Republic of Armenia: Maximizing Finance for Development in the Power Sector June 2021 ©2021 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved This Note is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this report is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development / The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Centre Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone: 978-750-8400; fax: 202-522-2422; e-mail: pubrights@worldbank.org. 2 This report has been prepared by a team of experts led by Emil Zalinyan and Artur Kochnakyan. The report benefitted from insights and the guidance received from Sebastian-A Molineus, Regional Director for South Caucasus, Sylvie Bossoutrot, Country Manager for Armenia, and Sameer Shukla, Energy Practice Manager for Europe and Central Asis Region. Valuable inputs were also provided by Sebnem Erol Madan, Zhengjia Meng, Gor Khachatryan, Joern Huenteler, Koji Nishida, Natalia Manuilova, Irina Gordeladze, Armine Aydinyan, Bernardo Barros, Artak Eloghlyan, Tanvir Hossain, Armenuhi Burnazyan, Thomas Vis, Claudia Ines Vasquez Suarez, Jeffrey Delmon, Gaetan Tiberghien, Armineh Manookian Salmasi, Pierre Prosper Mesalli, Bujana Perolli, and others. This report has been prepared with financial support from the World Bank and the Energy Sector Management Assistance Program (ESMAP). The financial and technical support from ESMAP is gratefully acknowledged. About ESMAP The Energy Sector Management Assistance Program (ESMAP) is a global knowledge and technical assistance program administered by the World Bank. It provides analytical and advisory services to low- and middle-income countries to increase their know-how and institutional capacity to achieve environmentally sustainable energy solutions for poverty reduction and economic growth. ESMAP is funded by Australia, Austria, Canada, Denmark, the European Commission, Finland, France, Germany, Iceland, Italy, Japan, Lithuania, Luxembourg, the Netherlands, Norway, the Rockefeller Foundation, Sweden, Switzerland, and the United Kingdom, as well as the World bank. ESMAP I 1818 H Street, NW I Washington DC 20433 I 202.522.3018 I www.esmap.org 3 Objective of this Study Overview of potential WBG support 4 TABLE OF CONTENTS  Synopsis of Main Issues and Solutions  Power Sector Overview  Power Sector Investment Needs  Financing of Power Sector Investments to Date  Financing of New Investments  Constraints to Raising of Additional Capital  Unlocking New Sources of Finance  Tariff Impacts of Long-Term Commercial Financing  Potential World Bank Group Support  Annex 5 Synopsis of Main Issues and Solutions SYNOPSIS MAIN ISSUES (1-3) 1. Absence of Framework for Public Investment Management with  Clear definition of project cycle related institutional responsibilities  Technical, economic, financial, environmental and social criteria for prioritization  Framework for evaluation of project risks, design of mitigation measures, and risk management  Project management, implementation, monitoring, and handover arrangements  Clear procedure for prioritization of projects 2. Inefficiencies in PPP Project Cycle  Project pipeline development bottlenecks  Lack of funding for project preparation  Prevalence of unsolicited proposals  Absence of model contractual documents  Institutional capacity constraints to prepare and implement PPPs  Lack of framework for assessment and management of government financial commitments under PPPs 3. Lack of Predictability of Tariff Revenues for Regulated Power Sector State-Owned Enterprises (SOEs)  Annual review and approval of operating and maintenance (O&M) expenditure does not create incentives for power sector SOEs to improve efficiency and reduces predictability of cash flows for potential long-term commercial lenders  Lack of transparent methodology for computation and regular adjustment of return on assets (WACC on regulated asset base) is not conducive for attracting long-term commercial financing in SOEs 7 SYNOPSIS MAIN ISSUES (4-5) 4. Shortcomings in Corporate Governance  Boards of Directors: (a) not empowered by corporate documentation, (b) non-clear division of responsibility, (c)absence of specialized committees for effective oversight of companies’ activities, (e) lack of clearly formulated compensation mechanis m, and (e) irregular performance evaluation  Performance Monitoring & Management: (a) SOE management is not accountable to the Board of Directors for implementing the strategy and adhering to the set operational and financial targets; (b) absence of linkage of SOE strategy and objectives with performance indicators and targets; and (c) SOE management remuneration is not linked to SOE performance and achievement of objectives  Financial Reporting, Audit & Disclosure : (a) HVEN has no Internal Audit function; and (b) SOEs do not publish their annual reports and corporate governance statements at the company website  Corporate Documentation: (a) Board of Directors do not have proper delegation of authority to carry its functions effectively; and (b) no Code of Ethics needs to be introduced 5. Limited Availability of Long-Term Financing  Lack of interest from international lenders & local pension and investment funds due to lack of pipeline and relatively small size of projects  Limited utilization of fintech innovations, such as crowdfunding, to increase availability of capital for small project financed deals  Limited knowledge of project financed by local capital market 8 SYNOPSIS Solutions (1-3) 1. Adoption and Implementation of Broader PIM framework. We recommend the Ministry of Economy to approve and implement PIM with clear requirements for:  Project Identification and Prescreening based on robust generation and transmission subsector planning inputs from MTAI  Formal Project Pre-Appraisal, Appraisal & Independent Review of Appraisal  Project Prioritization and Selection  Project Implementation and Adjustment  Facility Commissioning, Operation & Review and Evaluation 2. Elimination of Shortcomings in PPP Project Cycle. We recommend the Government to:  Establish a project development facility to serve as a one-stop project preparation fund for PPP projects  Carry out transparent and competitive procurement for PPPs  Carry out transparent and competitive procurement processes for PPPs consistent with the Law on PPPs  Roll out PPP template documents (e.g. PPAs for large projects, Government Support Agreements) under the PPP legal framework, while leaving flexibilities to adapt documents to specific future deal needs  Prepare a comprehensive capacity building program based on skill requirements across the PPP project cycle  Develop a framework for assessment of financial commitments and contingent liabilities under PPPs 3. Improve Predictability of Cash Flows. We recommend PSRC to consider:  Fixing O&M expenditures in the SOE tariff for a period of at least three years through cost-efficiency coefficient to be applied to those expenditures after each revision based on similar coefficients applied to well-performing utilities  Specifying and publicly disclosing the approach to computation and adjustment of return on assets for power sector SOEs 9 SYNOPSIS Solutions (4-5) 4. Improve Corporate Governance. Snapshot of key improvements required:  Strengthen Board of Directors: (a) align the authority with good practices in design of strategy, determining performance objectives, monitoring financial and operational performance & decisions on management appointment; (b) appoint at least two independent Board Members; (c) establish Board Committees; (d) introduce qualification and experience requirements for existing or potential board members; and (d) introduce annual evaluation mechanism  Introduce Performance Monitoring & Management: (a) establish clear accountability lines between SOE Board of Directors and its Executive Management; (b) introduce regular performance monitoring mechanism; and (c) design SOE performance monitoring system for keeping SOE management accountable for results  Strengthen Audit, Financial Transparency & Documentation: (a) appointing Internal Auditors to oversee the SOE’s internal control system; and (b) publish full annual reports, corporate governance statements and other non-financial information  Improve Corporate Documentation: (a) expand the section on a board of directors, defining the number of board members and their appointment terms; (b) add core functions to the Board, such as strategy-setting, management appointment, monitoring responsibility for the Company’s performance (via KPIs) and efficient internal controls; (c) develop and adopt internal by-laws and regulations (e.g. regulation on the Board of Directors and its Committees, Regulation on Related Party Transactions, Conflict of Interest, Information Disclosure Policy) 5. Increase availability of capital from domestic and international capital markets  Development of robust and adequately-sized (through aggregation) PPP pipeline would attract long-term financing from international lenders and local capital market (pension funds)  Introduction of crowdfunding would enable small projects to access larger pool of long-term resources  Strengthen the capacity of local capital market in project finance 10 SYNOPSIS Tariff Impacts and Benefits of Long-Term Commercial Financing of Power Sector SOEs Refinancing with US$ denominated commercial debt Refinancing with AMD denominated commercial debt  Commercial financing of HVEN and YTPC, including refinancing of existing debts, would raise the end-user tariff only by 2-3% vs “No Commercial Financing Scenario”  Credit-enhancement has beneficial impact to achieve much-needed extension of maturity Why Long-Term Commercial Financing of Power Sector SOE Investments and Refinancing of Existing Public Debt is Viable?  Public debt refinancing with foreign currency denominated commercial debts will smooth out the debt service requirements of power sector SOEs  In the long-run, the end-user power tariff will rise by 2.2%-3.2% relative to the base case scenario of “no public debt refinancing”  Refinancing of existing public borrowing of HVEN and YTPC can release at least $300 million for MOF to spend on other pressing needs 11 Power Sector Overview POWER SECTOR OVERVIEW Electricity Demand • 1999-2019: 2.2% average annual growth of domestic electricity sales • Demand growth driven by industrial, services, and residential sectors; average annual GDP growth of 6.4% in 2003-2019 1999-2002: Price 2008: Economic 2018: Reduction in industrial and residential 2003-2019: elasticity effect due downturn due to demand with economic growth driven by services  150% growth in “other commercial” demand – to improved billing global financial crisis with low energy intensity and trade intermediation primarily leisure and hospitality (non-recurrent growth episode)  89% growth in industrial demand  47% growth in residential demand driven by heating and air conditioning 13 POWER SECTOR OVERVIEW Electricity Supply Diversified electricity supply mix with efforts underway to further expand the share of RE Existing Power Plants Type Installed Capacity ANPP Nuclear 400 MW 800 MW (400 MW Hrazdan TPP Thermal (gas) operational)* Hrazdan-5 TPP Thermal (gas) 440 MW YTPC CCGT Thermal (gas) 242 MW Sevan-Hrazdan Cascade/IEC Hydro 560 MW Vorotan Hydro 404 MW Cascade/ContourGlobal  Share of gas-fired thermal* reduced from 43% in 2012 to 37% in Small RE and cogeneration Small hydro, wind, 280 MW 2017 (<30MW) and solar  Share of small RE** increased from 7% in 2012 to 13% in 2017 Under-Construction Power  Share of nuclear is relatively stable given it is a low-cost base-load Type Installed Capacity Plants power plant Yerevan CCGT-2/RENCO Thermal 226 MW * Share of thermal increased in 2018 and will be higher until 2023 because ANPP CCGT is off-line operating life extension project. SHPPs Small hydro 382 MW ** Small RE = primarily small and micro hydro, small wind and solar. Masrik-1 Solar PV Solar PV 55 MW 14 POWER SECTOR OVERVIEW Electricity Losses and Collection Performance • 1999-2019: Transmission losses reduced from 5% to 2% • 1999-2019: Distribution technical losses reduced from 16% to 7%; commercial losses – from 11% to 0.1% • 1999-2019: Collections increased from 67% to 100% 1999-2002: Price elasticity 2008: Impacts of 2010: Expansion of 2015-2016: Overhaul of commercial effect due to improved global financial crisis the share of smart and metering departments after sale metering and billing after meters of ENA to Tashir Capital and Liormand privatization Holdings 15 POWER SECTOR OVERVIEW Phases of Sector Reforms Operationally efficient and financially sustainable power sector ready to enter next phase of development • Unbundling of power sector into legally independent generation, transmission, dispatch, supply and distribution companies • Involvement of private sector including privatization of power distribution and several generation companies Phase 1: • Establishment of legal and regulatory framework including establishment of independent regulatory commission 1998-2006 (PSRC), licensing rules and regulations, cost-recovery tariff methodology • Rehabilitation of critical power transmission and distribution assets • Construction of new generation capacity and rehabilitation of existing Phase 2: • Kick-starting development of renewable energy and energy efficiency 2007-2019 • Implementation of financial recovery program to improve sector financial sustainability • Gradual liberalization of the power market and introduce elements of competition • Further improvement of operational efficiency and security, including digitization and cybersecurity, and financial strength of power sector SOEs Phase 3: • Facilitating capital market access of power sector SOEs 2020- • Further improvement of regulatory framework to improve long-term predictability of SOE revenues 16 POWER SECTOR OVERVIEW Current Power Market Structure Regulated and unbundled sector with legally independent generation, transmission, and distribution functions Sector Institutional Overview:  System operator is responsible for dispatch and supply security.  Independent multi-sectoral regulator- Public Services Regulatory Commission (PSRC) is responsible for tariff setting, service quality and licensing.  Ministry of Territorial Administration and Infrastructure is responsible for energy policy.  Renewable Resources and Energy Efficiency Fund Distribution/ (R2E2 Fund) is responsible for promotion of Supply investments into EE and RE. Significant Private Investments in the Power Sector:  Most of generation is privately owned except for Armenian Nuclear Power Plant (ANPP) and Yerevan Combined Cycle Gas Turbine (CCGT) Plant.  Electricity generation company – Electric Networks of Armenia (ENA) – is privately-owned.  Electricity transmission company – High Voltage Electric Networks (HVEN) – is state-owned. 17 POWER SECTOR OVERVIEW New Power Market Structure: Key Legislation and Regulations Regulatory framework is ready for roll-out of new power market structure PILOTING of the new Market Model happening now Amended Electricity market Action Plan for the Market Rules, Energy Law Contracts, New Liberalization Electricity market approved Liberalization Network Codes Market Concept approved by the approved by the approved by goes live by the PSRC Parliament GoA PSRC February 2018 August 2018 September 2018 December 2019 February 2021 Was adjusted on Will be revisited Delayed for 1 year due to COVID19 MARKET September 2019 during OPERATOR PILOTING functions MARKET assigned to MANAGEMEN Settlement T SOFTWARE Center development started 18 POWER SECTOR OVERVIEW New Power Market Structure: Details The Government has embarked on gradual liberalization of the power market to be rolled out by end-2021 Gas for electricity swap Balancing Market System Balancing Services Mechanism Exports 1. The objective of the new electricity market design is to Imports Traders Imports introduce structure to allow for Day Ahead Day Market Ahead Imports increased competition in the Market future Regulated Non-Regulated Segment 2. Electricity market will have the Non Bilateral Contracts APP following segments: Customers  Bilateral market comprised of Regulated Segment Regulated Bilateral Anci electricity long-term bilateral Bilateral Market Contracts contracts, month ahead regulated bilateral contracts Long Term Segment Capacity Electricity Long Term Bilateral Long Term Bilateral and non-regulated bilateral Contracts Contracts contracts  Day ahead market  System services and balancing SO MO TO Regulated Tariff mechanism market – New generation units (not commissioned yet) Customers Vulnerable Customers 19 POWER SECTOR OVERVIEW New Power Market Structure: Wholesale and Retail Market Participants Wholesale Retail Regulated Power Producers (incl. RES generators) Renewable Power Producers UNIVERSAL SUPPLIER POWER PRODUCERS Independent Power Producers Merchant Power Producers • Electricity Supply At Regulated Electricity Sale/Purchase Tariffs UNIVERSAL The new role of the universal supply granted by Law SUPPLIER (until end of June 2025) exclusively to ENA. ENA mainly providing distribution service Expected to be created initially for supplying large INDEPENDENT SUPPLIERS INDEPENDENT consumers that may not consider direct SUPPLIERS participation in the Wholesale Market and all retail • Electricity Supply At Market customers Prices Electricity Sale/Purchase TRADERS Traders expected to be facilitators of the wholesale trade and activate cross border trade AUTONOMOUS POWER PRODUCERS QUALIFIED Direct access to the Wholesale Electricity Market • Generators under net metering rules CUSTOMERS with a right to import electricity IPPs will continue selling to off-taker at contractually-agreed PPA tariffs 20 POWER SECTOR OVERVIEW New Power Market Structure: Market Service Providers SYSTEM MARKET TRANSMISSION DISTRIBUTION BALANCING SERVICE OPERATOR OPERATOR OPERATOR OPERATOR PROVIDER • Planning & • Operation and • Transmission • Electricity • Balancing services forecasting maintenance Service (Asset Distribution • Purchase & sale of Management) • Registration of • Scheduling & of MMS electricity under Dispatching software • Electricity transit Retail Balancing • Operational • Operation of Metering data Mechanism • Organization of Management Market Metering Complex • Distribution • Transmission Network • Interconnection Operation Network Rehabilitation Management • Registration of Rehabilitation and Extension Orders and and Extension Transactions • Metering & Settlement 21 POWER SECTOR OVERVIEW Asset Ownership Structure Significant private ownership in the sector: most of the electricity generation and the distribution are privately owned Installed Companies Type Ownership Capacity  80% of existing generation ANPP Nuclear 400 MW 100% SOE capacity is privately owned Hrazdan TPP Thermal 800 MW 100% private (Tashir Group)  100% of generation capacity Hrazdan-5 TPP Thermal 440 MW 100% private (Gazprom) under development is privately owned YTPC CCGT Thermal 242 MW 100% SOE  Electricity distribution company is Tashir Capital (70%) and Liormand privately owned Sevan-Hrazdan Cascade/IEC Hydro 560 MW Holdings (30%) Vorotan Cascade Hydro 404 MW 100% private (Contour Global) Existing generation Small hydro, Small RE 280 MW 100% private (various local investors) Under various stages of development wind, and solar RENCO CCGT Thermal 226 MW 100% Private (RENCO) SHPPs Small hydro 382 MW 100% private (various local investors) Masrik-1 Solar PV Solar PV 55 MW 100% private (FRV) HVEN Transmission 100% SOE ENA Distribution 100% private (Tashir Group) 22 Energoimpex Trader 100% SOE POWER SECTOR OVERVIEW Energy Strategy 2040 Energy Sector Strategy 2040 is the key document specifying the strategic objectives and priorities for next 20 years 1 Competitive and non-discriminatory Maximum utilization of renewable 1 potential Inclusive, diversified, and energy- 2 Strategic vision / objectives independent 2 Improvement of energy efficiency 3 Clean, efficient, effective and sustainable Priorities 4 Regionally interconnected 3 Life extension of ANPP Unit No. 2 5 Reliable and safe Improvement of regional 4 connectivity 6 Digitized and innovative Gradual liberalization of electricity Predictable and transparent 5 7 market Accessible, affordable, and attractive to 8 investors 23 POWER SECTOR OVERVIEW Key Legislation Sector legal framework is conducive for reliable and efficiency operation of the sector, and attraction of investments • Establishment of government policies in the energy sector and mechanisms for their implementation Law on Energy • Regulation of relationships among government bodies, energy sector legal entities, and energy consumers • Establishment of principles for promoting EE and development of RE to: (a) improve the reliability and security of energy supply; (b) facilitate new production/technologies and services aimed at promoting EE and Law on Energy development of RE; and (c) reduce negative impacts on human health and the environment Efficiency (EE) and • Regulation of relationships among government bodies, legal entities, and individuals involved in: (a) design, Renewable Energy manufacturing, and import of energy equipment and materials related to EE and RE; (b) design, (RE) manufacturing, and import of equipment for determining the quality of EE and RE equipment; and (c) activities for design, innovation, research & development in the fields of EE and RE • Regulates the procedures for establishment and functioning of the body responsible for regulation of public Law on Public Services services (electricity, gas, water, telecommunications) Regulatory Body • Defines the legal basis and regulates the principles related to: (a) use of nuclear energy with the aim to Law on Safe Utilization protect human life, health, property, and the environment; (b) advancement of peaceful nuclear science and of Atomic Energy for technical development ; and (c) cooperation in strengthening of the international regime governing the safe Peaceful Purposes utilization of nuclear energy 24 POWER SECTOR OVERVIEW Key Pillars of Regulatory Framework Sector regulatory framework is conducive for reliable and efficiency operation of the sector, and attraction of investments • Regulates generation, transmission, distribution and supply of electric energy Clear licensing • 80 days for review of license request applications by authorized body for all activities subject to regulation requirements with exception of small RE with review period of 25 days • Cost-recovery tariff methodology allowing for recovery of economically justified costs • Adequate track-record of tariff adjustment with pass-through of changes in costs Predictable and • End-user tariffs reflect the cost of supply to each category of consumers Robust Tariff Policy • Tariffs are regularly rebalanced to avoid unjustified cross-subsidies (this does not include lifeline tariff for vulnerable consumers) • Wholesale and Retail Electricity Market Rules • Wholesale and Retail Electricity Market Model Contracts Clear market rules • Transmission Grid Code • Distribution Grid Code Transparency and • High level of legal and regulatory transparency with key decision and other important info published by PSRC stakeholder • All key decisions are published for public feedback 30 days in advance of the decision meeting engagement • Key stakeholders are allowed to attend the PSRC meeting/discussion • Tariff regulatory filings are public 25 POWER SECTOR OVERVIEW Tariff Framework  Tariffs cover the cost of electricity service and have mostly been at cost-recovery levels since early 2000s  Lifeline tariff structure protects the vulnerable consumers End-user Tariffs Effective from Feb 1, 2021 Operating and Maintenance Costs Methodology Applies to:  Large regulated Category Tariff (VAT incl), AMD/kWh generators Fuel Costs - ANPP 110 kV (day-time) 36.48 - YTPC 110 kV (night-time) 32.48 - Hrazdan TPP 35 kV (day-time) 38.98 Depreciation - Hrazdan-5 TPP 35 kV (night-time) 34.98 - IEC - ContourGlobal, 6 (10) kV (day-time) 44.98 Debt Service (if public debt) 6 (10) kV (night-time) 34.98  Transmission company 0.38 kV (day-time) 47.98 Return on Assets (HVEN) 0.38 kV (night-time) 37.98  Distribution company 0.38 kV (day-time): monthly consumption <400 kWh 44.98 Taxes (ENA) 0.38 kV (night-time): monthly consumption <400 kWh 34.98 Consumers in PFBP with poverty score of >20* (day-time): 29.99 At least annual adjustment of tariffs to pass through the Consumers in PFBP with poverty score of >20 (night-time) 19.99 changes in costs due to inflation and/or depreciation of FX * Poverty Family Benefit Program 26 POWER SECTOR OVERVIEW Protection of Vulnerable Consumers The impact of tariff increases for residential customers is mitigated through a preferential tariff, which is a cross-subsidy with other residential consumers paying a higher tariff Category Tariff (VAT incl),  Residential consumers/households up with monthly AMD/kWh consumption of up to 400 kWh pay 6.3% lower tariff. This 0.38 kV (day-time) 47.98 threshold allows to reach all vulnerable consumers 0.38 kV (night-time) 37.98 because the estimated mean consumption of households in first two quintiles is less than 140 kWh/month 0.38 kV (day-time): monthly consumption 44.98 <400 kV  Consumers involved in PFBP and having poverty score of >20 pay 37.5% lower tariff. Further assessments are 0.38 kV (night-time): monthly consumption 34.98 required to determine what % of socially vulnerable <400 kV consumers benefit from this preferential tariff Consumers in PFBP with poverty score of >20 29.99 (day-time): Consumers in PFBP with poverty score of >20 19.99 (night-time) 27 POWER SECTOR OVERVIEW Legal Framework for Public-Private Partnerships In Armenia, Public-Private Partnerships (PPPs) are governed by the Law on Public-Private Partnership and the Law on Public Procurement The Law On PPP was adopted on June 28, 2019, on the basis of the PPP Policy of the Republic of Armenia, dated November 9, 2017. The Law defines the objectives of PPP, the rules and procedures of development and implementation of PPP programs, the institutional framework and the project selection criteria Objectives PPP project criteria Government support mechanisms Dispute Settlement • Reduction of life-cycle costs • Project life of more than 5 • Grants and subsidies All disputes are settled in and improvement of the years • Allocation of necessary assets for PPP accordance with: quality of construction, • Aimed at creation, projects • PPP Agreement operation and maintenance improvement, operation and • Guarantees of minimum revenues or • The mechanism set in the of public infrastructure maintenance of public minimum number of customers with agreement on investment • Increased access to public infrastructure PPP program promotion and mutual infrastructure and services • Risk sharing between private • Guarantees purchase of a portion of protection ratified by the • Use of private sector and public partners goods and services produced by the PPP Republic of Armenia experience, resources, • Economic returns higher than project Parties of the PPP Agreement are technologies and innovative the hurdle rate established by • Loans and other forms of free to choose the dispute capacities the PPP procedures (IRR>9%) financing/investment settlement mechanism, including: • Increased public • Alignment with priorities of • Compensation for certain risks and costs • Adjudicator accountability and Public Investment • Fiscal guarantees • Legally binding or unbinding transparency Management Policy expert assessment or opinion • Attraction of investments in • Fiscally affordable • Local or international new public infrastructure • Positive value-for-money (VfM) commercial or investment arbitration 28 POWER SECTOR OVERVIEW Institutional Structure of PPPs Institutional framework is clear with specific division of responsibilities for PPP projects Policy Making Authority Authorized Body (Line PPP Division (Ministry of PPP Authorized Body (Ministry of Economy) Ministry) Economy) • Develops PPP Policy • Controls the • Provides administrative, • Drafts PPP projects • Promotes PPP projects implementation of methodological, expert, • Presents draft decrees on and attracts private financial obligations set by advisory, technical and preparation and investors/partners a PPP agreement other support to PPP modification of a PPP • Develops legal acts • Monitors PPP projects Authorized Body and Public project and extension of concerning the PPP from the point of view of Partners PPP agreements procedures contingent liabilities • Organizes training and • Organizes tenders in • Analyzes PPP projects capacity building activities accordance with selection based on PPP selection for Public Partners and PPP procedures criteria Authorized Body • Signs PPP agreement with • Provides an opinion on the winning participant PPP projects • Monitors PPP projects 29 POWER SECTOR OVERVIEW Renewable Energy Framework The legal and regulatory framework is overall supportive for RE investments  One construction and operation license with clear requirements  PSRC is required to respond within 25 days after submission 1 Streamlined licensing process  All solar PV projects <5 MW, all SHPPs and wind projects <30 MW are licensed  Solar PV >5 MW and wind >30 MW are licensed as per PPP framework  Interconnection to transmission network regulated by Transmission Grid Code 2 Clear grid connection requirements  Interconnection to distribution network regulated by Distribution Grid Code  Net metering for PV for personal consumption  Small HPP (<30 MW): FiT of AMD24.4 or US$0.05/kWh*; Offtake of 15 years  Distributed Small Solar (<5 MW): FiT of AMD24.4/kWh; Offtake of 20 years 3 Feed-in tariffs and off-take for small RE  Small Wind (<30 MW): FiT of AMD24.4/kWh; Offtake of 20 years  Solar with Net Metering (<500 kW): Net metering regulation with sale of excess to the grid at roughly 50% of the regulated tariff for particular voltage level  Competitive procurement for utility-scale RE  Contractual framework regulated by the Law on Public Private Partnerships, Law 4 Competitive procurement for utility- on Renewable Energy, and PSRC regulations including template PPA scale RE  Tested package of government support agreement is available (used in Yerevan CCGT-2/RENCO and Masrik-1 Solar PV Projects) *Converted using the following 2020 average annual exchange rate: US$1= AMD489 30 POWER SECTOR OVERVIEW Progress with Development of RE Share of RE in supply mix has been expanding since 2010 and several new projects are at various stages of development Installed Capacities of Small 2010 2020 New projects to be RE Projects commissioned by end-2023 Small RE generation increased from 6% SHPP 106 MW 382 MW 35 MW of total in 2010 to 11% of total in 2020 Distributed Commercial PV - - 115 MW  Small RE is defined as <30 MW PV with Net Metering - 85 MW 15 MW  No new large RE projects were constructed Total 106 MW 467 MW 165 MW Small RE capacity to reach 632 MW in 2023 Projects Sponsor Financiers 55 MW Masrik-1 Solar PV: Sponsor: FRV FRV, IFC, EBRD and Development of utility-scale non-hydro financial close reached (Netherlands) Ameriabank privately developed RE is accelerating 200 MW Ayg-1 PV: in procurement - - stage 100 MW Solar PV: feasibility study - - underway 31 POWER SECTOR OVERVIEW Impacts of COVID-19 COVID-19 did not impact financial or operational performance of the power sector Key Reasons Behind Robust Power Sector Performance during COVID-19:  Robust electricity tariff setting methodology with full pass-through of economically justified costs to end-user tariffs  At lease annual tariff adjustments to reflect changes in the cost of supply  Tariffs at cost-recovery levels  No public finance impacts from IPPs given no excess energy or supply capacity  Adequate operational efficiency  No deterioration in the reliability of electricity supply Key Indicators 2019 (pre-COVID) 2020 (COVD year) Domestic electricity demand 5,802 GWh 5,810 GWh Total electricity generation 7,632 GWh 7,723 GWh Average collection rate for electricity 100% 100% Payment discipline to IPPs 100% 100% Sector investments No deferral of investments due to COVID Reliability of electricity supply (SAIFI) 7.94 7.33 32 Power Sector Investment Needs POWER SECTOR INVESTMENT NEEDS Electricity Demand Projection Under Base Case, electricity demand is expected to grow at 2% per year considering long-term GDP growth rate and expected increase in electricity price Electricity Demand Growth Rate = Real Per Capita GDP Growth x Income Elasticity of Demand (0.7) + Annual Electricity Price Increase x Price Elasticity of Demand (-0.2) Growth of real GDP would increase electricity demand, while electricity tariff increases would reduce the demand a. GDP annual growth rate assumptions based on IMF World Economic Outlook Report (Oct. 2020).  High Case GDP growth rate - 6%  Base Case GDP growth rate – 4%  Low Case GDP growth rate - 3%. b. 2.4% annual increase of electricity price is the growth rate required to reach the long-run average incremental cost of electricity supply (LRAIC) by 2035. LRAIC was estimated based on the supply scenario with the lowest evaluated present value of economic cost. c. Electricity transmission losses were assumed to remain at 2% of net outflow from transmission network. d. Electricity distribution losses were assumed to reduce from 9.45% of net demand Electricity demand was projected at generation level and comprises: in 2018 to 6.84% by 2029 due to large investment program (around $425 million)  Electricity demand at consumer level of ENA for 2020-2027.  Transmission and distribution losses  Energy own use by power plants e. Power plant own use was assumed to reduce from 5.1% in 2018 to 3.1% after decommissioning of ANPP and old thermal plants. 34 POWER SECTOR INVESTMENT NEEDS What New Generation Investments are Needed For? New capacity is needed to meet incremental electricity demand, substitute inefficient generators, and replace plants due for decommissioning The need for new generation capacity was assessed to : 1. Meet the projected 2% increase (base case) of average annual electricity demand. 2. Reduce overall cost of supply if new lower-cost generation options are available. 3. Fill in the supply gap after decommissioning of:  ANPP: It is estimated to reach the end of its useful operating life currently schedule for 2026.  Hrazdan TPP: This plant has been commissioned in 1965-1970 without any major capital upgrade since then. Out of 800 MW of installed capacity, only 400 MW is operational. The plant has the highest operating cost in the system due to low heat rate consuming 2 times more gas compared to modern CCGTs. Expected to be decommissioned once new 226 MW RENCO CCGT is commissioned by end-2021. 35 POWER SECTOR INVESTMENT NEEDS Estimating Need For New Generation Capacity Generally-accepted least-cost planning approach was used to assess the need for new generation investments Only technically feasible generation technologies were considered. The following key data was used related to each Identification of the potential generation generation technology: (a) capital costs based on recent completed projects; (b) standardized capacities available on the 1 technologies market; (c) technical specifications for each technology as per manufacturers’ data, including minimum load and ramp- up/ramp-down constraints; and (d) adjustments to efficiency for thermal units considering the elevation of locations in Armenia. For the first iteration of LCP, electricity demand was assumed to be dependent only on real GDP growth rate. The energy Evaluation of LCP assuming unconstrained price increase trajectory was derived using two-step process: (a) estimated LCP was used to compute the long-run average 2 incremental cost of supply (LRAIC); and (b) current average tariff was assumed to increase to the level of LRAIC by 2035 to electricity demand generate sufficient revenue to finance those investments. The total supply cost included the capital costs, fuel costs, non-fuel variable and fixed operation and maintenance (O&M) 3 Minimization of the total supply cost costs, and import tariffs. The minimization of the total supply cost was carried out subject to: (a) the technical constraints of existing and new potential power generation technologies; and (b) cost of un-served energy. The electricity demand was updated to include the impact of energy price increase to the level of LRAIC and the updated 4 Electricity demand update demand was used for second iteration of LCP to right-size the new electricity generation capacity. The hourly dispatch simulation was conducted to confirm whether the evaluated LCP or other expansion plans are feasible, Validation of 5 i.e. meet the projected electricity demand subject to constraints. results Power flow and transient stability analyses was conducted to determine whether the proposed combination of projects be 6 Grid integration study able to normally operate in the power system and whether disturbances caused by its variability can be absorbed by the system. 36 POWER SECTOR INVESTMENT NEEDS New RE Investments are Economically Justified and Improve Energy Security US$1.5 billion of new financing would be required in 2021-2035 for construction* of solar PV and wind projects Gradual commissioning of 1,050 MW of new Solar PV Existing thermal power plants and RENCO CCGT (under construction) in capacity in 2021 – 2035 with total capex of $750 million combination with Solar PV can substitute the ANPP Total demand is assumed to reduce in 2029 given expiration of “Gas-for-Electricity” Swap Agreement with Iran Base Case Supply Scenario:  Base case domestic demand  Current volume of exports to Iran  Excludes projects that have reached financial close or are under construction (230 MW Yerevan CCGT-2, 55 MW Masrik-1, and 115 MW of distributed solar PV projects) Supply mix 2020 2035  Increase in the share of thermal Energy Strategy also includes: generation is due to increased reliance  500 MW of wind capacity, which is not part of LCP, but is planned from Nuclear 34% 0% on existing thermal power plants to supply diversification and energy security perspective Thermal 34% 53% meet daily and seasonal peak demand  At least 600 MW new nucellar power plant (NPP), which was not included after ANPP is retired into this Study given unclarity about its justification. However, if pursued, it Hydro 29% 25%  The Government should update LCP in would require at least US$3.5 billion in new investments in addition to Solar 1% 20% 2022 given rapid ongoing change in cost of Solar, Wind, and BESS, which may US$1.5 billion for solar PV and wind Imports 2% 2% make Solar PV + +Wind + BESS *Does not include at least US$200 million of ANPP decommissioning costs and financing costs economically competitive 37 POWER SECTOR INVESTMENT NEEDS RE can Replace Capacity to be Retired Solar PV is a cost-competitive replacement for existing nuclear power plant Projected Supply Mix on Jan. 24, 2020* Projected Supply Mix on Jan. 24, 2028 During winter peaks, ANPP would be replaced by thermal and Solar PV with thermal accounting for larger share given low solar irradiation in winter Projected Supply Mix on Aug. 8, 2020** Projected Supply Mix on Aug. 8, 2028 During summer peaks, ANPP would be replaced by Solar PV and thermal with Solar PV accounting for the larger share given high solar irradiation in summer * Winter peak load in 2017: Jan. 24 ** Summer peak load in 2017: Aug. 8 38 POWER SECTOR INVESTMENT NEEDS Other Advantages of Scaling up Solar PV 1. Abundant financing. Availability of significant concessional and commercial resources to finance the project. 2. Short lead time: New solar PV capacity can be commissioned in 18-24 months after financial close of the transaction with private developer, including the time required for competitive selection of project sponsors. 3. Construction of new capacity in small increments. The capacity can be constructed in small increments (e.g. 100 MW) parallel to the growth in demand. 4. Other benefits:  Local job creation in green technologies (local assembly and, potentially, higher value-adding segments of PV value chain)  Introduction of modern PV technologies with positive knowledge spillovers to local energy sector (on-job- training and specialized education).  No operational risk for the government compared to thermal projects (supply of fuel and water). 39 POWER SECTOR INVESTMENT NEEDS What New Transmission Network Investments are Needed For? HVEN would require additional US$230 million in 2021-2035 for further strengthening of transmission network Rehabilitation of four substations Strengthening of network to integrate 1,050 MW of solar PV  Rehabilitation of 220/110/10 kV Shahumyan-2  387 km of new lines and 3 supply transformers would be needed substation  The total capital cost is estimated at US$70 million  Rehabilitation of 220/110/10 kV Marash substation  Bulk of investments needed by 2025 due to expected solar build-up  Rehabilitation of 220/110/35 kV Yeghegnadzor substation Total capital cost of US$60 million Participation in Georgia-Armenia Interconnection Project  Preliminary analysis suggests that Armenia would benefit from participation in this power and digital interconnection project  Armenia’s share in total project benefits is estimated at 4% of the total benefits over 2030-2040 Total capital cost of US$100 million assuming it is Total capital cost of US$70 million proportionate to Armenia’s share of project benefits Year 2025 2030 2035 Transmission Capital Costs (million US$) 60 68 70 Solar Installed Capacity (MW) 717 1,000 1,050 40 POWER SECTOR INVESTMENT NEEDS What New Distribution Network Investments are Needed For? ENA plans to invest US$445 million in 2021-2027 to further improve electricity supply reliability at distribution level as part of US$727 million Investment Program for 2017-2027 Main Targets of ENA’s Investment Program 2017-2027:  Reduction in number and duration of end-user planned and unplanned outages due to distribution network issues  Reduction of reported cases of voltage fluctuations  Connection of new customers  Reduction of technical loses and minimization of commercial losses  Further improvement of metering infrastructure  Further improvement of cost effectiveness  Update of Management Information Systems (MIS) and continued adoption of ISO standards 41 Financing of Power Sector Investments to Date FINANCING OF POWER SECTOR INVESTMENTS TO DATE How were Generation, Transmission, and Distribution Investments Financed? In 2007-2019, US$2.5 billion of power sector investments were financed by international & local private sector and public borrowing US$1.72 billion of private debt and equity for:  Upgrade and rehabilitation of distribution network  Construction of Gazprom’s Hrazdan-5 TPP  Upgrade and rehabilitation of Sevan-Hrazdan Cascade  Construction of privately-owned and operated small RE (primarily SHPPs) US$750 million of sovereign-guaranteed debt for:  Rehabilitation of critical power transmission lines and substations  Rehabilitation of Vorotan Cascade  Construction of Yerevan CCGT  Kick-starting development of small RE 43 FINANCING OF POWER SECTOR INVESTMENTS TO DATE How were Large Generation Projects Financed? The Government has been increasingly reliant on private financing for new utility-scale generation investments using long- term PPAs and Government Support Agreements (GSA) 2007-2010: Yerevan CCGT Project (public) 2009-2013: Hrazdan-5 TPP (private)  Size: 240 MW  Size: 440 MW  Cost: US$247M  Cost: US$465M  Financing: JICA concessional credit  Financing: ArmGazProm balance sheet  PPA: None  PPA: None  Sovereign Guarantees: Public debt on-lent to YTPC  Sovereign Guarantees: None Under-construction: Yerevan CCGT-2 Project (private) GSA risk coverage: Under-construction: Masrik-1 Solar PV (private)  Size: 250 MW  Legal, Force-  Size: 55 MW Majeure leading to  Cost: US$272 million  Cost: US$49.3 million (excluding VAT) termination  Sponsors: Renco Spa (Italy), Siemens Project Ventures  Sponsors: FRV Masrik (Spain)  FX conversion (Germany), and Simest Spa (Italy)  Profit repatriation  Equity: US$12.5M  Equity: US$68M  Off-taker default  Debt: US$36.8M  Debt: US$204M; IFC - US$65M; Syndicated Loan –  Transmission line  IFC - US$17M US$139M (ADB, OFID; and DEG) land acquisition  EBRD - US$17M (+2.9M EU grant)  PPA: 20 years, with ENA  Gas supply  PPA: 20 years, with ENA  Government support/undertaking: GSA  Government support/undertaking: GSA Government  Other: US$39 million MIGA non-commercial risk obligations under guarantee GSAs are contingent liabilities and are not added to public debt 44 FINANCING OF POWER SECTOR INVESTMENTS TO DATE How were Small RE Generation Projects Financed? In 2007-2020, about US$650 million was provided by local and international private sector for small RE projects without any sovereign guarantees  189 SHPP projects with total installed capacity of 382 MW* were commissioned with financing primarily from local private sector with financing from local commercial banks  15 distributed solar PV projects in operation and 47 under construction with combined installed capacity of 210 MW* Main Factors Enabling Private Financing of Small RE 1. Clear and streamlined legislative requirements . Clear and transparent requirements for construction and operation of small RE 2. Predictable FiT regime. The FiT regime with off-take obligation and annual adjustment of tariff for changes in EUR/ADM exchange rate and inflation, creates predictable cash flows 3. Creditworthy offtaker. ENA – the private power distribution company – had overall been in adequate financial standing with exception of 2014-2015 due to regulatory shortcoming, which was quickly fixed by PSRC 4. Availability of financing from local commercial banks . Local commercial banks have been providing US$ and EUR denominated loans for small RE project with maturities of 4-5 years and interest rates of 6-9% with project assets used as collateral. Those maturities have been sufficient for the developers to complete construction of the project (1-2 years) and service or refinance the debt *Source: PSRC, as of Dec 31, 2020 45 FINANCING OF POWER SECTOR INVESTMENTS TO DATE How were Transmission Projects Financed? In 2007-2019, HVEN invested US$260 million* in rehabilitation, upgrade, and expansion of power transmission network Approach to Financing of Transmission Assets No Name Face Value Date* Interest Maturity Grace 1. Reliance on public debt. All major electricity 1 IDA Credit: ETDP $11,600,000 1/11/1998 0.5% 35 10 transmission projects (completed and ongoing) 2 KfW Credit: PTRP €14,060,000 30/7/1998 0.75% 40 10 were financed by public debt provided by IFIs and bilateral development agencies to the Republic of 3 KfW Loan: Gyumri-2 €7,300,000 30/1/2009 2.76% 15 5 Armenia 4 KfW Credit: Gyumri-2 €7,300,000 30/7/2009 0.75% 40 10 2. Ministry of Finance (MOF) made the resources 5 IBRD Loan: ESRP $35,500,000 1/6/2011 6-m Libor + IBRD 25 10 available to HVEN. The concessional resources from variable spread IFIs were on-lent by MOF to HVEN for specific 6 ADB Loan: PTRP SDR24,022,000 5/9/2014 3.14% 25 5 investment projects 3. Debt service was included in HVEN’s tariff. Debt 7 IBRD Loan: AF to ESRP $36,000,000 6/8/2014 6-m Libor + IBRD 10 variable spread service costs were included in HVEN’s tariff as per debt amortization schedules in respective financing 8 KfW Loan: CTNP I €75,000,000 9/12/2014 1.85% 15 5 agreements and expected interest payments 9 KfW Loan: CTNP €10,200,000 11/12/2014 075% 40 10 10 EIB Loan: CNTP I €10,000,000 11/12/2014 1.5% 20 -  HVEN rehabilitated 12 out of 15 high-voltage substations 11 IBRD Loan: ETNIP $23,140,000 8/4/2015 6-m Libor + IBRD 25 14.5 variable spread  HVEN rehabilitated 270 km or 100% of 110 and 220 kV lines requiring rehabilitation 12 KfW Loan: CTNP III €83,000,000 11/12/2015 1.80% 15 5  HVEN is currently constructing new 400 kV lines to 13 EDBI Loan: Iran 400 kV Iran €83,083,000 2016 4% 10 2 Iran and Georgia 14 Sunir FZE Loan: Iran 400 kV line €24,817,000 2017 3% 5 2 *Based on actual disbursements as of Dec 31, 2019 46 FINANCING OF POWER SECTOR INVESTMENTS TO DATE How were Distribution Projects Financed? In 2007-2020, ENA invested US$530 million in power distribution network with reliance on commercial credits and plans to invest additional $390 million* in 2021-2027 Approach to Financing of Transmission Assets No Main Loans** Face Value Interest Maturity Grace 1. ENA successfully raised commercial financing, with attractive 1 Unsecured bank loans $7,012,658 5.5% On demand No info terms, for its investment needs. ENA has raised commercial 2 Unsecured bank loans AMD1,611,208,000 10% On demand No info financing for its investment needs using its own large balance sheet and even larger balance sheets of its parent companies, 3 Secured bank loans €15,716,904 Euribor +3% On demand No info during various periods of time (2002 - Midland Resources 4 Secured loans from the JPY1,758,682,232 1.8% 2029 No info Holdings (UK); 2005 – InterRAO (Russia); 2015 – Tashir Capital Government (70%) and Liormand Holdings (30%) 5 Secured loans from the JPY140,560,592 1.8% 2039 No info 2. Debt was attracted from various sources. The debt was raised Government from following main sources: (a) local and international commercial banks; (b) parent companies of ENA in form of 6 Secured loans from IFIs $40,244,442 Libor+3.95% 2024 No info subordinated loans; and (c) and private arms of IFIs (EBRD, 7 Secured loans from IFIs $40,234,690 Libor +3.95% 2024 No info PSOD, IFC) 8 Secured loans from IFIs €13,674,550 Euribor+3.95 2026 No info 3. Debt has been serviced through tariff revenues. ENA mostly % had cost-recovery tariffs allowing for 15% pre-tax return on 9 Secured loans from IFIs €13,474,281 Euribor+3.95 2026 No info regulated asset base (RAB). This return combined with % depreciation recovered through the tariff allowed to service the commercial debt 10 Secured credit line from €17,102,515 Euribor+2.75 2021 No info IFI % * Assuming following average annual exchange rate for 2021-2027: $1=AMD520 In 2020, IFC provided $60 million to ENA for financing of 2020-2021 capital expenditure program ** Based on ENA Audit Report of 2019 Annual Financial Statements 47 Financing of New Investments FINANCING OF NEW INVESTMENTS Can New Power Generation and Transmission Investments be Financed with Public Debt? New investments would need to be increasingly financed with private capital considering public debt constraints Medium-Term Economic Outlook is not Conducive to Public or Public-Guaranteed Financing of New Investments  Real GDP reduced by 7.6% in 2020 and may not recovery to pre-COVID level until 2023  Private investments will likely remain modest reflecting weak investor confidence  High post-conflict spending and public investments will likely keep the fiscal deficit elevated and increase the Public Debt-to-GDP ratio from 53.5% in 2019 to over 70% in 2021 Limited availability of public resources for financing of power sector investments given large social and other spending needs *Based on ENA Audit Report of 2019 Annual Financial Statements 49 FINANCING OF NEW INVESTMENTS How Will New Large and Small Generation Projects be Financed? New large generation projects would continue relying on project finance approach to raise commercial financing New large/utility-scale generation projects would continue relying on project finance because:  Public financing is not realistic given public borrowing constraints and substantial competing resource needs in other sectors of economy  Armenia has track record of financing such large investment projects with successful Yerevan CCGT-2/RENCO and Masrik-1 Solar PV IPP projects reaching financial close  The new power market framework allows for integration of IPPs with full pass-through of supply costs to end-user tariffs However, development of new IPP projects would need to incorporate lessons learned from previous projects:  Robust framework for identification and prioritization of PPP projects is critical for timely development of requirement infrastructure operations, including project preparation facility that Government should consider establishing  Competitive and international procurement process can yield significant benefits in form of lower tariffs and improve credibility of PPP pipeline for energy and other infrastructure sectors  Model legal documents for PPPs are important to ensure consistent and balance risk allocation between the Government and the private sponsors, reducing transaction costs, and creating predictability for private developers New small generation projects would continue relying on existing framework based on FiT  The existing regulator framework has proven its effectiveness in attracting private financing into small RE Projects with predictable FiT, licensing, model PPA, etc. 50 FINANCING OF NEW INVESTMENTS How Will New Transmission Investments be Financed? New transmission and generation rehabilitation projects would need to raise capital through corporate financing HVEN and YTPC would need to start using corporate financing to raise long-term commercial debt for their new investments as well as refinancing of existing investments given pressure on public debt pressure:  Public financing is not realistic given public borrowing constraints and substantial competing resource needs in other sectors of economy  Refinancing of entire or portion of existing sovereign guaranteed debt stock would generate additional HVEN and YTPC can rely on corporate financing because:  It has an overall satisfactory track record of operational and financial performance and predictable cash flows through tariff  Planned further improvements of power tariff setting methodology would allow to fix O&M expenses for up to 5 years with further improvement of predictability of cash flows from commercial lenders’ perspective The following measures should be prioritized to enable HVEN and YTPC to start accessing capital markets:  Improvement of corporate governance to align with internationally-accepted practices & ISO standards on operations, quality management, environmental systems, cyber security  Further improve tariff-setting framework to enhance predictability of tariff-based cash flows  Hire financial and legal advisors to apply for credit rating and carry out preparatory work to attract long-term debt and/or bond issuance 51 Constraints to Raising of Additional Capital CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL Constraints to Private Capital in Generation and Transmission Projects Generation Transmission New investments in large generation will continue to New transmission projects, rehabilitation/upgrade of rely on project finance; investments in existing assets, and refinancing of existing debts will rehabilitation/upgrade of existing assets will need to need to rely on corporate finance, which would use corporate finance require removal of key bottlenecks Main Impediments 1 Absence of a framework for prioritization of public investments 2 Inefficiencies in development of PPPs 3 Shortcomings in corporate governance of power SOEs 4 Improving predictability of SOE revenues from regulated tariffs 5 Limited availability of long-term financing 53 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 1 Absence of a Framework for Prioritization of Public Investments Ongoing construction of Public Investment Management (PIM) framework to allow for prioritization of public infrastructure investments and development of bankable PPP pipeline The Government has Energy Sector Strategy 2040, which defines the strategic priorities of the energy sector and identifies ne w power sector projects that need to be implemented following the principles of generation planning, but the Government does no t have a PIM which impacts decision-making on prioritization of all public projects and development of PPP pipeline:  Stipulates institutional responsibilities for preparation, quality control, and review of project proposals  Defines economic, financial, E&S, technical feasibility, and other criteria for prioritization of public investment projects  Specifies the requirements for early-stage technical and other preparatory work that is required for capital projects  Provides framework for evaluation of project risks  Requires design of risk mitigation and management techniques  Define project implementation and handover arrangements  Design project management and monitoring framework  Specifies the procedure for prioritization of projects 54 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 2 Inefficiencies in Development of PPPs (1) Inefficiencies in PPP project cycle from identification to financial close of project finance transactions 1. Pipeline development bottlenecks: The Government of Armenia lacks detailed national development or sector planning to prioritize investments, ensure efficient use of public and private financing sources, carry out required preparatory work for projects to make them PPP-ready, and to identify potential PPP projects in a coherent and systematized manner. 2. Prevalence of unsolicited proposals: The majority of Armenia’s PPP experience has come through unsolicited proposals (USPs), initiated via MoUs signed between the Government of Armenia and prospective project developers. The prevalence of USPs is linked to the lack of national development or sector planning, which led private developers to fill the project void. In addition, USPs have been developed in the absence of any template or guidance standardizing required contractual contents and procedures. 3. Absence of model contractual documents: Majority of existing PPPs were procured using contractual documents customized for each project. There are no model Prequalification documents, PPAs (except for small RE projects), or Government Support Agreements for PPP projects in the power sector and in infrastructure overall. This leads to: (a) long lead times project financial close given that documents are adjusted based on various requests from sponsors and financiers; (b) higher transaction costs; and (c) unpredictability for project participants. 55 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 2 Inefficiencies in Development of PPPs (2) Capacity constraints at key entities involved in PPPs and lack of PPP-suitable projects 1. Capacity constraints: In the World Bank’s 2018 Procuring Infrastructure Public-Private Partnerships report, which analyzed Armenia’s PPP capacity prior to the enactment of the PPP Law, Armenia received low scores on metrics related to PPP project preparation, PPP contract management and unsolicited proposal. Despite the subsequent enactment of the PPP Law in 2019, capacity issues remain, and strong political commitment is required to ensure the law’s effective implementation. 2. Lack of PPP-suitable projects: Armenia is a relatively small PPP market and has a history of privatizing major infrastructure assets. As a result, there is limited low-hanging fruit in its current infrastructure project pipeline. It may therefore be sensible for Armenia to focus future pipeline development efforts on brownfield, small-scale, and/or O&M projects, where the benefits of PPPs lie more in private sector efficiencies rather than in financing or commercial operations, particularly given the continuing availability of IFI financing. 56 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 3 Shortcomings in CG Well-governed SOEs can raise private financing from local and international markets Improves While state participation is necessary in order to provide operational essential services and combat market failures, increased performance private participation in certain sectors has been proven of SOEs successful in increasing value for money for consumers Increases Contributes to access to As part of this study, Corporate Governance (CG) Review od financing of domestic and infrastructure SOEs (HVEN and YTPC) was conducted to: development international Good capital markets • a) take stock of the existing corporate governance and Corporate Governance financial accountability mechanisms at High Voltage Electric Networks of Armenia (HVEN) and Yerevan Thermal Power Center (YTPC) Reduces fiscal Reduces burden of • b) offer recommendations to improve corporate SOEs and corruption and governance based on internationally recognized standards, increases net contribution to improves guidelines, and practices the budget transparency 57 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 3 Shortcomings in CG: Board of Directors, Performance Monitoring & Management Incentives Power sector SOEs are not compliant with the current CG Code and the international good practices, which impacts availability of corporate finance Board of Directors  Board of Directors is not empowered by corporate documentation to properly exercise their functions and act as effective governance body  HVEN Board of Directors does not have independent board members  Board of Directors does not have clear division of responsibilities  Board of Directors does not have specialized committees for effective and specialized oversight of technical matters  Board of Directors can be strengthened to have balanced skills set and industry background, while considering diversity aspects  Board of Directors’ compensation should be clearly formulated and free of undue influence  Board of Directors is not regularly evaluated  Lack of awareness about the Board members’ duties and as benefits of how properly functioning board can bring value to SOE Performance Monitoring & Management Incentives  SOE management is not accountable to the Board of Directors for implementing the strategy, and adhering to the set operational and financial targets  Absence of linkage of SOE strategy and objectives with performance indicators and targets  SOE management remuneration is not linked to SOE performance and achievement of objectives 58 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 3 Shortcomings in CG: Corporate Documentation, Financial Reporting, Audit & Disclosure Power sector SOEs require overhaul of corporate documentation and improvement of transparency Corporate Documentation  Board of Directors require proper delegation of authority to carry its functions effectively  SOE’s corporate documentation requires revision to reflect targeted CG improvements  SOE Charter requires update  Other Documents  Code of Ethics needs to be introduced Financial Reporting, Audit & Disclosure  HVEN has no Internal Audit function  No Corporate Governance Statement  SOEs do not publish their annual reports and corporate governance statements at the company website 59 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 4 ROA for SOEs not Always Reflective of Market Cost of Capital ROA for SOEs not always reflecting market cost of capital  During various time periods, the tariffs for power sector SOEs did not include ROA as allowed under the Tariff Methodology  Absence of ROA was due to lack of self-financed investments by SOEs  Current tariff (effective from Dec 2021) includes 12% pre-tax (10% post-tax) ROA for all power sector SOEs  ROA does not always reflect the market cost of capital 60 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 4 Limited Availability of Long-Term Financing: International Lenders Interest from international capital markets to local energy projects is modest given relatively small size of projects and lack of pipeline 1. Corporate finance. Large international lenders, primarily Russian commercial banks, have experience in lending to large industrial, energy, and mining projects in Armenia using corporate financing approach.  US$340 million loan from VTB (Russia) to Vallex Group and US$62 million from Danish pension fund. The project was suspended in 2018  €55 million from HSBC to ENA for its long-term Investment Program 2. Project finance. It is primarily IFI and DFI market including three projects reached financial close for hydro, CCGT and solar IPPs. The relatively small size of the market and project are main reasons for limited interest from international lenders 3. Pipeline of infrastructure PPPs. Lack of robust multi-year pipeline of PPPs in infrastructure limits interest from international developers and lenders given the high market entrance costs relative to small future deal flow 61 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 5 Limited Availability of Long-Term Financing: Local Capital Markets (1) Local banks have limited involvement in infrastructure finance Key Reasons: Local bank Owner- International lending rates  High cost of funds and lending rates Corporate entity ship lenders’ rates on >5-Y  Lack of long-term funding to match the tenor of project loans finance debt Electric Private Base rate + Networks of 2.75% - 3.95%  Relatively small size of individual domestic banks and large Armenia (ENA) 8-10% in USD size of required infrastructure loans High Voltage State- - 6-7% in EUR  Absence of a local syndicated loan market Electric owned  Lack of familiarity with project and structured finance Networks of Armenia (HVEN)  Credit methodologies emphasizing past financial results and Yerevan Thermal State- - None availability of collateral rather than future cash flows Power Center owned (YTPC) Source: World Bank team estimation based on audited financial statements of respective companies 62 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 5 Limited Availability of Long-Term Financing: Local Capital Markets (2) Lending capacity of local banks to large energy sector investments is constrained by the capital adequacy requirements, driven by financial stability considerations, and the capital base of the banks  Following recapitalization of the banks to meet the increase of 30% capital requirements set by the CBA in 2016, the ratio of total 28% capital to risk-weighted assets declined from 20.5% in Jan 2017 26% to 17.2% in July 2020 24% 22% 20%  Considering that the prudential minimum of capital adequacy 18% ratio is 12%, only 5.2% of the total capital in the banking system 16% or AMD 45.7 billion (US$93 million) is available for additional 14% lending* 12% 10%  Available funds for long-term infrastructure financing would be significantly small if we exclude medium and small banks Total capital/RWA Prudential mininum (Standard N 1/2) because of their profile, strategy and existing client base Source: Statistics of Financial Organizations, Central Bank of Armenia, https://www.cba.am/am/SitePages/statfinorg.aspx *Assuming those loans have 0% risk classification rate 63 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 5 Limited Availability of Long-Term Financing: Local Capital Markets (3) Banks are also constrained by the exposure limit to a single borrower - 20% of a bank’s total capital – driven by financial stability considerations Single borrower exposure limit of the banks  The maximum size of a single loan for top 5 banks is in Single borrower Total Capital, Total Capital, the range of US$20-40 million* Bank AMD billion US$ million limit, US$ million  Other banks are less likely to finance large (even Ameriabank 101 211 42 ArmBusinessBank 52 109 22 syndicated) infrastructure, because: Ardshinbank 78 162 32 ACBA 69 144 29 a) they are mostly retail banks with limited corporate Inecobank 56 117 23 exposure Converse Bank 45 94 19 b) have much higher cost of funds and Bank VTB 48 101 20 c) cannot offer competitive interest rates Armswissbank 60 125 25 Armeconombank 39 82 16 Unibank 34 70 14 Araratbank 37 78 16 HSBC 42 87 17 Artsakhbank 42 87 17 Evocabank 30 62 12 IDBank 44 92 18 *During the interviews, the top 5 banks indicated that the maximum loan amount they would consider is $15 million. Byblos Bank Armenia 30 62 12 Mellat Bank 39 80 16 Source: Финансовые Рейтинги Банков Армениа, 2019, ArmInfo Information Company 64 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 5 Limited Availability of Long-Term Financing: Local Capital Markets (4) Corporate bonds account for only 10% of local currency fixed income investments  Corporate bonds mostly consist of 3-year debt paper issued by 13 629 16 000 financial institutions – commercial banks and credit 14 000 12 000 organizations. There are only 3 other smaller issuers 10 000 6 267 8 000 representing minining, telecom and logistical services sectors 3 393 6 000 with total outstanding volume of US$8.5 million 1 424 1 200 4 000 864 784 651 122 2 000 - - - - - - -  Total market value of pension fund investments in corporate Cbond 2-Y Cbond 3-Y Cbond 4-Y Cbond 5-Y Cbond 6-Y debt in all currencies as of the end of June 2020 is US$57 million, AMD USD EUR which is 9.5% of total NAV and 70% of Armenia's corporate debt AMD issues Maturity Coupon rate market Logistical services 24 12.5% Mining, telecom 36 11.0%  69% of corporate issues are in AMD (equivalent of USD 40 USD issues Maturity Coupon rate million), 25% in US$ and 6% in EUR Logistical services 24 8.5% Mining, telecom 36 7.5% Source: 2019 annual reports of pension funds (Amundi, C-Quadrat) 65 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 5 Limited Availability of Long-Term Financing: Local Capital Markets (5) Insurance market Investment funds • Armenia’s insurance sector is small and still in the • The investment fund industry is nascent, with one early stages of development publicly offered collective investment fund with • Insurance sector assets amount to US$140 million AUM of US$3 million that invests in listed or 1% of total financial sector assets and are government and corporate bonds invested in bank deposits and government • The low savings rate, unsophisticated investor securities base, and high marketing expenses associated • Given the lack of life insurance, the sector is not a with such funds, plus competition from attractive major provider of long-term domestic capital levels of bank deposits, constrain development of the sector • Such funds are unlikely to be a significant source of long-term investment capital in the medium term 66 CONSTRAINTS TO RAISING OF ADDITIONAL CAPITAL 5 Limited Availability of Long-Term Financing: Local Capital Markets (5) Lack of technical capacity among local financiers and familiarity with project and structured finance is a barrier to infrastructure lending  Banks exposure to the energy sector has been mainly limited to lending to SHPPs and retail energy efficiency  Banks have expressed interest to consider lending projects, if it is led by an IFI  This, apart from reducing the exposure of a bank in total lending project, is explained also by the fact that in such arrangements and IFI would normally acquire the expertise and incur the costs, associated with the due diligence  In cases when IFIs were ready to consider such opportunities with local banks, IFIs and banks had the issue of agreeing on possession rights to the borrower’s collateral and how it could be shared between IFI and a local bank  Lending to energy sector SOEs also poses both commercial and legal challenges for local banks. From a legal perspective, the property/shares of SOEs cannot be seized and therefore cannot serve as a collateral 67 Unlocking New Sources of Finance UNLOCKING NEW SOURCES OF FINANCE Pillar 1: Adoption and Implementation of PIM Framework Robust PIM framework for identifying, preparing and selecting public investment projects is under construction and will streamline the process for developing bankable PPP pipeline which would stimulate increased interest from investors PIM should include the following key features across full life-cycle of investment projects  Step 1: Project Identification and Prescreening  Step 2: Formal Project Pre-Appraisal and Appraisal  Step 3: Independent Review of Appraisal  Step 4: Project Prioritization and Selection  Step 5: Project Implementation  Step 6: Project Adjustment  Step 7: Facility Operation  Step 8: Review and Evaluation 69 UNLOCKING NEW SOURCES OF FINANCE Pillar 2: Improvements to PPP Framework & Strengthening of Institutional Capacity Issues Recommendations Pipeline development Identify potentially suitable PPP projects following appropriate generation and transmission planning approaches – bottlenecks least-cost generation planning - and prioritize them using the broader framework of PIM. Lack of funding for project The Government to establish a centralized pool of funding/project development facility to serve as a one-stop preparation project preparation fund for PPP projects, to be managed by the PPP Agency. The Government should consider options for capitalization of such a fund, including from the national budget or with donor support Prevalence of unsolicited Focus on the implementation of the PPP Law in order to encourage reliance on transparent and competitive proposals procurement processes Absence of model contractual Roll out PPP template documents (e.g. PPAs for large projects, Government Support Agreements) under the PPP documents legal framework, while leaving flexibilities to adapt documents to specific future deal needs Institutional capacity constraints Ministry of Economy to prepare a comprehensive capacity building program based on skill requirements across the PPP project cycle. Identification of suitable PPP projects requires greater investment in building the staffing and technical capacity of the PPP Agency, MOF, and line ministries No guidance materials PPP Agency to prepare a set of standardized materials o help guide institutions through each phase of the PPP project cycle. Given current capacity constraints within the PPP Agency, this can initially be outsourced to consultants, and update of the materials can form part of the PPP Agency’s future work program Lack of framework for MOF to develop a framework for assessment of financial commitments and contingent liabilities under PPPs to assessment and management of allow for assessment and management of all PPPs with clear criteria for approval of all financial commitments of government financial the Government. The roll-out of such a framework should be accompanied by significant capacity building and commitments under PPPs training for relevant agencies to ensure the effective oversight of the Government’s fiscal commitments to PPPs 70 UNLOCKING NEW SOURCES OF FINANCE Pillar 3: Improvement of CG: Stakeholder Interaction Stakeholder Interactions and Responsibilities in SOE Corporate Governance Structure 71 UNLOCKING NEW SOURCES OF FINANCE Pillar 3: Improvement of CG: Strengthen the Board of Directors (1) Issues Recommendations Board of Directors’ role is unclear and undervalued Re-assess the role of SOE’s Board of Directors and align its authority with good practices as compared with good corporate governance in strategy-setting, determining performance objectives, monitoring Company’s financial practices and operational performance & appointing, remunerating and removing management, Board of Directors is not empowered to properly Once the role of Board is clarified and agreed, formally document the Government’s exercise their functions delegation of authority and respective functions to SOE Board in the Company’s Charter HVEN Board of Directors does not have  Identify and appoint at least two independent Board Members. independent board members  Set term limits for independence: once independent members have served on the board for 5 years; they are no longer considered independent Board of Directors does not have clear division of  Identify and appoint Chairman of the Board and Corporate Secretary responsibilities  Consider appointing an independent board member as the Chairman of the Board Board of Directors does not have specialized  Establish Board Committees, staffing them with board members possessing committees for effective and specialized oversight appropriate skills and experience, preferably headed by independent board members of technical matters  In medium-term, SOEs may establish an Investment Committee to oversee matters related to implementation of public investment projects  Three board members per committee should suffice. Consider appointing an independent board member as the Chairman of the Committees Board of Directors can be strengthened to have  Develop and introduce qualification and experience requirements for existing or balanced skills set and industry background, while potential board members, and evaluating their combined skills set considering diversity aspects  Appointing Government officials to the Board should be reduced with time 72 UNLOCKING NEW SOURCES OF FINANCE Pillar 3: Improvement of CG: Strengthen the Board of Directors (2) Issues Recommendations Board of Directors compensation should be Adopt a clear remuneration policy for SOE Board members aligning it with the long-term clearly formulated and free of undue influence interests of the Company. The policy should:  Be approved by the GMS  Not envisage compensation for the Government representatives working ex officio  Not envisage additional remuneration for the General director serving on the board  Be competitive, within reasonable limits and benchmarks  Introduce standard approach: i.e. fixed salary plus variable component for extra work/ responsibility  Avoid compromising independent directors' objectivity Board of Directors is not regularly evaluated Develop and introduce annual evaluation mechanism for the Board effectiveness:  Launch the process from second year after adoption of the mechanism  Start with self-evaluation under the Chair’s supervision  Ultimately move to individual board member assessments  Consider engaging external experts for facilitated assessments Lack of awareness about the Board members Establish formal Board induction and training process to facilitate transition, sharpen skills, duties and how properly functioning board can and enhance performance. Provide specific trainings to the board members, based on the bring value to SOE evaluation results 73 UNLOCKING NEW SOURCES OF FINANCE Pillar 3: Improvement of CG: Introduce Performance Monitoring & Management Issues Recommendations SOE management is not accountable to the Develop and establish clear accountability lines between SOE Board of Directors and its Board of Directors for implementing the Executive Management via respective by-laws ensuring that executive management is strategy, and adhering to the set operational accountable and reporting to the Board on SOE’s operational and financial results and financial targets Create linkage of SOE strategy and objectives Introduce regular (quarterly, annual) performance monitoring mechanism based on clear with performance indicators and targets financial and non-financial performance indicators and targets that are linked to SOE strategy and objectives Remuneration is not linked to SOE performance  Design SOE performance monitoring system for keeping SOE management accountable and achievement of objectives for results  Implement transparent system of incentives for SOE management, linking it to SOE’s performance, considering potential sanctioning (dismissal, reappointment) 74 UNLOCKING NEW SOURCES OF FINANCE Pillar 3: Improvement of CG: Strengthen Audit, Financial Transparency, and Documentation Issues Recommendations HVEN has no Internal Audit function Consider appointing Internal Auditors to oversee the SOE’s internal control system on an ongoing basis and be accountable directly to the Board’s Audit Committee SOEs do not publish their annual reports Start publishing full annual reports, corporate governance statements and other non-financial and corporate governance statements at information to raise the Company’s corporate profile and increase transparency the company website Board of Directors require proper Formally document the Government’s delegation of authority and respective functions to delegation of authority to carry its HVEN Board of Directors, empowering it to properly exercise its functions and act as effective functions effectively governance body. Delegated functions should cover: strategy-setting, appointing, remunerating and removing management boards, monitoring the Company’s performance and management’s efficiency SOE’s corporate documentation requires Update SOE charters and other corporate documentation to reflect proposed improvements in revision to reflect targeted CG CG practices improvements 75 UNLOCKING NEW SOURCES OF FINANCE Pillar 3: Improvement of CG: Improve Corporate Documentation Issues Recommendation SOE Charter  Expand the section on a board of directors, defining the number of board members and their appointment terms  Once agreed, add core functions to the Board, such as strategy-setting, appointing, remunerating and removing management board, monitoring responsibility for the Company’s performance (via KPIs) and efficient internal controls  Remove reference to inexistent body - Review Commission  Introduce clauses on equal treatment of minority shareholders, their rights and protection mechanisms Other documents Develop and adopt internal by-laws, regulations, i.e. Regulation on the Board of Directors and its Committees, Regulation on the Corporate Secretary, Regulation on the Executive Body, Regulation on Related Party Transactions, Conflict of Interest, Information Disclosure Policy, etc. Code of Ethics  Draft and implement Code of Ethics  Identify and inform about whistleblowing mechanisms and communication channels to report violations  Include the code as part of all directorship/ employment contracts for board members, directors and employees  Train staff to understand and apply code’s provisions and conduct periodic staff assessments to ensure a knowledge base  Appoint a “lead” to oversee compliance  Formalize incentives and penalties for compliance and violations 76 UNLOCKING NEW SOURCES OF FINANCE Pillar 4: Improving Predictability of SOE Revenues from Regulated Tariffs (1) Adjustments should be made in tariff computation of power sector SOEs to increase predictability of revenues and thus enable access to capital markets Option 1: Revision of Return on Assets and depreciation Option 2: Inclusion of actual costs of debt service into the tariff method to allow for servicing of commercial debt consistent with terms of commercial financing agreements Return on Assets: It is recommended that PSRC: Return on Assets: It is recommended that PSRC:  Elaborates tariff methodology to clarify that return on assets  Includes in the tariff of power sector SOEs the debt service costs would be equal to WACC of SOEs and how it would be computed as per schedules in the relevant legal documents  Regularly adjust WACC using market indicators/benchmarks and  Adjusts the return on assets and depreciation expense accordingly to allow SOEs to service the debt to avoid double-counting of same category of expenses.  Fixes WACC for at least 3-year period and adjusts accordingly Specifically, if SOE gets debt service, then it should not also get Depreciation Expense: It is recommended that PSRC: depreciation on the same asset otherwise it will be double-  Revise the depreciation from straight line (assuming 30-40 years counting asset life) to accelerated to match better with repayment of principal under commercial debt Multi-Year O&M It is recommended that PSRC:  Approves annual O&M expenses for at least 3 years  Specifies cost-efficiency coefficient (reduction from previous level) to be applied to those expenditures after each revision based on similar coefficients applied to well-performing utilities  This would increase predictability of operating cash flows 77 UNLOCKING NEW SOURCES OF FINANCE Pillar 4: Improving Predictability of SOE Revenues from Regulated Tariffs (2) PSRC should specify and publicly disclose the approach to computation and adjustment of ROA for power sector SOEs ROA (equal to WACC) is one of the most important components of companies’ tariff and its computation and adjustment methodology should be clearly specified and transparent to allow commercial lenders to estimate predictability of cash flows of SOEs Share of Debt and Equity 60:40 Typical structure for utility companies Risk Free Rate (rrf) 1.58% 10-Y US Treasury Yield; as of May 6, 2021; Source: https://www.treasury.gov/resource-center/data- chart-center/interest-rates/pages/textview.aspx?data=yield Sovereign Debt Premium (DP) 3.18% Country default spread estimation based on rating; as of Jan 1, 2021; Damodaran Online; Source: http://pages.stern.nyu.edu/~adamodar/ Cost of US$ Debt (rrf + DP) 4.76% FX Risk Premium (FXrp) 4.43% Was estimated as the difference in yield between 10-Y Armenian Government Eurobond issue and 10-Y AMD bond issue; Source: http://moneymarket.am/index.php?language=Eng&page=menuinfo&id1=1&id2=2&id3=1 Cost of AMD Debt (rrf + DP + FXrp) 9.19% Country Equity Risk Premium (rm) 8.21% Rating based equity risk premium; as of Jan 1, 2021; Damodaran Online; Source: http://pages.stern.nyu.edu/~adamodar/ Sectoral Risk ( ) 1.00 http://pages.stern.nyu.edu/~adamodar/ Cost of Equity in AMD (re = rrf + rm x + FXrm) 14.22% Corporate Profit Tax Rate (T) 20% Pre-tax WACC 11.21% Post-tax WACC 10.10% 78 UNLOCKING NEW SOURCES OF FINANCE Pillar 5: Improving Availability of Long-Term Financing: Project Finance Development of a robust pipeline of PPP projects and quality project preparation can increase attractiveness of power projects to large commercial lenders  Pipeline development bottlenecks. Identify potentially suitable PPP projects following appropriate generation and transmission planning approaches – least-cost generation planning - and prioritize them using the broader framework of Public Sector Investment Prioritization  Project preparation funding. It is recommended that a centralized pool of funding is created to serve as a one-stop project preparation fund for PPP projects, to be managed by the PPP Agency. The Government should consider options for capitalization of such a fund, including from the national budget or via donors  Model PPP documents. The Government has taken an ad-hoc approach to prepare transaction documents for the past projects reaching financial close. It is recommended to take lesson learnt from past projects and to roll out PPP template documents (e.g. PPAs for large projects, Government Support Agreements) under the PPP legal framework, while leaving flexibilities to adapt documents to specific future deal needs 79 UNLOCKING NEW SOURCES OF FINANCE Pillar 5: Improving Availability of Long-Term Financing: Tapping Pension Funds Pension funds would be suitable source of long-term financing for power sector investments  Pension funds’ limited involvement in infrastructure finance to 2 500 date has been conditioned by a small universe of domestic 2 000 AMD billion investable instruments. Demand from SOEs in form of bankable 1 500 projects will create the supply 1 000  Pension funds are well placed to finance power sector 500 investments due to their long-term liabilities. As such, pension 0 Apr-19 Apr-24 Apr-29 Jun-18 Jun-23 Jun-28 Oct-21 Oct-16 Oct-26 Feb-20 Feb-25 Feb-30 Aug-27 Aug-17 Aug-22 Dec-15 Dec-20 Dec-25 Dec-30 funds can extend financing at very long maturities (15-20 years) matching their long-term liabilities Actual AUM Forecast AUM  On assumption that average nominal wages increase by 4 Other percent p.a. and the number of beneficiaries reaches 800,000 assets Shares in Cash and over the next 10 years, AUM are forecast to exceed US$4.9 ETFs 1,2% deposits billion by the end of 2030. 28,5% 29,8%  Close to 2/3 of funds are held in Government bonds and deposits. And 1/3 of funds are invested in foreign currency Other denominated instruments. bonds Governm 9,3% ent bonds of RA 31,2% 80 UNLOCKING NEW SOURCES OF FINANCE Pillar 5: Improving Availability of Long-Term Financing: Crowdfunding Introduce innovative crowdfunding solutions to increase availability of capital for small projects Key Benefits: 1. Diverse investor base. Crowdfunding allows accredited international investors (both individual and institutional) to participate in debt financing and/or provide equity to infrastructure projects 2. Ease of access. The crowdfunding allows to substantial the accessibility of projects for especially small retail investors because the digital platform operator does the due diligence and pre-selects the transactions/deals which are opened to investors/lenders 3. Experience to learn from. There is global track-record with crowdfunding platforms financing infrastructure. Examples:  Developed markets: Mosaic (United States), Windcentrale (Netherlands), Funding Societies (Singapore), CitizenEnergy (EU)  Emerging and frontier markets: EstateGuru (Estonia), Neofinance (Lithuania), Investree (Indonesia), Afluenta (Argentina), Nexus (Brazil) Next Steps: 1. Central Bank of Armenia (CBA) to make the required legal and regulatory changes to allow for creation, licensing, and operation of crowdfunding companies 2. Prioritize development of a bankable set of PPP projects 81 UNLOCKING NEW SOURCES OF FINANCE Terms of Financing Available for Power SOEs Capital markets would become accessible for power SOEs if key previously-listed challenges are addressed  Five largest banks and institutional investors surveyed  All surveyed financial institutions expressed interest subject to addressing the key issues identified in this report  All surveyed financial institutions reported increased interest in provision of long-term financing to SOEs if credit- enhancement is available (e.g. IBRD guarantee) US$ Lending Terms without Credit AMD Lending Terms without Credit Enhancement Enhancement Tenor 7 years Tenor 5 years Grace - Grace - Interest rate 8% Interest rate 11% US$ Lending Terms without Credit AMD Lending Terms without Credit Enhancement Enhancement Tenor 10 years Tenor 7 years Grace - Grace - Interest rate 7% Interest rate 9% Source: World Bank estimation based on results of market sounding 82 Tariff Impacts of Long-Term Commercial Financing TARIFF IMPACTS OF LONG-TERM COMMERCIAL FINANCING Approach to Projection of Tariffs Tariff impacts were evaluated considering Base Case investments and existing tariff methodology 1 Demand Projection: Base Case electricity demand growth of 2% 2 Projected Electricity Generation: Use of electricity dispatch simulation assuming Base Case/Least-Cost Plan 3 Capex of New Generation: All new RE based on project finance: All future PPAs at US$0.031/kWh* 4 Capex of New T&D: As per Energy Strategy 2040 and ENA Investment Plan for 2020-2027 5 Depreciation Straight line method based on useful economic life of assets 6 Fuel Costs As per projections for purposes of Least-Cost Planning 7 Non-fuel operating and maintenance Using existing items in the tariff escalated with projected GDP deflator 8 Debt Service  In case of public debt - as per amortization schedule and interest costs in agreements *Conservative assumption to simplify the analysis; the  In case of private debt: capital costs for solar PV and wind are expected to reduced Option 1: Increase of ROA and accelerated depreciation further Option 2: Increase of ROA and unchanged depreciation method. Used for this analysis Option 3: Existing ROA and accelerated depreciation return on assets 84 TARIFF IMPACTS OF LONG-TERM COMMERCIAL FINANCING SOEs to be Raising Commercial Financing Among SOEs, HVEN and YTPC would have the largest need to access commercial financing  HVEN has more than US$400 million in sovereign-guaranteed debt part of which may need to be refinanced with commercial borrowing to free up fiscal space for decommissioning of ANPP (estimated to cost at least $200 million*) and other sectors  HVEN needs another US$230 million for rehabilitation of three substations, strengthening of transmission network to integrate additional RE, and participation in Georgia-Romania Power and Digital Interconnect Project.** Sovereign-guaranteed debt may not be feasible given macroeconomic fundamentals and outlook  YTPC has around US$40 million in public debt that may require refinancing Other SOEs do not have major capital expenditure programs requiring them to access capital markets:  ANPP has secured $300 million of public debt to carry out its life extension investment program, no other major upcoming investment needs, and expected decommissioning within next several years.  EPSO is a system operator with very modes investment needs Commercial financing options analyzed  Uncovered commercial financing in US$  Uncovered commercial financing in AMD  Commercial financing in US$ with IBRD guarantee  Commercial financing in AMD with IBRD guarantee *This is the Government’s estimated from 2011 and was not verified and/or updated by the World Bank or any other party ** Given complexity and size of this project, financing options would be explored as part of the ongoing feasibility study commissioned by GSE (Georgia) 85 TARIFF IMPACTS OF LONG-TERM COMMERCIAL FINANCING Prioritization of HVEN Loans for Refinancing HVEN loans for refinancing were prioritized based on a method considering time to first installment, repayment period, and interest rate Time to first Weight in Repayment Ranking by Weight in Weight in First repayment Final repayment Ranking by Interest Ranking Combined Loan installment, combined period Repayment combined combined date date TFI rate (INT) by INT score TFI (months) score (months) period score score Sunir FZE Loan: 400 kV OHL 15-Mar-20 15-Mar-21 0 1 10% 3 1 70% 3.00% 3 20% 1.40 KfW Loan: Gyumri-2 30-Dec-14 30-Jun-24 0 1 10% 42 2 70% 2.76% 4 20% 2.30 EDBI Loan: 400 kV OHL 15-Mar-22 15-Sep-26 15 11 10% 54 3 70% 4.00% 1 20% 3.40 KfW Loan: CTNP I 30-Dec-19 30-Dec-29 0 1 10% 108 4 70% 1.85% 5 20% 3.90 KfW Loan: CTNP III 30-Dec-20 30-Dec-30 0 1 10% 120 5 70% 1.80% 6 20% 4.80 IBRD Loan: ETNIP 15-Nov-29 15-Nov-39 107 14 10% 120 5 70% 1.21% 7 20% 6.30 IDA Credit: ETDP 5-Jun-08 5-Dec-33 0 1 10% 156 7 70% 0.50% 13 20% 7.60 IBRD Loan: ESRP 15-Nov-21 15-May-36 11 10 10% 174 8 70% 1.21% 7 20% 8.00 ADB Loan: PTRP 15-Nov-19 15-May-39 0 1 10% 221 11 70% 3.14% 2 20% 8.20 IBRD Loan: ESRP AF 15-Aug-24 15-Feb-39 44 12 10% 174 8 70% 1.21% 7 20% 8.20 KfW Credit: PTRP 30-Jun-08 30-Dec-38 0 1 10% 216 10 70% 0.75% 10 20% 9.10 KfW Credit: Gyumri-2 30-Jun-19 30-Jun-49 0 1 10% 342 13 70% 0.75% 10 20% 11.20 EIB Loan: CNTP I 16-Apr-20 16-Oct-43 0 1 10% 274 12 70% 0.48% 14 20% 11.30 KfW Loan: CTNP 30-Dec-24 30-Dec-54 48 13 10% 360 14 70% 0.75% 10 20% 13.10 Note: Calculations were done for a baseline date of Dec 31, 2020 86 TARIFF IMPACTS OF LONG-TERM COMMERCIAL FINANCING New Project Financing and Existing Debt Refinancing Schedules Financing for new HVEN Investments for Substations Unit 2022 2023 2024 2025 2026 2027 2028 2029 2030 Total Shahumyan-2 substation MUS$ - - - 20.00 - - - - - 20.00 Marash substation MUS$ - - - - 20.00 - - - - 20.00 Yeghegnadzor substation MUS$ - - - - - 20.00 - - - 20.00 MUS$ - - - 20.00 20.00 20.00 - - - 60.00 Proposed refinancing schedule of HVEN loans Unit 2022 2023 2024 2025 2026 2027 2028 2029 2030 Total KfW Loan: Gyumri-2 MUS$ 3.83 - - - - - - - - 3.83 EDBI Loan: 400 kV OHL MUS$ 43.16 37.99 - - - - - - - 81.15 KfW Loan: CTNP I MUS$ - - 45.84 - - - - - - 45.84 KfW Loan: CTNP III MUS$ - - - 25.49 23.06 - - - - 48.55 IBRD Loan: ETNIP MUS$ - - - - - 23.14 - - - 23.14 IBRD Loan: ESRP MUS$ - - - - - - 18.93 - - 18.93 IDA Credit: ETDP MUS$ - - - - - - 2.55 - - 2.55 ADB Loan: PTRP MUS$ - - - - - - - 15.94 - 15.94 IBRD Loan: ESRP AF MUS$ - - - - - - - - 21.60 21.60 MUS$ 46.99 37.99 45.84 25.49 23.06 23.14 21.49 15.94 21.60 261.54 Proposed refinancing schedule of YTPC loans Unit 2022 2023 2024 2025 2026 2027 2028 2029 2030 Total IBRD Loan: ETNIP MUS$ - - - 16.59 - - - - - 16.59 IBRD Power Sector Financial Recovery Loan MUS$ - - - - 21.45 - - - - 21.45 MUS$ - - - 16.59 21.45 - - - - 38.04 87 TARIFF IMPACTS OF LONG-TERM COMMERCIAL FINANCING Foreign Currency vs Local Currency Refinancing  Commercial financing of HVEN and YTPC, including refinancing of existing debts, would raise the end-user tariff only by 2-3% vs “No Commercial Financing Scenario”  Credit-enhancement has beneficial impact to achieve much-needed extension of maturity 82,6 82,4 82,0 84,0 81,5 84,0 80,4 80,4 82,0 82,0 79,2 78,9 79,0 78,7 80,0 80,0 77,1 77,1 75,8 75,8 75,7 75,6 78,0 78,0 74,7 74,6 74,6 73,6 73,7 76,0 73,6 76,0 72,4 72,4 74,0 74,0 72,0 72,0 70,0 70,0 AMD'kWh 68,0 65,3 68,0 64,4 64,2 64,4 63,6 66,0 64,2 63,3 62,8 66,0 62,7 63,4 63,3 62,5 61,9 62,8 62,6 61,7 64,0 61,4 62,0 61,0 61,9 61,7 60,7 64,0 61,4 61,0 60,8 60,7 59,6 59,6 62,0 59,6 59,6 62,0 58,3 58,3 58,3 60,0 58,3 58,3 58,3 60,0 58,0 58,0 56,0 56,0 54,0 54,0 52,0 52,0 50,0 50,0 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 No refinancing Refinancing in AMD with WB Guarantees No refinancing Refinancing in USD with WB Guarantees Refinancing in AMD without WB Guarantees Refinancing in USD without WB Guarantees Refinancing with US$ denominated commercial debt Refinancing with AMD denominated commercial debt Tariff projections include new required investments in electricity generation, transmission, and distribution 88 TARIFF IMPACTS OF LONG-TERM COMMERCIAL FINANCING Commercial Financing of New Investments and Refinancing of Public Debt are Feasible  Public debt refinancing with foreign currency denominated commercial debts will smooth out the debt service requirements of power sector SOEs  However, pre-tax ROA of more than 12% would be required to cover the debt service costs of HVEN and YTPC in case of AMD borrowing  The rate of return on the regulated asset base and/or the asset depreciation rate would have to increase to ensure the cost recovery of power sector SOEs.  In select years, the cost recovery levels of the rate of return for HVEN are estimated to be around 14% for FCY refinancing and 20% for LCY refinancing. For YTPC, the respective cost recovery levels of the rate of return could be around 15% for FCY refinancing and 20%-21% for LCY refinancing.  In the long-run, the end-user power tariff will rise by 2.2%-3.2% relative to the base case scenario of “no public debt refinancing”  Refinancing of existing public borrowing of HVEN and YTPC can release at least $300 million for MOF to spend on other pressing needs 89 TARIFF IMPACTS OF LONG-TERM COMMERCIAL FINANCING Mitigation of Impact on Socially Vulnerable Consumers Designing energy benefits at the household level generally requires decisions about: (i) How to target the vulnerable population, (ii) How to deliver the benefit (i.e., modality – whether in terms of cash benefit, in kind, or tariff discount) , (iii) How to define the benefit amount, and (iv) Financing source.​ Further analyses on the following is needed when evaluating subsidy delivery options: ​  Economic distortion—the degree to which each option distorts marginal cost price signals and/or distorts consumption patterns and preferences  Administrative and fiscal costs—the administrative and fiscal cost burden imposed on the Government as a result of administering and funding the subsidy program.​  Coverage—the extent to which all poor households receive the subsidy in different modalities  Targeting and leakage—the extent to which the subsidy is exclusively delivered to poor households (efficiency of delivery) 90 Potential World Bank Group Support POTENTIAL WORLD BANK GROUP SUPPORT Pillar 1: Development of Wind  Geospatial analysis to identify sites for proper wind resource measurements Resources  Feasibility study including site-specific wind resource measurements  Support in structuring of project financed transaction with competitive procurement process for first utility-scale wind project Pillar 2: Development of PPP Pipeline  Support with development of bankable pipeline of PPP projects within broader PIM framework and Strengthening of PPP Agency  Strengthening of capacity of MTAI in project identification and preliminary assessment Capacity  Strengthening of capacity of PPP Agency in screening and evaluation of projects as well as FCCL (Financial Commitment and Contingent Liability) assessment capability. Pillar 3: Preparing HVEN and YTPC for  Implementation of corporate governance improvements including ISO standards on operational, a diversified funding sources management, environmental systems, and cyber security  Suport to PSRC to implement improvements to tariff-setting framework to improve predictability of SOE cash flows for commercial financiers  Support companies to obtain credit ratings by reputable international agencies  Facilitate companies to design a financing plan to diversify their funding sources (local, international banks and capital market solutions)  Support companies to work with transaction advisors to implement and execute specific financing (with potential IBRD guarantee support) Pillar 4: Further Improvement of Tariff  Support to the Government in evaluation of social impacts of various tariff scenarios Impact Mitigation Mechanisms  Advice on further improvement of mechanisms to mitigate impact of tariff increases on socially vulnerable consumers 92 Annex CAPITAL MARKETS The financial sector is dominated by commercial banks Assets (Dec 31, 2019)  There were 17 active banks with total assets of AMD 5,828 Financial institutions AMD billion US$ billion billion (US$12.2 billion) as of the end of 2019 Banks 5,828.00 12.15 Credit organizations 711.50 1.48  Total banking sector assets significantly grew significantly Pension funds 251.20 0.52 over the past decade from 45 percent of GDP in 2010 to 89 Insurance companies 66.90 0.14 of GDP in 2019, partly due to an increase in the minimum Investment firms 63.50 0.13 capital requirement 6,921.10 14.43  Bank lending in GPD has similarly doubled from 27.4 100,0 83,1 89,0 78,7 78,2 percent in 2010 to 52.1 in 2019 80,0 69,0 70,3 68,5 Percentage, % 61,8 60,0 54,7 52,1 45,1 45,8 45,1 48,9 40,2 42,1 42,7 39,8 40,0 33,6 27,4 20,0 0,0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Bank assets/GDP Bank loans/GDP Source: Statistics of Financial Organizations, Central Bank of Armenia, https://www.cba.am/am/SitePages/statfinorg.aspx 94 CAPITAL MARKETS Bank lending to the energy sector has reduced since recapitalization 2016 Maturity structure of Loans and Liabilities  Corporate lending makes up about 60% of total loan book of 1 000 domestic banks AMD Billions 800 600  Reduction of the dollarization level from the high of 64% in 400 2010 to 45% in 2019 supported the notable increase in local 200 currency lending - Demand Up to 3-12 1-5 years more than With no 3months months 5years maturity  Mid-term (1-5 years) and long-term loans (>5 years) are 23% Loans Liabilities to clients and financial institutions and 44% of the total loan book of the domestic banks Bank lending to the energy sector (generation, respectively, while mid-term and long-term deposits represent transmission and distribution) only 15% of total deposits 200 000 40% 150 000 30% AMD million  Loans to energy sector (generation, transmission and 100 000 20% distribution) are only 3.2% of total bank lending or US$245 50 000 10% million with only a third in AMD - 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2H AMD Foreign currency Share of AMD loans (right axis) Source: Monetary and Financial Statistics, Central Bank of Armenia, 95 https://www.cba.am/en/SitePages/statmonetaryfinancial.aspx CAPITAL MARKETS Nearly 70% of pension funds are invested in the local market with 94% in local currency 35 444  As of the end of July 2020, 53% of local currency 40 000 31 926 35 000 (AMD) denominated assets are held in fixed income instruments 30 000 – government bonds (43%) and corporate bonds (10%) 25 000 20 000  The remaining 47% are invested in AMD term deposits 15 000 8 300 6 693 10 000 2 333 5 000 183  82% of local currency denominated government bonds comprise - - - - - - - GNote 3-Y Gbond 5-Y Gbond 7-Y Gbond 10-Y Gbond 20-Y Gbond 30-Y of 10-Y and 20-Y government bonds with YTM of 7.7% and 8.3% respectively AMD USD 20 18  US$ denominated 10-Y government bonds maturing in on Sept 16 26, 2025, and March 26, 2029, are currently trading at 4.3% and 14 12 4.5% respectively 10 8 9,4 8,6 8,9 6 7,4 8,0 6,7 7,0 4 5,3 5,4 5,5 6,0 6,4 5,1 5,1 5,2 1D 1M 3M 6M 9M 1Y 2Y 3Y 4Y 5Y 7Y 10Y 15Y 20Y 30Y 2015 2016 2017 2018 2019 2020 Source: World Bank team estimation based on “Финансовые Рейтинги Банков Армении, 2019, ArmInfo Information Company” 96 CORPORAT GOVERNANCE The OECD Guidelines on Corporate Governance of State-Owned Enterprises are the internationally agreed standard for how governments should exercise the state ownership function to avoid the pitfalls of both passive ownership and excessive state intervention OECD Guidelines recommend a clear distinction of roles between the state, ownership entities, boards, and management. The aim is to separate decision-making from ownership responsibilities to avoid conflicts of interest and disincentives. The state as owner should be responsible for defining and communicating SOE ownership policy and objectives, including any entity-specific objectives for individual SOEs Boards should be charged by the state with overseeing the development of a strategy to achieve the objectives, and to monitor progress. Boards should be ultimately responsible for the entity’s performance to its shareholders - state or non-state Executive management is accountable to the board for implementing corporate strategy. Strategy is normally developed by the executive management and proposed to the board for approval, though in a minority of cases strategies may be imposed top-down The recommendations of the Guidelines are tailored to the current needs of SOEs taking into account Armenia’s legislative framework and regulatory environment 97