 1.9 Labor force rk) 1.8 0.4 2.3 GNI Gross M o s t recent estimate (latest year avallable, 1996-02) per primary capita nrollment Poverty (%of populationbelownationalpoverfyline) Urban POpulation ("70f totalpopulation) 52 63 30 Lifeexpectancyat birth (pars) 65 89 59 1 infant mortality (per 1000livebirths) 74 25 81 Childmalnutrition ("of childrenunder5) l7 Access to improvedwater source Access to an improvedwtersource(%ofpopulation) 78 91 76 Illiteracy(%ofpopulation age E+) 3 37 Gross primaryenrollment (%of school-age population) 98 102 95 -Azerbaijan Male 97 103 103 . Low-incomegroup ____ Female 99 101 87 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1982 1992 2001 2002 1Economic ratios' I GDP (US$ billions) .. 0.44 5.7 6.1 Gross domestic investment/GDP .. -0.7 20.7 32.8 Exportsof goods andservicesiGDP .. 68.2 415 43.8 Gross domestic savings/GDP 24.9 25.3 Gross nationalsavings/GDP 20.4 202 Current account balancelGDP -0.9 -P.6 interestpaynentsiGDP 0.4 0.3 Total debtiGDP 22.2 23.6 Total debt service/exports 5.3 65 Presentvalue of debt/GDP 7.4 Presentvalue of debffexports 39.5 Indebtedness 1982-92 1992-02 2001 2002 2002-06 (averageannualgrowth) GDP 12 9.9 10.6 -Azerbaijan II GDP percapita 0.1 8.9 9.6 I - - Low-incomeorouo 1982-92 lgg2-02 2o01 2o02 -Growth o f exports and imports (averageannualgrowth) ( O h ) Agriculture .. 0.8 111 7.5 40 Industry .. -2.2 7.3 8.5 Manufacturing .. -8.6 -3.7 4.0 PO Services .. 11.3 P.1 4.1 Privateconsumption 9.2 n.9 5 2 -20 - Generalgovernmentconsumption .... 6.8 -9.5 5.5 - -40 Gross domestic investment .. 7.2 -44.4 61.0 Imports of goods and sewices .. 5.3 -2.4 20.7 -Exports -1rrports 88 Aierbaiian PRICES and GOVERNMENT FINANCE 1982 1992 2001 2002 I tnflation ( O h ) b Domestic prices ("hchange) Consumer prices 15 2 7 Implicit GDP deflator 2.5 0 7 Government finance (%of GDP,includes current grants) Current revenue 215 28 0 Current budget balance 4.7 5 4 Overall surplusideficit 0.9 -0 5 TRADE 1982 1992 2001 2002 Export and Import levels (US$ mill.) (US$ millions) Totalexports (fob) 2,046 1969 12,500 T n.a. n.a. 2,000 Manufactures 205 226 1,500 Total imports (cif) 788 1,465 2,136 1,000 Food Fuel and energy 500 Capital goods 138 732 0 00 Export price index(W95=00) 262 259 96 97 98 99 01 Importprice index(1995=00) 98 98 Exports lnports Terms of trade (W95=WO) 268 264 BALANCE of PAYMENTS 1982 1992 2001 2002 Current account balance to GDP (%) (US$ millions) Exports of goods and services 2,369 2,667 Importsof goods and services 2,130 3 P1 Resource balance 239 -454 .10 Net income -367 -365 Net current transfers 77 70 -20 Current account balance -52 -768 -30 Financing items (net) 3 7 965 Changes in net reserves -266 -97 -40 Memo: Reserves includinggold (US$ millions) 725 721 Conversion rate (DEC,local/US$) 54.2 4,656.7 4,860 7 EXTERNAL DEBT and RESOURCE FLOWS1982 1992 2001 2002 (US$ millions) Composition of 2002 debt (US$ mill.: Total debt outstanding anddisbursed 1266 1,438 IBRD 0 0 G 82 IDA 235 314 Total debt service 132 187 IBRD 0 0 IDA 2 2 Composition of net resourceflows Official grants 45 Officialcreditors 88 l79 Privatecreditors 36 -79 Foreigndirect investment 227 Portfolio equity 0 D' 120 World Bank program Commitments 50 82 A E-Bilatera. Disbursements 28 57 6 IDA -- IBRD D Otkr mltilaterd - F- Private Principal repayments 0 0 C-IMF G. Sbrt-terrr 89 IBRD 33695 45° To Tbilisi 46° 47° 48° 49° 50° 51° R U S S I A N A Z E R B A I J A N To Derbent G E O R G I A YALAMA BALAKEN Katekhchay POWER TRANSMISSION PROJECT F E D E R AT I O N OTHER KATEX ZAGATALA KHUDAT REHABILITATION EXISTING Samur PROJECT SUBSTATIONS (REHABILITATION) THERMAL POWER PLANTS River KHACHMAZ PROJECT NATIONAL DISPATCH CENTER (NDC) HYDRO POWER PLANTS To Tbilisi GUSAR PROJECT BACKUP CONTROL CENTER (BCC) SUBSTATIONS EYRICHAY Iori PLANNED GUBA CHARCHI PROJECT TRANSMISSION LINES (REHABILITATION): TRANSMISSION LINES: 500 kV 500 kV DEVECHI 330 kV 330 kV Not in SHEKI SHEKI service, 220-230 kV 220-230 kV p a r t l ydismantled 154 kV 154 kV 41° SIYAZAN 110 kV 110 kV GAZAKH AGSTAFA 41° SHAMKIR Kura NATIONAL CAPITAL Shamkir GILAZI Reservoir Mingachevir GABALA YENIKEND Reservoir INTERNATIONAL BOUNDARIES MINGACHEVIR ISMAILLI DYUYERLI AZERBAIJAN Chikilchay YASHMA See inset for detail ShamkirchGANDJA ay GANDJA GORAN VARVARA SHAMAKHI SUMGAYIT C a s p i a n S e a 1 GANDJA GOYCHAY KYUREKCHAY YEVLAKH AGSU SANAYE-GOVSHAGI SHIMAL KHIRDALAN GALA LEKI DASHKESAN KIRAZ 1 UDJAR MYUSYULYU APSHERON BCC NDC BAKU YSK MUSHVIG BARDA KAZAKHSTAN UKRAINE Lake TARTAR KURDAMIR LÖKBATAN Sevan RUSSIAN FEDERATION SANGACHAL TARTAR Kura er Riv GAZI-MAMMAD KELBADZHAR GOYTAPA KHINDIRISTAR 40° A R M E N I A Black Sea 40° AGDZHEBEDI SABIRABAD ALAT Caspian ZULFUQARH GEORGIA Sea TURKMENIST ISTISU SAATLI ALI-BAYRAMLI ARMENIA AGDAM YENI AZERBAIJAN Baku BEILAGAN SADARAK BAHRAMTAPA IMISHLI TURKEY AN KHANKENDI KHOCAVAND KHALAJ To Turkey SHUSHA DASHBURUN LACHIN PARS- ABAD SALYAN SYRIAN ARAB REP. IRAQ ISLAMIC REP. OF IRAN Araz BOYUK SHARUR SABIR NS HARAMI SAMADABAD FIZULI River Araz To BILASUVAR Yashma SUMGAYIT 2 Kura NEFTCHALA C a s p i a n QOZLUCAY GIVRAG SANAYE-GOVSHAGI JEHRI GUBADLI JABRAYIL SUMGAYIT 1 GOREDIL ZAVOD S e a BABEK GARGALIG BSK XALCAQILIQ NAKHCHIVAN 2 kV) JALILABAD BUZOVNA NAKHCHIVAN KOROGLU KarasuRiv MASHTAGA Araz JEYRANBATAN BÖYÜK SOR SHIMAL Reservoir re (132 MASALLI ARAZ ZANGILAN 39° ZABRAT 39° JULFA AIRPORT 0 10 20 30 40 50 APSHERON KHIRDALAN ORDUBAD BORADIGAH RAMANA BCC NIZAMI ISLAMIC REP. KILOMETERS GALA SÜRAKHANI KHOY 2 OF IRAN LENKORAN 1 This map was produced by the Map Design Unit of The World Bank. BAKU NDC HÖVSAN KHOY Lenkaran LENKORAN 2 The boundaries, colors, denominations ZYG KHOY 1 and any other information shown on this map do not imply, on the part of MUSHVIG The World Bank Group, any judgment PATAMDAR SARDROUD on the legal status of any territory, or TAGI DIZE TABRIZ ASTARA any endorsement or acceptance of such boundaries. LÖKBATAN B a k u B a y To Ali 45° 46° 50° Bayramli To Urmiya To Zanjan 48° ASTARA MAY 2005