Report No. 29062-IR Islamic Republic of Iran Energy-Environment Review Policy Note May 21, 2004 Water, Environment, Social and Rural Development Department Middle East and North Africa Region Document of the World Bank Currencv Equivalents (Exchange rate effectiveMarch 19,2004) Currency Unit =Iranian Rial (Rls) US$l.OO =Rls 8,434.80 FiscalYear Iranian Fiscal Year ends March 20 Acronvms BAU BusinessAs Usual CAS Country Assistance Strategy CBA Cost-BenefitAnalysis CDM Clean DevelopmentMechanism CEM CountryEconomicMemorandum CNG CompressedNatural Gas DOE Department of Environment EER Energy EnvironmentReview ESI Environmental SustainabilityIndex EU EuropeanUnion FA0 Food & Agriculture Organization FY FiscalYear GEF GlobalEnvironmentFacility GDP Growth DomesticProduct GHG Greenhouse Gases GO1 Governmentof Iran INEA InternationalNuclear Energy Agency PCC Intergovernmental Panel on ClimateChange Mboe million barrels oil equivalent MDG MillenniumDevelopmentGoal MNA MiddleEast andNorth Africa OEP Officeof EnergyPlanning OFDA Officeof Foreign DevelopmentAgency OPEC Organisationof the PetroleumExportingCountries PCF PrototypeCarbonFund PPP Parity PurchasingPower SEA StrategicEnvironmentalAssessment T&D Transmission and Distribution TPER Total PrimaryEnergy Requirement TTERP Tehran TransportEmissionReduction Project UNDP United Nations DevelopmentProgram UNEP United Nations EnvironmentProgram UNFCC-COP United Nations FrameworkConvention on ClimateChange-Convention of Parties voc Volatile Organic Compound WHO World Health Organization Vice President: ChristiaanJ. Poortman CountryDirector: Joseph P. Saba SectorDirector: Letitia A. Obeng SectorManager: Vijay Jagannathan TaskTeamLeader: SherifArif 1 Introduction ...................................................................................................................................... 1 1.1 Background to the Note............................................................................................................. 1 1.2 Linkages to previous work......................................................................................................... 2 1.3 Purposeof the Note ................................................................................................................... 3 2 Key Aspects ofthe Economy ofIran ................................................................................................ 4 3 Environmentalsustainability in Iran ............................................................................................... 5 3.1 Politicalcommitment................................................................................................................. 5 3.2 Environmental issues................................................................................................................. 6 3.2.1 Water scarcity andquality ................................................................................................. 6 3.2.2 Urban andindustrial pollution........................................................................................... 6 3.2.3 Landdegradationanddeforestation................................................................................... Untreatedhazardousandmunicipal wastes....................................................................... 7 3.2.4 7 3.2.5 Exposureto natural hazards............................................................................................... 8 3.2.6 Trans-boundary andregional issues.................................................................................. 8 3.2.7 Institutionalandlegalframework ...................................................................................... 8 3.2.8 Summary of issues............................................................................................................. 9 3.3 The costs of environmentaldegradation.................................................................................... 9 4 The Energy Sector in Iran .............................................................................................................. 11 4.1 Energy supply andconversion................................................................................................. 11 4.2 Energy demand........................................................................................................................ 13 4.3 Energy trends........................................................................................................................... 15 4.4 Implications for the environment............................................................................................. 17 5 Assessment ofDamage Costsin the Energy Sector ....................................................................... 20 5.1 Methodology............................................................................................................................ 20 5.2 Estimatesof local environmentaldamage costs in2001......................................................... 22 5.3 Global damagefromflaring of natural gas.............................................................................. 25 5.4 Forecastsof localdamage........................................................................................................ 25 5.5 Conclusions............................................................................................................................. 27 6 Policy Options ................................................................................................................................. 28 6.1 Price reform............................................................................................................................. 28 6.2 Sectoralmeasures.................................................................................................................... 31 6.2.1 Modelingprinciples ......................................................................................................... 34 6.2.2 Impact on the environmentof measures without price reform........................................ 36 6.2.3 Impact on the state budgetof measures without pricereform......................................... 36 6.3 Sectoralmeasures, combinedwith price reform...................................................................... 38 6.4 Options for partial price reform............................................................................................... 40 6.5 Conclusions............................................................................................................................. 42 7 Conclusionsand Recommendations .............................................................................................. 43 7.1 Findings................................................................................................................................... 43 7.2 Recommendations: A New Energy-Environment StrategicFramework (2004-2014)...........45 7.3 Action Plan.............................................................................................................................. 47 7.4 Role of the World Bank........................................................................................................... 48 7.5 Conclusion............................................................................................................................... 49 Figure 4.2: Per capitaenergy consumption(inbarrelsof crude oil equivalent/ year)........................... Figure 4.1: Production andexport of crude oil....................................................................................... 11 Figure4.3: Energy demandin2001 (mboe) ........................................................................................... 13 13 Figure 4.4: Internationalcomparisonof energy intensity....................................................................... Figure 4.5: Subsidiesto energy by fuel and sector (1012Rials).............................................................. 14 15 Figure4.6: Allocation of subsidiesby fuel and sector (2019)................................................................ Figure 5.1: Emissions by sector.............................................................................................................. 16 22 Figure 5.2: Damageby fuel and sector in2001(10l2Rials) .................................................................. 23 Figure 5.3: Damagecost by pollutant and sectorin2001 (10l2Rials) ................................................... 24 Figure5.4: The economic cost of fuel.................................................................................................... 24 26 Figure 5.6: The evolution of damageby pollutant.................................................................................. Figure 5.5: Damageby fuel and sectorin2019 (1012Rials) .................................................................. 26 Figure 5.7: The evolution of damageby sector...................................................................................... 27 Figure 5-8: Evolution of damage by fuel................................................................................................. Figure 6.1: Energy demandinthree reformscenarios(mboe) ............................................................... 27 29 Figure6.2: Damagecosts by pollutant inselectedyears underreform(10l2Rials) 30 Figure6.3: Direct impactson economic growth fromprice reform........................................................ ............................... 31 Figure 6.4: Damageby pollutant over time: measures no price reform................................................. Figure 6.5: Cumulative net benefits to Iran(1012Rials)......................................................................... 36 37 Figure 6.7: Damagecostsby pollutant: price reformplusmeasures(10l2Rials)................................... Figure6.6: Net financial flows to the state of measures......................................................................... 37 39 Figure 6.9: Cumulative net cash-flow to the state (1012Rials)............................................................... Figure 6.8: Cumulative economic benefits (1012 Rials).......................................................................... 39 40 Figure 6.10: Damagereductionsfor single fuel price increases (2019) ................................................. Figure6.11: Subsidyreductionsfor individualfuel price increases (2019)........................................... 41 41 Table 4-1: Impactsof gas flaring(1994/95) ........................................................................................... 15 Table 4-3: Partial energy balancefor 2019 (entries inmboe) ................................................................ Table 4-2: Energy balance2001 (entriesinmboe)................................................................................. 18 19 Table 5-1: Benefit values assumedfor Iran............................................................................................ 21 28 Table 6-2: Effecton consumerprice index of price ref0rm..................................................................... Table 6-1: Marketprices and opportunity costs (2001).......................................................................... Table 6-3: Summary of sectoralmeasures............................................................................................... 30 Table 6-4: CBA of sectoralmeasures..................................................................................................... 32 34 Table 6-5: Key parametersof the modeledpolicies ............................................................................... 35 Table 7-1: Maineffects of price reformand sectoralmeasures.............................................................. 44 Acknowledgements This sector note was prepared by Mr. Sherif Arif (Regional Environmental & Safeguards Advisor and Task Team Leader) and Mr. Nigel Lucas (Environmental Economist, Consultant). Mr.Vijay Jagannathanisthe SectorManager, andMs.LetitiaA. Obengisthe SectorDirector. The team would like to acknowledge the cooperation and support received from the Government of Iran, particularly H.E. Dr. MassoumehEbtekar, Vice-president and Head of the DOE, Dr.Yousef Hojjat, DeputyHeadHumanEnvironment (DOE), Dr.MajidShafie-Pour,SeniorAdvisor to the Head of DOE and Director of the EER Office in the Department of Environment (DOE), Dr. Mojtaba Ardestani, Project Coordinator, the Members of the DOE SteeringCommittee, as well as the staff members of the DOE EER Office. The team would also like to thank the Consultants at Electrowatt-Ekono, TERI and Ghods Niroo, especially Dr. Robert Zwahlen, Team Leader of Electrowatt-Ekono, and Mr.Michael Cupit, Environment Economist at the Environment Management Resources(ERM). Messrs. Tjaarda P. Storm Van Leeuwen (Lead Financial Analyst, MNSIF), Victor B. Loksha (Energy Economist, ECSIE) were the peer reviewers and provided useful comments and feedback. Ms.MagaliePradeldesktoppedandeditedthereport. The team finally gratefully acknowledges the financial support provided by the Norwegian Governmentthrough atrust fundto the study. EXECUTIVESUMMARY The Government of Iran(GOI) has requestedthe World Bank assistance to integrateenvironment priorities into its energy sector, with the intention that some of its recommendations could be included in the 4" Five Year Development Plan (2005-2010). The mainstreaming tool for integrating environmental concerns into the energy sector is an Energy-Environment Review (EER) intothe energy sector, which is called inthe World Bank's "Environment Strategyfor the Energy Sector: Fuelfor Thought", approved by the Board on July 20, 1999. The results of the EER should be interpreted inthe light of the objective of the 4" Five Year DevelopmentPlan to achieve fast and sustainable growth and accelerate the transition to a market economy. In particular the suggested actions will promote economic efficiency through a proper allocation of scarce resources, including environmental resources, so as to achieve economic efficiency and environmental and social protection. This Policy Note i s based on the Final Report of the Environmental Energy Review (EER) prepared over two years with the full collaboration with the GO1 and the assistance of international and national consultants. The EER was financed by the Norwegian Trust Fundfor Sustainable Development. The EER report comprises: (a) an analysis of the current situation with regardsto energy generationand use; (b) an evaluation of the growth prospectswith regard to energy generation and use; (c) the identification of the environmental issues induced by the generationand use of energy andestimation of the costs of the damages; (d) the evaluation of the extent of contribution to the climate-change phenomenonthrough emission of greenhouse gases; (e) the evaluation of the proposedmitigating measuresfor the previously identified environmental problems; (f) conclusionsandrecommendations;and(g) aproposalfor anaction plan. The emphasis of the EER is on air pollution, because it i s the most extreme and visible sign of environmental damage, certainly in the large cities. This does not meanthat other environmental issues are of secondary importance and should not be addressed. The EER describes a process and methodology for using damage-costs as a tool for engaging the GO1into a policy dialogue into integrating environment concerns into the energy sector. Such process and methodology could be adapted and be used in the policy dialogue in other sectors such as water, land degradation. Other important issues are marine pollution from oil spills and contamination of water from oil production and processing. Marine pollution is covered in the Note. Refinery issues are better treated by normal processes of industrial pollution control. The policies recommended will generally lead to more efficient use of resources and a diminution of other environmental impactsandwill haveno adverse effects on other media, such as water andsoil. The major source of air pollution i s the energy sector which i s key to the Iranian economy. It is the main engine of future economic growth, a principal cause of environmental pollution and damage anda major source of market distortion. Iranpossesses substantial reserves of hydrocarbons. Iran i s OPEC's second largest oil producer. At the end of 2002 it possessed 12.3 billiontons of provedreserves, amounting to 8.3% of global proved reserves. Oil production peakedat over 6 million barrels per day (mbd) in 1990, but has since fallen and in 2002 was 3.3 mbd. Iran aims to raise its oil production to 8 mbp by about 2025, andi s seeking foreign investmentto this end. Irani s also well-endowed with natural gas. In2002 there were 23 trillion cubic metres of proved reserves of natural gas in Iran, equivalent to 14.8% of known world reserves and the second largest in the world after the RussianFederation. Production of natural gas in Iranthat year was i 64.5 billion cubic metres (bcm) giving it a reserves to production ratio of around 360 years, comparedto 8.6 years inthe U S and 81 years inthe RussianFederation. Other sources of primary energy in Iran include thirteen hydropower with a total capacity of 2,000 MW; which generated 6,908 GWhin2000, equal to 7.4% of the national output Iran has a long-standing commercial nuclear program. In1995 and 1998, it signed agreements with Russia to complete the 1000MW pressurised light water reactor at Bushehr. The power plant i s to be commissioned in2004. The presentaimi s to have7000 MW of nuclear power installed by 2021. Despite its vast oil and gas reserves Iran has also renewable energy programs in photovoltaics, wind, geothermalandbiomass. Per capita consumption of energy has risen from 2.0 boeper year in 1965 to 10boe per year now The energy intensity value is higher than that characterizingmost industrial economies and also higher than more densely populateddeveloping countries suchas China andIndia. Energy inthe domestic market is heavily subsidized; the EER estimatesthe total subsidy in2001 at 118 ~ 1 0Rials' ~ ($ 15 billion) equal to 17.8% of the Iranian GDP. This practice not only distorts consumer choice and obscures state accounts, but is the cause of high environmental damage. The present pricing policies of the GO1aim broadly to keep energy prices constant in real terms; if these policies continue to 2019 (the end of the 6" Plan) then the subsidy to the sector will rise to 2 8 8 ~ 1 0 'Rials (measured in Rials of 2001) equal to 20% of GDP. ~ Consumption of energy andemissionsof green-housegases will more thandouble. The Iran's Country Economic Memorandum for Iran of April 2003 made detailed studies of the consequences on the state accounts and consumer prices of various schedules of energy price adjustment and the ways in which unwelcome impacts could be managed by compensation schemes. The Memorandum concluded that the preferable combination would be of a quick adjustment of energy prices in two to three years and a phased compensation scheme over 5-7 years. This procedure would allow time to develop the targeting mechanisms and institutional structures required to deliver the social safety measures and also allow the accumulation of the revenuesto fundit. On the basisof the energy supply anddemand, the EER assessedenvironmental damagefrom air- pollution inIranusing the ExternE study that has extendedover 10years and is still inprogress; it has been funded by the EU Commission and Member States'. Damage costs were transferred from WesternEuropeanpracticeto the conditions of Iranby scaling accordingto GDP per capita measuredinPPPterms. Usingthis approach, the EERassessedthe total healthdamage from air-pollution in2001 at about 5 6 ~ 1 0Rials ($7 billion); equivalent to 8.4% of nominal GDP. Inthe absence of rice reform ' ~ and control policies, the EER estimated that damage in Iran will grow to 155x10l! Rials ($19 billion) by 2019, inthe money of 2001. This is equivalentto 10.9% of nominal GDP, i.e. a larger percentageof a larger GDP. Of this total, 1 0 7 ~ 1 0Rials ($8.4 billion) comes from the transport ' ~ sector. The damage cost to the global environment fromthe flaringof natural gas assessed on the basis of a carbonprice of $10/tonCOz,andfound to be approximately $600 millionper year. Fulldetails ofthe methodology ofExtemE, the results for allfuel-cycles andthe applications to MemberStatescanbe found on www.exteme.jrc.es. ii This is equal to a little less than 1% of current GDP. There are large costs associated with recovery anduse of suchgas, butequally there are largepotential benefits. The EER investigated the policy options to control and decrease the damage costs. It examined separately price reform policies and/or sectoral measures. By sectoral measure i s meant an intervention that aim to cause a specific behavioural change, e.g. through targeted financial incentives and standards for equipment and appliances. The EER examined three scenarios for price reform in which subsidies were eliminated by: (a) 2009 at the end of the Fourth Year Economic and Social Development Plan (4' Plan) a fast price reform, to be close to the recommendationsto the CEM; (b) the end of the 5fi Planin2014; as an intermediateprice reform to consider a less acute public reaction and lower pressure of the CPI; and (c) by the end of 6' Plan; as very slow price reform; this scenario would require price increasesphasedover 15 years and could be difficult to sustain. The EER conducted also detailed cost-benefit analyses on thirteen sectoral measures that could be taken to reduce the environmental impacts of the energy sector. The challenge therefore is to recommendthe necessary policy reforms and sectoral measuresthat will substantiallyreducethe damage costs from 8.4% of GDPin2001andfrom 10.9% of GDP in 2019, inthe case that no reformor measures are introduced. Inorder better to define the options and their impacts, a total of twelve scenarios were analyzed, characterized by a combination of four price reform scenarios and three different sets of measures. The main results can be summarizedas follows: (a) Compared to 2001, in a Businessas Usual (BAU) Scenario, primary energy requirement and final energy consumption would more than double till 2019, with the corresponding detrimental effects on the amountpaidas subsidies, on emissionsand on damage costs. Subsidies and damagecosts would not only increaseinabsoluteterms, but also as percentageof GDP. Fast price reform by 2009, as proposed in the CEM, would decrease the damage costs by half. It would increase overall financial benefits to the state and bringbigger environmental benefits in the intervening period 2004 - 2019, however it would have stronger impact on the consumer price index. (b) Elimination of energy subsidies in 2014 without sectoral measures would reduce energy consumptionby half from 1556mboeto 789 mboe, andresult ina 50% decrease of damage costs from 10.9% of GDP to 5.7% of GDP. However, both energy consumption and damage costs (81trillion Rials or US$ 11billion) would still be higher thanin2001. (c) Applying sectoralmeasures without price reformwould lead in2019 to acertain, although not very substantial, reduction inenergy consumption anddamage costs from 10.9% of GDPto 7.6% of GDP. (d) The combination of price reform and sectoral measures would bringenergy consumption in 2019 almost to the level of 2001, andwould actually result ina decreasingenvironmental impact, and therefore inreduceddamage costs as comparedto 2001 from 8.4% of GDP to 3.9% of GDP. The effects are the same for all price reform scenarios, because of the assumptionof immediate adjustmentto price. (e) If price reform strategies cannot be comprehensive, then targeting transport fuels i s the best .compromise. There is a double gain in avoided subsidy and avoided damage. Roughly, these benefits are comparableinmagnitude. ... 111 The major conclusions form this analysis are that: a) rapid price reform i s the best strategy for the environment. The policies proposedinthe CEM for energy price reformare entirely coherent with those that the ERR shows most benefit the environment; b) only a combination of price reform plus appropriate sectoral measures can keep damage costs by 2019 below those assessed for 2004; c) if price reformis delayedpast 2009 then the Iran can improve its financial cash-flow by providing financial incentives to the efficient use of energy and to the substitution of fuel-oil by natural gas. These measures create a cash-flow to the state as a consequence of avoided subsidy. Some of this positive cash-flow can fund other environmental control measures where the costs are not easily assignedto the polluter. The EER shows that reform of prices to the level of opportunity costs will bring significant benefits, but will still leave substantial environmental impacts that will increase thereafter as a consequence of increasedenergy use arising from continued economic growth. Price reform in itself is not enough. Prices could be increasedabove the level of opportunity cost by taxes as is done in many industrialized countries; such measures are normal driven by a combination of fiscal andenvironmental motives. Taxation shouldbe borne inmindas a long-termoption, but in the short-termthe price reformneedsto be supplementedby targeted sectoralmeasures to control emissionsat source. Basedon a vision of sustainabledevelopmentanchoredina thriving market-basedeconomy with efficient institutions and strong regulatory oversight, this policy note puts forward a four-point strategy with the proposed actions: a) to improve human health and the quality of life of the population through a reduction in the prevalence of respiratory diseases brought about by specified environmental control measures; b) to price energy resources efficiently to stimulate energy efficiency and competitiveness of the economy; c) to improve the productivity and sustainability of the country's energy capital by investment inclean technology; d) to improve the institutional and legal framework and strengthen information dissemination and public awareness-raising. The policy note also proposes an Action Plan to implement the main sectoralpolicies described above aiming at improving the environmental situation as far as it is related to the energy sector. This Action Plan will haveto be developedfurther, andchanged where required, since it can only be implemented within a coherent framework of Iranian environmental, energy and economic policies, which needto be defined and adoptedby the Iranian Government. Therefore the Action Plan, as presentedin the EER report, should be consideredas a basis for the ongoing discussion with the GOI, which in any case must be continued for the further implementation of work that hasbeeninitiated by the EER. This Action Plan should be the basis for continuing discussion between the Bank and the GOI. The DOE has already established an Energy-Environment Review (EER) Office and has also formed an EER Steering Committee. Both should continue to function untilthe Policy Support Unit which is envisagedunder the World Bank co-financed Environment Management Support Project become fully operational with staff and resources. Later, the High Council of the Environment should oversee the Action Plan with the PSU acting a secretariat for monitoring, evaluatingandcoordinating the policy options executedand implemented by various agencies. On the basis of the strategic actions, the role of the World Bank will be to assist Iran in developing tools for meeting its MDG target # 7 on environment sustainability, in particular: a) to mainstreamenvironment into target policies, programs and projects at the national and local levels; b) to promote sustainabledevelopmentinthe energy sector. This approachrequires strong iv commitment and involvement from all departments and levels of government, including civil society andthe private sector. The policy note proposes that the Bank will use five main tools in its support for the implementation of the EER: a) assisting DOE and the key energy Ministries of Oil, Energy, Transport, and Environment in setting environmental priorities and in improving their environment management capacity; b) assisting the DOE and other relevant institutions of government to strengthen capacity in environment and social assessment; c) integrating environment into Bank's instruments through the environment-energy priorities expressedin the CAS, sector work, and program and project design in the energy sector; d) buildingthe capacity of key sector ministries, local governments, and municipalities in technical and managerial matters, as well as policy planning and evaluation; e) promoting regional cooperation in combating marine pollution from oil and gas, and protection of marine resources in its Shatt El Arab waterway with IraqandKuwait andits downstreamzone of influence inthe PersianGulf. Since the year 2000, the Bank has been the major environment policy interlocutor in Iran. Its presence is needed now, even more than in the past, to play its catalytic role of addressing the root causes of inadequateenvironmental management and inintegrating environmental concerns into decision making and the management of the economy, providing tools for environmental policy analysis and linking project preparation to investment. The EER i s the beginning of a process. Accompanying Iran in this process of environmental sustainability is a challenge that the Bank has accepted to assume in order to help Iran improve the quality of life of the Iranian peoplenow and inthe future. V 1 Introduction 1.1 Backgroundto the Note 1. The Government of Iran (GOI) has requested the assistance of the World Bank to integrate environment priorities into its energy policy, with the intention that recommendationscan be integrated intothe fourth five year developmentplan (2005-2010). The aimof the GO1is to improve the protection of the environment without hinderingthe economic development of the country. Economic growth i s required to improve the living standardof the population and to reducepoverty, but also to correct bad environmental practice andto address environmentalissues that are not restrictedto the energy sector. 2. The mainstreaming tool for integrating environmental concerns into the energy sector is found inthe World Bank Group "EnvironmentStrategyfor the Energy Sector: Fuelfor Thought",which was approvedby the Board on July 20, 1999. The mainobjectives inthis strategy are: (a) to facilitate more efficient use and substitution of traditional fuels; (b) to protect the health of urban residents from air pollution due to fuel combustion; (c) to promote environmentally sustainable development of energy resources; (d) to mitigate potential impacts of energy use on global climate change; and (e) to develop capacity for environmental regulation, monitoring andenforcement. The strategy sets a courseof action using three key instruments: policy assistance, knowledge management and targeted investments. It also emphasizes that local, regional and global problems are excellent opportunities for developing countriesto address environmentalproblems at all levels. 3. The objective of the EERi s to assist countries to better integrateenergy sectordevelopment and investments with their environmental objectives. The preparation of an Energy-Environment Review (EER) is one tool proposed by Fuel for Thought for providing recommendations on environmental mainstreaming in the energy sector; the strategy also identifies options and opportunities for the reduction of emissions of greenhouse gases (GHG) through the Clean DevelopmentMechanism (CDM) of the Kyoto Protocol. 4. This diagnostic tool was therefore usedto help identify gaps andpriorities for assistingthe GO1 to move closer to its sustainable development objectives. The EER of Iran uses a systematic analytical framework founded in cost-benefit analysis (CBA) and a participatory process to recommend a set of priority investments and policy reforms. The results of the EER should be interpreted in the general framework of promoting economic efficiency through a proper allocation of scarce resources,including environmental resources, as to achieve economic efficiency and environmental and social protection (see paragraphs91 and92). Supportto GO1i s consistent with: The Bank's commitment to assist its clients in achieving their MillenniumDevelopment Goals (MDGs). Inthe case of environment, the MDG#7 related to environmental sustainability calls for mainstreaming the environment in policies and programs, reversing the losses of environmentalresources, and improving access to environmental services; The Banks environmental strategy to mainstream environment into policies, programs and projectsfor improving the quality of life, the quality of growth andquality of global commons; The InterimCAS of Iran (June 2001) by supporting its sector reform agenda on environment, water and waste-watermanagement, housing and social sectors; The MNA's regional strategy to strengthen policy reform and institution buildingthat lead to poverty reduction through the appropriatecombination of lending andknowledge. 1 5. This Policy Note is based on the Final Report of the Environmental Energy Review (EER) prepared over two years with the full collaboration with the GO1andthe assistance of international and national consultants'. The EER was financed by the Norwegian Trust Fund for Sustainable Development. The EER report comprises: (a) an analysis of the current situation with regards to energy generation and use; (b) an evaluation of the growth prospects with regards to energy generation and use; (c) the identification of the environmental issues induced by the generation and use of energy and estimation of the costs of the damages; (d) the evaluation of the extent of contribution to the climate-change phenomenonthrough emission of greenhouse gases; (e) the evaluation of the proposed mitigating measures for the previously identified environmental problems; and (f) conclusions and recommendations,andaproposalfor an action plan. 6. The EER-Iran was carried out under the guidance and leadership of the Department of Environment (DOE), which i s the national authority for environmental protection in Iran. A special Energy-Environment Office was establishedin the DOE under the leadership of the Senior Advisor to the Head of DOE, who also i s a Vice-president of the Islamic Republic of Iran. The EER Office included full time staff who participated inthe study and worked closely with the Consultant, receiving on-the-job training inthe process. A SteeringCommittee was appointedby the Headof DOEto oversee and review the work, interface with Bank staff and support the Consultant. The Steering Committee -wasformed with representativesof all thoseMinistries that haveresponsibilities within the environment energy nexus. Along with the Offices of the DOE (EER Office, Climate ChangeOffice, World Bank Coordination Office), the following ministries were representedinthe SteeringCommittee: Ministry of Oil, Ministry of Energy, Ministry of Industry and Mining, Ministry of Housing and Urban Development, Ministry of the Interior, Ministry of Health and Medical Education, Management and Planning Organization,Atomic Energy Organization. 7. Four training workshops were organized by the EER through which 130 participants attended courses on energy and environmental issues in Iran, cost benefit analysis techniques and economic evaluation of damage costs. A fifth workshop was held in February 2004 in conjunction with the presentationof the FinalReport and chairedby the Vice-president of Iran. 1.2 Linkagesto previouswork 8. The principal documents consultedfor the EERwere: e The Energy Balance Report published by the Office of Energy Planning (OEP), Ministry of Energy e The Third Five-year DevelopmentPlan of the GO1 e The FinalReport of the Tehran Transport Emissions Reduction Project (TTERP), implemented by the World Bank withjoint financing from GEF andthe Municipality of Tehran 1993-1997 The Study on an Integrated Master-Plan for Air Pollution Control prepared by JICA in 1997 that deals also with air quality inTehran e The GreenhouseReport of Iran's InitialNational Communicationto UNFCCC-COP e The Environment Strategy Study of Iran, prepared with the assistance of the World Bank in 1995 'Environmental Energy Review; Final Report by Electrowatt-Ekono group in association with TERI and Ghods-Niroo, February2004 2 e The World Bank report of 1999 on Economical Aspects of Increasing Energy Prices to Border Price Levels a The Iran: Medium Term Framework for Transition, Converting Oil Wealth to Development, Country Economic Memorandum, World Bank, April, 2003 The Environment Management Support Project, World Bank, June 2003. 1.3 Purpose of the Note 9. This Policy Note reportsthe process andachievementsof the EERinIranwith specialreference to the use of cost-benefit analysis as a tool for diagnosis, communication and the framing of solutions. It identifies the value of the methodology as a means of communicating with government about the level of environmental damage, in establishing priorities for environmental policy and in the detailed design of such policies. It makesrecommendationsfor actions to be taken by the government, it draws implications for the World Bank programs and it proposes studies to strengthenthe methodology. The main focus i s on air pollution because this is the most important generic impact of energy use. Other important issues are marine pollutionfromoil spills andcontamination of water from oil production and processing. Marine pollution is covered in the Note. Refinery issues are better treated by normal processes of industrial pollution control. The policies recommended will generally lead to more efficient use of resources and a diminution of other environmental impacts and will have no adverse effects on other media, suchas water andsoil. 10. Inthis Note, Chapter 2 resumes some of the salient features of recent economic development and the immediate priorities. Chapter 3 analyses the main environmental aspects of sustainable development, the major environmental issues, and the evidence for the political commitment of the GOI. Chapter 4 reviews the pertinent characteristics of the energy sector, summarizes the supply and demand structureandthe level andallocation of subsidiesandidentifies presenttrends. Chapters 5 and 6 form the core of the note; Chapter 5 comprises an account of the approach and methodology used in the EER to determine the damage cost of air pollution to the economy; Chapter 6 assesses the likely impact of specific policies of price reformand sectoral measures for reducing air emissions. Chapter 7 summarizes the conclusions and recommendations, provides a proposal for an Action Plan and draws some implications for programsof the World Bank. 3 2 Key Aspects of the Economy of Iran 11. The Iranian economy is now at its most stable since the Revolution. External and internal balances have improved significantly and large surpluses have appeared. The current external balance in 1991/92 was in deficit by $10.2 billion and in 2002/03 was in surplus by $3.5 billion. The trade balance was in deficit by $6.5 billion in 1991/92 and in surplus by $3.9 billion in 2002/03'. Inflation has beensystematically reducedfrom around20% per annumin 1997to 11.6%by 2001/02. 12. The country has a population of 64.5 million (2002) and a GDP of US$ 114billion, Economic growth in2001/02 is estimatedat 5.7%; this is the highestrate of growth since 1992. Nominal GDPper capita in 2002, according to the World Bank World Development Indicators, was 1710 US$/capita (115" place in the world); in PPP measures it was 6340 US$/capita (89" place). The total size of the economy was US$ 107billion (34" place) andinaPPPmeasurewas US$415 billion (21" place). 13. The improved oil prices in 1999 and 2000 were responsible for much of the recent recovery. The country still faces severe economic problems. Average unemployment is about 16% and much higher in some provinces. Because of high fertility rates inthe past, the rate of growth of labor supply i s about 5% per year. An enhanced participation of women in the labor market and continued high fertility rates will sustain this oversupply. Unemployment has been recognized by the leaders of the country as the greatest economic challenge that they face. The extensive subsidies applied across the economy and especially to energy not only lower efficiency by distorting the perceived value of factor inputsthey also obscure important aspects of government finance. Mineral rents do not appear in the state accounts because they are passed straight through to the consumer in low energy prices. If these adjustments are made, then the impliedpublic sector budget is around 42% of GDP compared to the 23.5% inthe official presentation. This i s double the typical size of a middle income country and even higher thanthe Europeanaverage. 14. The World Bank has recently issued a Country Economic Memorandum (CEM) on Iran, entitled Medium Term Framework for Transition: Converting Oil Wealth to Development. The Memorandum concludes that Irani s about 10%of GDP off an economic equilibrium that would reduce unemployment and improve welfare by converting oil wealth into sustainable development. The Memorandum estimates that the country is about 10% of GDP short in the additional savings and investment needed to attain the growth that will reduce unemployment. The CEM also estimates that the optimal management of the non-renewable resources of Iran requires that it allocates about 10% more of GDP to savings and investmentand less to consumption. Thirdly, the Memorandumestimates that the 10% adjustmentcan come from the reformof the energy subsidy system. 15. The CEM expects the average growth of labor supply to decline from the current level, but calculates that with an annual improvement in labor productivity of 2.4% per year, it will require an average growth rate of 6.5% to maintain unemployment at 16%; or 8% GDP growth to bring unemployment down to 10% by 2010. Proper economic policies that put the mineral rents to effective use could achieve this level of growth. These revised economic policies must go hand-in-hand with proper environmental policies to ensure part of the nominal growth is not destroyed by disproportionate environmental damage. * Iran MediumTermFramework for Transition, World Bank Country EconomicMemorandum, April 2003. 4 3 Environmentalsustainability inIran 3.1 Political commitment 16. Iranhas madea strongpolitical commitment to sustainabledevelopment. The IranianNational Committee on Sustainable Development i s the key institution. The Committee i s chaired by the Head of the Department of the Environment who is a Vice-president of the Islamic Republic of Iran; it includes members from the President's Office, the Department of Environment, the Meteorological Organization, the Managementand Planning Organization, the Academy of Sciences, the Ministries of Culture and Higher Education, Oil and Energy, Housing and Urban Development, Mines and Industry, Telecommunication, Foreign Affairs, Jihad-Agriculture, and Health. Iran participated in the recent JohannesburgSummit. 17. Article 50 of the Constitution of the Islamic Republic of Iran states that "in the Islamic Republic, it is considered a public duty to protect the environment where the present and jkture generations are to have a thriving social life. Thus, any form of activity, whether economic or otherwise, that causes pollution of or irreparable damage to the environment is prohibited". Political uncertaintiesandthe Iran-Iraq war preventedthe proper implementation of this constitutional provision duringthe early years after the Islamic Revolution. Inrecent years, the constitutional backing has been reinforced and supplemented by the reform process that the Iranian Government has implemented. Official statements recognize the need: a) to mainstream environmental considerations into policy making and planning; b) to strengthen the national environment apparatus; c) to enhance regulatory standards; d) to provide for more efficient monitoring; and e) to foster greater public education and public awareness. 18. The recognition by the GO1of the need to better manage the environment i s slowly translating into improved policies. InChapter 12of the Law of the Third Planfor Economic, Social andEconomic Development, the Government introduced measures "to protect the environment and to secure sustainableexploitation of the country's natural resources". The Law recognized for the first time the polluter-pays principle and requiredall polluters to comply with appropriate standards and guidelines. It also establishedinits Executive By-laws a dual systemof fines for polluters as well as tax exemption for establishments that invest in pollution control and prevention or in energy conservation and efficiency. InChapter 18, pertaining to urban and rural development, the Law requires cost recovery for waste water and a system of fines inthe event that establishments do not comply with appropriate treatment. Cost recovery for treated waste water has been introduced inTehran. Fullcost recovery for the disposal of municipal waste will be initiated inTehran as a first step that could be expandedinother major cities. The fines and tax incentive systems have not yet been made operational, but the process indicates an active engagement by the Legislature, Executive and Judiciary to develop a proper regulatory structure. The fourth Economic and Social Development Plan i s expected to further emphasize sustainabledevelopment as the core of economic growth. 19. However, there is a long way to go to reach this objective. The Environmental Sustainability Index (ESI)3based on a number of indicators, puts Iran in the rank of 104 of a total of 122 countries with anESIindex of 38.4, indicating a low sustainability. 'Esty andComelius, WorldEconomicForumPublication,2002. 5 3.2 Environmentalissues 20. The pattern of socio-economic development, linkedto the physical characterof the country and the geo-political context, has engendered a variety of environmental problems that are structurally integratedinto the developmentprocessandhavebeendifficult to treat. They include: 0 Water scarcity andquality 0 Urban and industrial pollution 0 Untreated hazardousandmunicipal wastes 0 Land degradationanddeforestation 0 Exposure to naturaldisasters 0 Trans-boundaryandregional disputes 3.2.1 Water scarcity and quality 21. The renewable water resource available annually is about 2150 m3per capita. Access to water i s unevenly distributed, inpart becauseof policies that allocate 90 percent of the water resourcesin Iran to agriculture in an attempt to increase self-sufficiency in food. Chronic deterioration of water quality aggravates the scarcity. The main causes of the deterioration are the disposal of untreated municipal wastewater, industrial wastewater and contaminated drainage water from agriculture to groundwater, combined with a decreasing flow. Twenty five rivers out of thirty five are heavily polluted and out of thirteen groundwater tables, ten show mediumto highlevels of pollution4. 22. So far, only isolated and scattered sampling and analysis of water quality have been made and the monitoring infrastructure in place i s too slow (and insufficiently reliable) to provide an adequate basisfor intervention. As apart of aWorld Bank-financed EnvironmentalManagement Support Project (US$ 20 million), it i s plannedto carry out a large scale monitoring programof the Karunriver, which i s one of the largest and most important rivers. Waste water quality i s expectedto improve as result of the water supply and waste water projects co-financedby the World BankinTehran, Ahwaz and Shiraz. 3.2.2 Urban andindustrial pollution 23. The rapid anduncontrolled expansionof the main cities, particularly Tehran, Mashhad, Isfahan, Tabriz and Ahwaz, coupled to growth in heavy industry with little environmental control, has seriously damagedair quality. The life of motor vehicles indry countries like Irani s long andthe capital stock in Iran i s aged. Vehicle performance is characterized by old technology, poorly maintained. The high altitude of the country reduces combustion efficiency. Roads are congested, vehicle speeds are low. Consequently, the impact of the transport sector on air pollution i s substantial; emissions of carbon monoxide alone are estimated at 5 million tonnes per year across the country of which 1.5 million tonnes are inTehran. 24. Some initiatives have been taken to reduce vehicular emissions in Tehran, Shiraz, Mashhad, Isfahan and a few more of Iranian megacities; CompressedNatural Gas (CNG) has been introduced and recently the GO1 has required that all imported vehicles and all new locally assembled and manufactured vehicles must be equipped with catalytic converters. Unleaded gasoline was also introduced. The consumption of natural gas by taxis and passenger cars reached 1976 million m3in Compilationby the Department of Environment inIran. 6 2000. A sustained switch from gasoline or gas-oil to CNG i s expected. Metallurgical industries, refineries, cement works and electroplating also contribute to air pollution, especially when they bum high sulfur fuel oil. Low prices for energy weaken the incentives to industry to convert to clean and efficient natural gas. 25. The topography of the country causes wind speeds to be low, so pollution is not blown away and the aridity much of the year means that pollutants are not washed out. Residence times are long. Standards for ambient air are stringent, but frequently exceeded. Key pollutants such as PMlo, SO,, N O , and Volatile Organic Compounds (VOC) exceed WHO guidelines by between 30-350%. Air pollution is estimated to cause over 4,000 deaths per year in Tehran alone. The Tehran Transport Emission Reduction Project (TTERP) assessed the cancer risk from the exposure to mutagenic substances, taking the NO, concentrations as a proxy for these; it estimated 3500 cases a year might be attributed to air pollution. 26. Schools are occasionally closedandresidents are asked to remain indoors because of the health risks of heavy air pollution. In November 2002, residents of Tehran were advised to remain at home because air pollution, particularly carbon monoxide, had reached emergency levels. Detailed air pollution reduction strategies for Tehran and Isfahan have been completed, but implementation is problematic. 3.2.3 Untreatedhazardousand municipalwastes 27. Approximately 15 million tonnes of municipal solid waste i s generated annually, of which about 2.5 million come from Tehran5. Industries in Iran generate about 100,000 tonnedyear of hazardous waste. Hazardouswaste, agricultural and hospital wastes are mixed with municipal waste in open dumps. No appropriate sanitary landfills exist. The GO1 and the World Bank are preparing a municipal solid waste management project for Tehran which will set forth the institutional, legal and financial framework for anintegratedsolid waste managementsystemand will finance the first sanitary landfill inIran. 3.2.4 Landdegradationanddeforestation 28. It is estimatedthat between 1.5 and 8 million tonnes of soil a year are lost from erosion. The loss comes from poor irrigation, poor road construction and overgrazing. The poor irrigation practice causes a build-upof salts inthe soil which, combined with water-logging, leads to an estimated loss of 2.5 percent in agricultural productivity. A joint study by the FAO, UNDPand UNEPestimatedthat 45 per cent of agricultural land is affected by light to moderate water erosion. Overgrazing i s a consequence of population pressure and social change, particularly urbanization and the eventual pressureson marginal lands. 29. The total forested area of the country has reduced, over the past 57 years, from 19.5 million ha. to 12.4 million ha.6;this corresponds to an annual loss of 120,000 ha. of forest or a daily loss of 340 ha. The World Bank and the Government of Iran are preparing a project on integrated land and water management (US$ 120-140 million) to enhance current GO1 efforts to achieve sustainable land and Organizationof Waste RecyclingandComposting(OWRC), Tehran. Department of Environment,PrivateCommunication, 2003. 7 water managementinthe Alborz river basin. The project includes a large component on watershed and forestry management. 3.2.5 Exposureto naturalhazards 30. Iran experiences periodic droughts, floods, dust storms, sandstorms and earthquakes along the western border and inthe northeast. The last major earthquake occurredinDecember 2003 in the city of Bam in which 30,00040,000 people died. An earthquake in 1990was equally disastrous. In2000, according to the OFDNCRED International Disaster Database, 37 million people were affected by drought and25 million peopleinthe following year. Severe floods in 1980andin2001affected around 1millionpeopleoneachoccasion. 3.2.6 Trans-boundary and regionalissues 31. Iran is one of the littoral countries of two international water bodies; the Persian Gulf in the South and the Caspian Sea in the North. The National Strategy for Environment and Sustainable Development has estimated that a total of 1.5 million tons of oil were discharged to the waters of the PersianGulf inthe period of 1980to 1989. The Caspian Sea is also vulnerable to discharges from oil production and transport. Producing two percent of global greenhouse gas emissions, Iran i s a significant contributor to climate change. Per capita carbon dioxide emissions increased by almost 25 percent between 1990 and 1999, and per capita energy use increased by 50 percent; the discrepancy betweenthe two figures is aconsequence of the importanceofnaturalgas inthe incremental fuel mix. 3.2.7 Institutional andlegalframework 32. The Constitution of the Islamic Republic of Iran requires the protection of the environment. Despite this constitutional support it has proved difficult to elaborateaneffective legal framework. The Environment Protection and EnhancementAct was passedinJune 1974 and createdthe Department of the Environment (DOE) as an entity affiliated to the PrimeMinister's Office. This affiliation was later transferredto the Office of the President. The Presidentchairs the Council and a Vice-president heads the Department. Much of the activity of the Department is concemed with the conservation aspects of the environmentandthe operation of nationalparks andprotectedareas. There are 28 provinces inIran; each has a DOE provincial directorate that monitors all aspects of environmental protection and the implementation of Departmentprograms. 33. There are legal provisions for levies, taxes and charges on polluting enterprises. These include the following: 0 Fines on polluters that exceed the national standards set out in the executive by laws of the 31d Plan. The fines collected fromthe city of Ahwaz amountedto US$5.0 million inthe first year; 0 Revenues from the law known as law 1/1000" which mandates that enterprises should deposit l/lOOO' of their sales revenues in an escrow account for expenditures on improvement of environmental conditions in accordancewith a plan which should be approvedby DOE. Such expenditures would be deductedfrom their taxes on their net income; 0 The revenue from 1%of the CIF costs of all automotive parts and vehicles. At present, the revenue goes to the Ministry of Finance. The newly passed law in 2003 merged this 1% with all other sales taxes amounting to atotal of 3% andthe generatedrevenuegoes to the treasury. 34. Ingeneral scope and orientation, the environmental legislation of Iran is comprehensive; it covers the mainenvironmental issuesanddefines appropriatestandards; when specific Iranian standards are not defined, international standards are adopted. The problems lie so much in the scope of the 8 legislation, but in the regulatory principles adopted and in the provisions for implementation and capacity for enforcement of the legislation. 35. The Environmental Management Support Project will provide technical assistance to the DOE and selectedprovinces to strengthencapacity inpolicy formulation, to enhance the legal framework, to monitor and enforcement of water and air quality and to reinforce public information, and dissemination. 3.2.8 Summaryof issues 36. There is evidence of strong commitment to sustainable development at the highest levels of governmentinIran. Despite this political supportandmany appropriateactions, there is still inadequate sign of success on the ground. Among the reasonsfor this are: 0 There i s no comprehensiveenvironmentalpolicy other than the provisions of the Economic and Social Development Plans; 0 The Environmental Protection and Enhancement Act of 1974 for Improved Environmental Protection, within existing Legal Framework much needs to be updated to introduce modern principles of environmentalregulations; 0 There i s insufficient sustainable finance for environmental services and investments. There is some revenue to the DOE from fines and taxes and the GO1will provide in the 4" Economic andSocial DevelopmentPlanfor an environmental fund; 0 There i s a lack of sufficient analytical capacity to assess the economic and financial costs and benefits of policies, programsandprojects; 0 Mainstreamingof environmentalconcernsinto line Ministries i s not yet effective; 0 Massive price distortions in the economy, if they persist, will be incompatible with sustainable development. 37. As Iran struggles with its longstandingenvironmental problems, it must consider its responsein the context of two main economic challenges: (i) domestic economic liberalization, as it is committed to market-basedeconomic reforms; and (ii) entry into the global economy. It must foster economic growth while properly managing its natural resource base and remaining competitive in international anddomestic markets. As Iranmovesforward with trade liberalization, private sector development, and privatization, the challenge for the World Bank is to assist theminthese transitions. 3.3 The costs of environmentaldegradation 38. The World Bank is preparing an assessment of the cost of environmental degradation in Iran that will be completed in FY 05. Meanwhile, the GO1 has requested Bank assistance to develop a strategy to better integrateenvironmental concerns into policy for the energy sector. The energy sector i s the key to the Iranian economy; it i s the main engine of future economic growth, a principal cause of environmentalpollution anddamage, and a major source of market distortion. Withinthe scope of this immediate assistance, there i s a focus on air pollution, which is an important and direct impact of energy use on the environment, andthe one affecting most people, especially the inhabitants of the large cities, with Tehran inthe forefront. 39. A critical tool for mainstreamingthe environment into energy policy is amechanismto identify the strategic political priorities. A systematic approach i s needed to ensure that a) environmental considerationsenter the development planning process at an early stage, b) there i s a multi-sectoral and long-termvision of development; c) there is efficient allocation of the Government's scarceresourcesof 9 time andcapital. Severalmethodologiesare available for this purpose. The tool selectedfor the EER is cost-benefit analysis (CBA). 40. Cost-benefit analysisquantifies the benefits of environmentalcontrol and comparesthemto the costs. To do this requires an effective means of assessing the cost of environmental degradation. Methodological choices are inevitable. The choice made by the EER is to represent the damage from any pollutant by a cost per physical unit that is applied to all emissions of that type. This procedure constitutes the first step towards economic valuation of environmental benefits. The results from the study of environmental degradationin Irannow in processmay help refine the valuation. Specifically, damage cost assessmentscan serve as aninstrumentto: Identify the environmentalimpacts that imposethe largestcost on society; 0 Identify the environmental impacts that most undermine the social and economic development process; 0 Provide a basis for integrating environmental issues into the financial and economic evaluation of investmentprojectsandsectorandeconomy-wide policies andregulations; 0 Provide an economic basis for the allocation of scarce private and public resources towards environmental protection. 41. The emphasis of immediate concern on air pollution does not mean that other environmental issues such as water and land degradation are of secondary importance and should not be addressed. Rather, this Policy Note describes a process and methodology for using damage-costs as a tool for engaging the GO1into a policy dialogue for integrating environmental concerns in the energy sector. Such process and methodology could be adapted and be used in the policy dialogue in other sectors suchas water, land degradation. 10 4 The Energy Sector inIran 42. The purpose of this Chapter i s to provide a quick overview of the energy sector in Iran; it presentsthe information that is necessary to understandhow the environmental issues linkback into the structure of energy supply anduse. The Chapter first reviewsthe supply andconversionactivities inthe sector, then surveys the historical trends indemand; from these analyses it developsenergy balancesfor 2001 andfuture years. Finally, conclusionsare drawn aboutthe implications for the environment. 4.1 Energysupply andconversion 43. Iranhas large resourcesof hydrocarbonsthat provide an opportunity either for prodigal use and environmental destruction or for a sound and sustained development. Iranis OPEC's second largest oil producer; at the end of 2002 it possessed 12.3 billion tons of proved reserves, amounting to 8.3% of global proved reserves. The Figure 4.1 shows crude oil production and export over the last 30 years in million barrels oil equivalent (mboe). Oil production was much higher inthe 70's than in recent years (over 2000 mboe/yr). The most recent peak in production was around 1993 to 1995 (close to 1500 mboe/yr), but has since fallen and in 2002 was about 1300 mboe/yr. Iran aims to raise production to close to 3000 mboelyr by about 2025, and is seekingforeign investmentto this end. 1 Figure4.1: Productionandexportofcrudeoil Crude Oil Productionand Exports 2500 I 0ProductionWExport 44. Production of oil in 2001 was 1,274 million barrels; 775 million barrels were exported and the remainder was refined domestically. Iran has nine refineries with a nominal capacity of 1.35 mbd. Many of these refineries were established in the 1970s. Some have since been upgraded. The substitution of heavy fuel oil by gas in power generation has created a surplus of heavy fuel oil that i s exported; exports were around 80 mboe in 2001. Because of the rapid increase in the ownership of private cars there i s now a substantial import of gasoline, around 17 mboe in2001 and risingsteadily. 45. In2002, there were 23 trillion cubic metresof provedreservesof natural gas inIran, equivalent to 14.8% of known world reserves and the second largest in the world after the Russian Federation. Production of natural gas in Iran that year was 64.5 billion cubic metres (bcm) giving it a reserves to production ratio of around 360 years, compared to 8.6 years in the US and 81 years in the Russian Federation. 11 46. Of the 64.5 bcm of natural gas produced in 2002, around 21.1 bcm was re-injected into the reservoirs and 10 bcm was apparently vented or flared. Venting and flaring are economically wasteful and environmentally damaging procedures. About 14.7 bcm per year of natural gas are used in power generation and 12.9 bcm inthe residential and commercial sectors. There i s little international trade of gas at present, but there i s no doubt that Iranwill becomea major exporter of natural gas indue course. In the meantime, the good availability of natural gas provides an important opportunity for environmentally sounddevelopment. 47. Thirteen hydropower schemes operate in Iran with a total capacity of 2,000 MW; they generated 6,908 GWh in2000, equal to 7.4% of the national output. Under the Third Plan, 3,773 MW i s being added to the present hydroelectric capacity and by the end of 2004 the total hydroelectric capacity will reach 5,776 MW. Eight large hydropower projects are now under construction. These are expected to add 8,000 MW of capacity by 2006. The theoretical potential for power generation from unconstrainedhydropower developmentprojectsinIrani s estimatedat 42,000 MW. 48. Coal has beenproduced since the early sixties but, because of the abundance of oil and gas, has played only a minor role in the economy. A large new underground mine, of 3.5 million tonnes per year, may be developed at Tabas. The project needs access roads, water pipelines, railways and an airport and would impact seriously on the environment. 49. Iran has a long-standing commercial nuclear program. In 1995 and 1998, Iran signed agreements with Russia to complete the 1,000 MW pressurized light water reactor at Bushehr. The power plant is to be commissioned in 2004 andhas beenapprovedby the International Nuclear Energy Agency (INEA). A 10-year agreement has beensigned with Russiafor fuel. The nuclear waste will be handled under the supervisionof the INEA, and brought to Russia for disposal. The present aim is to have 7,000 Mw of nuclear power installed by 2021. The EER did not consider this expansion of nuclear capacity inits forecastsas the abundantnatural gas and good quality hydropower appear to offer cheaper andless environmentally problematic alternatives for power. 50. Despite its vast oil and gas reserves Iranhas also renewable energy programs in photovoltaics, wind, geothermal and biomass. These were investigated within the EER. They are generally not competitive with electricity from natural gas-fired combined cycle plant, but they do have global environmental benefits and were considered within the EER as candidates for the Clean Development Mechanismandrelated schemes. 51. Iran has an installed electricity generation capacity of 34,200 MW of which 92.6% is thermal and the rest hydroelectric. The total annualproduction in2002 was 130,083 GWh. Thermal plants bum natural gas (70.8%) and fuel oil, but conversion of the remaining fuel-oil plants i s underway. Only the more recent gas plants are combined cycle. There are plans to convert these to combined cycle. The 3rd Five Year Plan seeks to add 12,600 MW of capacity and to increase the average efficiency from 33.8% to 36%. A capacity of 96,000 MW is plannedfor 2020. 12 4.2 Energy demand 52. Per capita consumption of energy has risen from 2.0 boe per year in 1965 to 10 boe per year now. Figure 4.2 shows the trend. Figure4.2: Percapitaenergy consumption(inbarrelsofcrudeoil equivalent/ year) I PerCapita EnergyConsumptlon I "*1 53. Gas is widely, but not universally available in Iran. Of the urban population of 42 million, 30 million were covered by the year 2000. There i s a strong consumer preference for natural gas as it i s cheaperthan other domestic fuels. Electricity consumption has increasedfrom 59,102 GWWyr in 1990 to 121,332 GWWyr in2000, at an average annual growth rate of 7.7%. Per capita consumption grew at an average rate of 5.8% per year. The tariffs for electricity sales (US 1.5 cent/kw) offer substantial subsidies to residential consumers, especiallythe smallest. 54. Energy demand in Iran in2001 i s summarizedinthe Figure4.3. Here, as inother Figures and Tables, the designation"ResComm" refers to the combined residential andcommercial sectors. Figure 4.3: Energy demandin2001(mboe) I 300 250 Eec'y Lffi 5 200 Fueloil fal Gasoil al 150 a0 Kerosene E Gasoline 100 NaturalGas Solidfuels 50 0 Agriculture. RescOmn Industry Transport Others Source: Energy-Environment Review and Energy Balance 2001, Ofice of Energy Planning 13 55. The Country Economic Memorandum made independent assessments of the energy balance. There are slight differences in the figures reported by the CEM and those calculated by the OEP. The differences arise in the use of different base years and in different conventional treatment of primary sources suchas hydro. There are no substantialdivergences. 56. Figure 4.4 compares the energy intensities of Iran and selected developed and developing countries. The figure suggests that Iranis less efficient than other countries. The energy intensity value i s higher than that characterizing most industrial economies and also higher than more densely populateddeveloping countriessuchas ChinaandIndia Figure4.4 Internationalcomparisonof energy intensity I 0 3 0.25 n k 0 2 8 2 0 1 5 5 0.1 0.05 0 57. Energy in the domestic market is heavily subsidized. The target increase in energy price of 10% per annum i s lower than inflation (11.4 % in2001). The EER estimated the total subsidy in2001 at 118~10'~Rials (US$ 15 billion). The Figure4.5 shows how the subsidies are distributed by fuel and sector. The Office of Energy Planning (OEP) has independentlyestimatedthat subsidies in 2000 were 114~10'~Rials. Total GDP in nominal Iranian Rials in 2001 is calculated by the IMF to be 6 6 2 ~ 1 0 ' ~ Rials. Energy subsidies therefore amount to 17.8% of the Iranian GDP'. Such a level of subsidy inevitably leadsto hugedistortion inconsumerchoice and indirectly to highenvironmental damage. 58. The environmental damage occurring fromthe production anduse of energy should not be seen in isolation from other distortions in the economy. Environmental damage is one special case of a systemic misuseof resourcesarising inpart from poor price signals. The widespread subsidy of energy prices not only causes damage to the environment from profligate use, but at an economic level also reduces economic growth and the medium-term capacity to create modemjobs. There i s concem that sudden increases in energy prices will cause pressure on prices, short-term unemployment and local hardship. The resourcesfreed by proper pricing will more than compensate for this short-term social impact, but appropriate safety measures and institutional structures to target affected groups need to be found. 'The CEM estimated a somewhat lower value of subsidy at around 11%of GDP. The difference arises from consistently lower assumptions about the border price of fuels. This canintumbe traced to fluctuations inoil prices. 14 Figure4.5: Subsidiestoenergy by fuel and sector(1OI2Rials) 1 Natural Elect Gaso- Kero- Gasoil Fuel LPG Gas line sene Oil Source: Energy-Environment Review 59. The Islamic Republic of Iran signed the United Nations Framework Convention on Climate Change at the Rio de Janeiro Earth Summit in 1992 and ratified the Convention in 1996 as a Non- Annexl-Party. It has submitted its First National Communication to the COP of UNFCCC recently. Iranian annualGHGemissionsare estimatedto have been405,000 GgC02eq., or 6.7 tons per capita in 1994. The contribution of Iran to the global C02 emissions is about 2%. This i s similar to some important industrialized countries suchas Canada or France. 60. Very large volumes of natural gas are flared or vented in Iran at the present time. The Iranian submission to the UNFCC estimatesthe greenhousegas emissions from venting and flaring in 1994 to be about 60 mt of CO2eq. Fullrealization of the flare gas recovery project as included in the 3rdPlan would result ina reductionof about 180,000 Gg CO2eq. Severalprojectshavebeenimplemented or are inconstruction, othersareatthe designor conceptstage. The net impact of these efforts onthe volumes of gas flared i s reduced to some extent by flaring from new sites as new production facilities are developed. The Go1 intends to eliminate flaring by the end of the 4th Economic and Social DevelopmentPlan. Table4-1: Impacts of gas flaring (1994/95) 1 Source co2(kt) Cl& (kt) Total (ktC02eq.) Hotflaring 31,537 492 32,029 Ventinglcoldflaring 931 931 Total flaring 31,537 1,423 32,959 C02equivalent 31,537 29,883 61,420 4.3 Energy trends 61. The EER provides forecasts of energy use and associatedenvironmental damage up to 2019 in the absenceof intervention. It then assesses the potential impacts on these trends of energy price reform and sectoral measures. The startingpoint for this analysis is a forecast of the energy balance in future years and this in turn i s based on the historic energy balance for 2001 shown in the Table 4.2. This 15 balance has been constructed from the Iran Energy Balance Report, 2001 of the Office of Energy Planningandthe IranStatistical Yearbook, 2002. 62. The base-case forecast is aBusinessAs Usual (BAU) scenariowhere current policies andtrends are assumed to continue. The Government of Iran has instructed that nominal energy prices should increase by 10% per year during the period of the 3rdPlan and must rise thereafter in such a way as to maintain the real price of energy constant. The Office of Energy Planning (OEP) in the Ministry of Energy has projected energy demandup to the year 2021 on the basis of these assumptionsandthe EER adoptsthis work as the basisof its referencescenario. 63. The forecast for power generation assumes that cost-effective hydropower developments proceed. The forecasts further assume that the use of fuel oil for power generation i s phased out by 2014 and no new fuel oil powered plant i s built. All incrementalgeneration, apart from that from new hydro andrenewableplants, comes from natural gas burntmainly incombined cycle plants. 64. The energy balance for 2019 so calculated is shown in Table 4.3. The balance is simplified compared to that calculatedfor 2001, by removing condensate and solid fuels, for which the EER had no estimates of future supply or demand and for which it proposedno policies, and also by removing the productive activities that do not haveenvironmental impacts addressed by any of the policies treated intheEER. Inthis base-casescenario, thetotalprimary energyrequirementattheendofthe 6thPlanin 2019 is estimated at 1947 mboe, compared to the 878 mboe recorded in 2001. This i s an increase of 122%or 4.5% per year on average. This rate of growth inprimary energy demand is a little higher than the 4% rate of growth in GDP that i s envisagedfrom 2005 to 2021. The relative growth rates imply an income elasticity of 1.1. 65. Under present pricing policies, the subsidy to the sector will have risen to 288~10Rials by ' ~ 2019, measuredin Rials of 2001. The OEP projections assume 6% GDP growth to the end of the 3rd Plan and 4% thereafter. If achieved, this would result in a GDP in 2019 of 1420~10'~Rials of 2001. Energy subsidies therefore will amount to 20% of GDP. The allocation of subsidies by fuel and sector i s shown inFigure4.6. Domestic energy, especiallyelectricity, gas-oil and gasoline dominate. Figure4.6: Allocationof subsidiesby fuel andsector (2019) I 0 Industry t ResComm a 40 Y , Ull Agriculture 'b 20 N 7- 0 Natural Elect Gaso- Kero Gasoil Fuel LPG Gas line Oil 16 4.4 Implications for the environment 66. The analysis shows that if energy demand continues to grow in line with historic trends then consumption will more than double by the end of the 6* Plan. Iran has the resources to permit this extravagance, but it willjeopardize future generations, put huge stresses on the economy and exacerbate what is already extreme environmental damage. 67. The next Chapter describes the methodology used to estimate damage costs and then Chapter 6 investigates the impacts of price reformand sectoral measuresto control emissions. 17 5 Assessment of Damage Costs inthe Energy Sector 68. Estimation of damage costs is a key step in the cost-benefit analysis (CBA) of environmental policies. CBA is the usual tool for policy assessment in many developed countries, especially inthe EUand its Member States. It i s by no means a determinant of policy, but it provides the fundamental methodology for the screening and diagnosis of policies and standards. The estimation of damage costs is one way among several to estimate willingness to pay for environmental improvement. If this willingness to pay can be established at different levels of environmental impact then the set of values forms a demand curve for environmental improvement. When combined with a marginal cost abatement curve, that is essentially a supply curve for environmental improvement, we can establish in principle what actions and policies conformto consumervaluations of the environment. 5.1 Methodology 69. There are two approaches to the identification of healthdamage costs for Iran: 1. The creation and characterizationof a detailed impact pathway approachfor Iran. This would require the identification andcharacterizationof the five steps by which economic activity creates contingent damage, namely determination of: (i)activity data; (ii)emission factors; (iii) dispersion processes; (iv) dose-response functions; and (v) economic valuations. Such work is demanding of time and resourcesand it was not possible within the EER to perform such a study, mainly because of unavailability of reliable air quality data. 2. Transfer of existing values derived outside Iran, but calibrated to the Iranian case. This approachwas usedby the EER. 70. Damage costs are one way of determining a demand curve for environmental improvement. The other principal approach is to ascertain the Willingness to Pay. An assessmentof damagecosts requires characterisationof the pathway along which pollutants travel fromthe sourceto the receptor. Itrequiresthat the emissions associatedwith aprocessor activity be known, that the mechanism of dispersion in the atmosphere and any subsequent chemical recombination canbe described, that the response of areceptorto the receiveddose is known and determined and that the response can be valued. A great deal of work has been done on establishingdamage costs. A major referencefor the assessment of damage from air pollution is ExternE, a project launcheda decade ago by the Commission of the EuropeanCommunity. The techniques have been widely usedboth inthe formulation of EUDirectives and also by Member States for national legislation. Work to date has concentrated on air pollution from power generationandtransport, but it i s inthe processof extensionto other media. Results havebeenusedto supportEUlegislationconcerning: 0 legislationconcerning incineration, 0 the Large Combustion Plant Directive, 0 the EUstrategyto combat acidification, 0 the National Air Quality Strategies, 0 the Emission Ceilings Directive, 0 proposalsunderthe UNECEmulti-pollutant, multi-effect protocol, 0 the Auto-Oil programme, 0 andmuchother work. 20 The damages considered within the scope of this work include damage to health (mortality and morbidity), buildings, crops and eco-systems. The loss of economic output from health impacts tend to dominate. On the assumption that the value of these impacts i s roughly proportional to the income of the community concernedthe values derived for the EUhavebeen scaledby GDP to provide first order estimates for Iran. Evidently the application of the full impact-pathway analysis would be preferable, and the possibility of such research should be considered, but the resources to make these direct estimates were not available to the EER. The benefit transfer approach was therefore adopted. The limitations of the methodology should though be borne in mind. 71. The values obtained when this conversionwas appliedto the ExternE values are shownin the Table 5.1. Only a restricted set of local pollutants, PMlo, SOX,NOx and CO was included in the EER, but these are the pollutants that cause most of the total damage. Other pollutants such as VOCs are important in specific localities, but were not included for the sector appraisal. Ozone i s a product of chemical reactions initiated by NOx andthe damage costs for NOx include these secondary impacts. Lead was not considered as it i s being phased out at present. The values in the Table are not of course precise. Taking into account the ranges quoted for the original estimatesand some of the uncertaintiesinthe benefit transfer it i s likely that the range of estimates is within 50% and 200% of the mean. These ranges are shown. They offer some indication of the likely robustnessof cost-benefitcalculations made usingthese values. Although there is this substantial degree of uncertainty regarding the exact damage costs, the errors will tendto beconsistent over time andthereforetime trends will be unaffected. 72. For global pollutants, a rangeof damage cost values was used. A low estimatewas based on the value of trades in the Prototype Carbon Fund (US$ 3/tonne C02 equivalent); a medium estimate was based on anticipatedvalues inthe future EUcarbon trading scheme (US$ lO/tonne C02equivalent) and a high estimate was based on damage cost assessment made by the PCC (US$ 80/ tonne C02 equivalent). Table5-1: Benefitvalues assumedfor Iran 1 Pollutant I (kRiaVton) I I ($/tonne> I low medium high PMlO 34,400 2,150 4,300 8,600 so2 14,600 912 1,825 3,650 NOx 4,800 300 600 1,200 co 1,500 94 188 376 COZ 24 3 10 80 73. It is clear that calculating values of damage costs on the basis of a single value for each tonne of emissions is a gross simplification. Inreality, the linkbetweenthe quantity of emissions andthe eventualdamage costs i s complex. Many factors will affect the damage costs causedby a unitof emissions,including: 0 Weather conditions (wind speed anddirection, air pressure, whether it i s raining, etc.). 0 The height andvelocity of emissions to air. 21 e The population eventually affected (number, distribution by age and income, proportion of vulnerable people, etc.). e The existenceof other chemicals inthe atmosphere. e The retention of the pollutants in the atmosphere. Pollutants stay inthe air for longer in Iranthan inWesternEurope. There is little rain and average wind speeds tend to be low. The impact of a ton of pollutant i s thereforehigher in Iran than intemperate zones. The EERmadeno allowancefor this. e Saturation effects. The nature of marginal impacts differs at higher ambient levels of pollutants. In areas of high concentrations, marginal reductions can have a significant benefit for the environment. The effects were not calculated inthe EER, so the damage costs may under-estimatetotal value. e Different economic preferences. Valuation of the environment may shift with income. There i s evidence that with wealth there is a disproportionate increase in perception of environmental benefits. The analysis did not make this adjustment because there i s no obvious basis for estimatingthe income elasticity of environmental values inIran. 74. Inpractice, there is a range of damage costs for unit emissions of each pollutant. The EER made no attempt to establish this range. The weaknesses in the available data on the geographical distribution of emissions and the fuel used, coupled with the lack of data on air pollution outside the major cities and on epidemiological studies throughout Iran, means that assigningvalues within ranges i s difficult. As the understandingof the derivation and application of these values increases in Iran, it may be possible to assign different values dependent on location andactivity. This couldbe arelatively simple way of improving the analysis. 5.2 Estimatesof localenvironmentaldamagecostsin2001 75. From the energy balance for 2001 shown in Table 4.2, the EER estimated the emissions to air from each transformation and consumption activity as well as the corresponding damage costs. A summary of the calculated emissions and their origin by sector i s shown in the Figure 5.1. The Figure shows the percentageof emissions of eachpollutant that arise from each sector. The numbers underneaththe designationof the pollutants are the annual emissions inkilotonnes, or inthe case of CO2,megatonnes. Figure5.1: Emissionsby sector ResComm IPowerGen PMlO sox co NOx C02 (131 kt) (1349 kt) (5435 kt) (1106 kt) (352 mt) 22 76. By applying the unit damage costs presented in Table 5.1 to the emission balances described above, the environmental damage by fuel, sector and pollutant can be assessed. The annual sum of damage from all sources in 2001 was estimated to be about 3 8 ~ 1 0Rials ($4.7' ~ billion); this i s equivalent to 5.7% of nominal GDP. This i s a large figure, but not out-of-line with estimates made elsewhere. The World Bank Technical Paper No. 508 on Urban Air Quality Management cites damage from air pollution of up to 10% of urban income in Bangkok, Kuala Lumpurand Jakarta. The large discrepancybetweennominal and PPPmeasures of GDP in Iran also impacts on this percentagefigure. Becausethe damage costs have been adjusted to reflect PPPestimates of per capitaGDP, it is perhapsmorereasonableto comparethem to PPPestimates of national GDP inthis case the estimateddamagefalls to 1.6%. 77. The origin of damage by sector, fuel and pollutant is shown in the Figures 5.2.and 5.3. These figures show the percentagecontributions of the different sectors respectively to the total damage associatedwith each fuel and pollutant. The numerical entries attachedto each bar are the total damage from that fuel or pollutant calculatedin 10l2Rials. It can be seen that transport i s by far the largest contributor to damage and power generation i s the second. Most damage from transport occurs from low-level emissions of particulates, carbon monoxide and oxides of nitrogen. Local damage from the power sector is mainly from oxides of sulfur. The substitution of natural gas for fuel oil in power generationi s proceedingrapidly and this can be expectedto take care of much of the environmentaldamage arising from this activity. The transport sector i s clearly the proper focus for future effort. Figure 5.2: Damageby fuelandsector in2001(10l2Rials) I 100% 80% 60% 40% 20% 0% NatGas (1.1) Crude (2.9) Gasoline(9.0) Gasoil(9.5) FuelOil (14.5) Total (37.7) Damageby fuel loi2 Ws: $1 bn=8 x 10l2Ws 23 Figure5.3: Damagecost bypollutant and sectorin2001(loi2Rials) I 100% 80% Others Transport 60% Industry 0 Res" 40% 0Agriculture m Power generation 20% Oil refining 0% m10(4.5) SO2 (19.7) Nox (5.3) co(8.2) Damgecostin1012FUs:$l bn=8x 1012Rls 78. Figure 5.4 shows the damage cost by fuel compared to the market price and the opportunity cost. The total height of the bar indicatesthe full economic cost of the fuel under the present conditions of use. The large damage cost arise of gasolinereflects the huge emissions of carbon monoxide from old, inefficient and badly maintained cars. If the technology were to be improved then the economic cost of the fuel inthis sense would fall. 8 7 6 5 Damagecost a z 4 Subsidy 3 Market price 2 1 0 1 Natural Gas Gasoline Gasoil FuelOil 24 5.3 Global damagefrom flaring of naturalgas 79. The EER estimatesthe damage cost to the global environment from the flaring of natural gas. The C02 equivalent of 60 million tonnes equals 15% of the GHG inventory of Iran. The damage, assessed on the basis of a carbonprice of $10/ton C02,is around $600 million per year. The volume of gas flared in 1998 was 13.2 bcm'; if it could have been brought to market for power generation or industry it would have had a value based on its opportunity cost of about 5 . 7 ~ 1 0Rials per year ($700 million per year). This is equal to a little less than 1% of current ' ~ GDP. There are large costs associatedwith recovery and use of such gas, but equally there are large potential benefits. 80. Cost-benefit analysis of the options for gas recovery requires information on: a) the location of sites where gas i s vented or flared, b) the volume and composition of the gas and c) the location of potential consumers. This information has been assembled by the National Iranian Oil Company (NIOC) and discussions have been held with the Global Gas flaring Reduction Public-Private Partnership(GGFR) program of the World Bank. There appears to be considerable potential for projects to recover flared gas that are cost-effective on a commercial basis as a consequence of normal technical optimisation. There may be others that will require additional support through credits for carbon saved. The GGFR has proposedto NIOC and the Go1that NIOC should prepare summary descriptions for some of the more problematic projects and that these should be reviewed along with experts from private companies and Bank staff to identify to what extent non-conventional funding sources should be sought and what options couldbe available. 5.4 Forecastsof local damage 81. Using the energy forecasts presented in Table 4.3 as a reference scenario, the EER estimated how damage would increase if nothing were done to control it. Valuation of the environment increases with income so to provide estimates of unit damage costs in future years the values for 2001 were scaled accordingto the growth inper capita GDP. The consequenceof this procedure i s that the unit damage costs in 2019 are roughly double those of 2001. This i s because people value a reduction in damage more when they are better off. Adopting these assumptions on unit costs, combined with the forecasting work described earlier, the EER estimatedthat damage would grow to 9 4 ~ 1 0Rials ($12 billion) by 2019, inthe money of 2001. ' ~ This i s equivalentto 6.6% of nominal GDP, i.e. a larger percentageof a larger GDP. Of this total damage, an amount of 5 0 ~ 1 0 Rials ($6.2 billion) arises from the transport sector. If the ' ~ relationship between PPP and nominal GDP were maintained to 2019, then the damage as a percentageof PPP GDP would be 1.8%. Figure 5.5 shows how this damage originates by sector and fuel. The Figure shows the percentage share of the damage for each fuel by sector. The numbers associatedwith each fuel are the damage from the fuel in 10l2Rials; the allocation by sector is somewhat similar to that in 2001 for the case of all fuels except fuel-oil, on which the penetration of gas into the power sector has a significant effect. The dominant contribution of transport to the damage i s even more marked in 2019 than in 2001 as a consequence of the penetrationof gas into power generationandindustry. IranStatistical Yearbook, 2001. 25 Figure 5.5: Damageby fuel andsectorin2019 (lo'*Rials) 100% I 80% Transport 60% w Industry 0 Rescomn 40% Agriculture m Fbw erGen 20% e Oilrefining "," r NatGas (5.3) Crude (8.5) Gasoline (30.7) Gasoil(29.8) FuelOil(17.9) Damagecost 10l2Rls ($US1bn =8xlOl2Rls) 82. Figures 5.6 to 5.8 show how damage grows over time in terms of pollutants, sectors and fuel-type. Oxides of sulphur are the biggest source of damage, arising from diesel and fuel-oil use in industry. CO i s also significant; the unit damage cost for CO i s not as high as for other pollutants, but it is producedinhuge volumes. Figure 5.7 shows transport to dominate amongthe sectors inits contribution to damage because of the contributions to oxides of sulphur andcarbon monoxide. Figure 5.8 shows gasoil andgasoline to be the biggest sources of damage by fuels. Figure 5.6 The evolution of damageby pollutant I 100 h Eu) % 80 r x Qo 11 60 33 40 90 t 20 r I 0 2001 2004 2009 2014 2019 26 Figure5.7 Theevolutionofdamageby sector 1 100 80 m Others Transport 60 Industry ResComm 40 Agriculture PowerGen 20 Oil refining 0 2001 2004 2009 2014 2019 Figure5-8: Evolutionofdamage byfuel I 100 80 60 40 20 0 2001 2004 2009 2014 2019 5.5 Conclusions 83. Presentpolicies andbehavior are not sustainable. The environmental damage in 2019 is a larger proportion of a larger GDP than in 2001. This deterioration occurs despite the good fortune that natural gas substitutesfor all use of fuel oil inpower generationby 2019. Transport i s the main source of damage andthe obvious priority for policy. 84. The next Chapter examines how this great deterioration might be controlled by policies ofprice reform and sectoralmeasuresthat bringalso economic benefits. 27 6 Policy Options 85. This Chapter investigates the policy options available to the GO1 to control environmental damage. The EER examined the consequences of price reform policies and sectoralmeasures, separately and incombination. By a sectoralmeasure i s meantan intervention that aim to cause a specific behavioral change, e.g. through targeted financial incentives and standards for equipment andappliances. 6.1 Price reform 86. The Table 6.1 below compares market prices for fuels in Iran with opportunity costs and shows the annual percentage increases necessary to bringthe prices to an economic level by the end of the 4th, 5th and 6th plans. The reformof energy price to reflect international levels would be beneficial to the economy at large andto the environment. Table 6-1: Marketpricesandopportunity costs(2001) 1 Price Subsidy Annual Annual Annual (kRlslboe) (kRlslboe) (% of OC) increase to increase to increaseto 2009 (%) 2014 (%) 2019 (%) Gasoline 84 68% 25% 12% 8% Kerosene 19 191% 63% 28% 18% Gasoil 217 22 I 90% II58% II26% I1 16% FurnaceOil 108 17 1 85% I 45% I 20% I 13% 1 NaturalGas 23 167% 125% 112% 18% (Industry) Gasoil (Industry) 44 1I79% 75% I 136% 32% II 17% 11% Natural Gas 19 15% (ResComm) I1lo% CNG (Transuort) 17 86% 48% 22% 14% Electricity (Agric) 18 II 98% II122% II 49% I 31% Electricity 118 I 88% 152% 123% I 15% (ResComm) Electricity (Industry) 217 11% 2% 1% 1% Electricity (Others) 162 78% 35% 16% 10% 87. The CEM for Iran studied the impact on the state accounts and consumer prices of various schedules of energy price adjustmentandthe ways inwhich social consequences could be managed by compensation schemes. The Memorandum concluded that the preferable combination is a quick adjustment of energy prices in two to three years and a phased compensation scheme over 5-7 years. This procedure would allow time to develop the targeting mechanisms and institutional structures required to deliver the social safety measures and also allow the accumulationof the revenuesto fund them. 28 88. The EERexaminedthree scenariosfor price reformwith end dates: 0 2009: end of 4th Plan; fast price reform. This i s close to the recommendationsof the CEM, given the time that is likely to elapse beforereformi s implemented. 0 2014: end of the 5" Plan; this date has some political attractions interms of less acute public reaction and lower pressureon consumerprices, but requires sustainedpoliticalwill. 0 2019: end of 6th Plan; slow price reform; this scenario would require price increasesphased over 15 years andcould bedifficult to sustain. The price reform scenarios have been modeled using the reference scenario taken from OEP. This scenariois basedon constantprices inreal terms. The EER then constructeddemandcurves for eachfuel infuture years usingown-price elasticitiesderivedby OEP. 89. The predicted effect of price reform on the energy sector i s dramatic. Figure 6.1 shows final energy demand in 2001,2004, 2009, 2014 and in 2019 under the three scenarios. For each subsequent snap-shotyear, there is a group of four bars showingthe composition of final demand. The labels within each group, @e. None, -09, -14, -19) show the year reform i s completed. If prices equaled opportunity costs then the TPER in 2019 would be 1030 mboe, comparedto 878 mboe in 2001 and to 1947 mboe in 2019 if there i s no price reform. The TPER in 2019 is the same regardless of when reform i s achieved, because the simple elasticity model assumes immediate adjustment. The emissions of C02 in 2019 with price reform will be 358 mt comparedto 708 mt without price reformandto the 325 mtemitted in2001. Figure6.1: Energydemandintbree reformscenarios(mboe) I 1800 1600 1400 1200 8 1000 E 800 600 400 200 0 2009 2014 2019 90. The environment improves under price reform as a consequence of the energy saving. These improvementsare showninFigure 6.2. With price reform, the total damage cost in2019 i s 48x10l2Rials ($US6 billion) compared to 9 4 ~ 1 0Rials ($US 12 billion) under the reference ' ~ scenario. This damage cost i s still higher than that of 2001. Price reform will avoid annual environmental damage by 2019 of 4 6 ~ 1 0Rials ($US6 billion). All price reformscenarios show ' ~ 29 the same annual saving by 2019, but of course inthe slow price reform scenarios there is higher damage inearlier years. Price reform i s not sufficient to bring damage in 2019 back to the value of 2004. Note that the damage costs that are experienced in 2019 represent a lower level of physical damage than in 2004. Becauseof higher valuations by the public, these lower physical damages represent a highereconomic cost. Figure 6.2: Damagecostsby pollutantinselectedyears underreform(10" Rials) I 100 80 60 40 20 0 2004 No -09 -14 -19 NO -09 -14 -19 NO -09 -14 -19 2009 2014 2019 Price reform in the energy sector will increase the level of prices to consumers directly through the energy bill and indirectly through the impact on other goods and services. The likely upper level of impact on the consumerprice index is shownin Table6.2. Table 6-2 Effect onconsumerprice index of price reform 1 Reformby: IncreaseinCPI (% per year) 13.9% I2014 I 6.7%._ 2019 I 4.4% I 91. The CEM made estimates of the impact of various price reform policies on consumer prices and these are broadly consistent with the EER. The CEM made a substantial analysis of the various compensation schemes that government could use to offset the impacts of price reform. The CEM estimated that without offsetting action by government households would experiencea 30.5% loss inconsumer surplus. It i s necessary to ensure that this large shock does not affect the vulnerable. The CEM suggests that part of the oil revenue now used to subsidise energy consumption should be invested to create jobs. After an extensive analysis of three principal options the CEM concluded that the share of the appropriate compensation inthe three 30 cases would be between 35% and 47% of the loss in consumer surplus. In other words the government can easily afford to compensate vulnerable groups and still keep a large part of the surplus released. 92. The export of oil releasedby the price reform will add to national income. Figure 6.3 shows the estimated impacts on growth from the reform strategies. It is a lower bound because the extra revenues will allow more investment that will stimulate growth. The y axis shows the extra growth each year. With fast reform, there i s an extra 2-3% growth over 5 years, with mediumpacedreform the benefits are around 1- 1.5%, but spread over ten years and with slow reform the benefits are about 1 - OS%, but spread over 15 years. The discontinuities in the Figure arise from discontinuities inthe growth assumptionsofthe NationalPlanningperiods. Figure 6.3: Directimpactsoneconomic growthfrompricereform I 3.00 I 1 5 :::: 2.50 +2009 +2014 1.00 e 2 0 1 9 0.50 I 1 zc (0 0.00 2000 2005 2010 2015 2020 6.2 Sectoral measures 93. Price reform is not the only, or indeedthe most direct way of controlling emissions to air. The EERconducteddetailed cost-benefit analyses on the sectoralmeasuresthat mightbe taken to reduce the environmental impacts of the energy sector. The CBA valued energy at opportunity costs and included local and global damage costs. Where sectoralmeasures save energy, there is a financial benefit to the state budget from avoided subsidies. The cost-benefit analysis in these cases has beenusedto estimate the net cash-flow to the state. The short-list of sectoralmeasures analyzedby the EER was composedfrom a long-list that inturn was compiled from study of the reports of previous technical assistance projects and in consultation with representatives of relevant Iranian institutions. The short-list is shown in Table 6.3. Activities in some of these areas have already begun. There is legislation regarding the requirement for catalysts on new vehicles andprogrammeshave beeninitiated inenergy efficiency, demand-side management and for the inspection and maintenance of vehicles. The inclusion of these measures inthis list does not necessarilysuggest that there is no ongoing activity, but that what activity has begunneeds to be sustained and possibly strengthened. The Iranian Fuel Conservation Organization (IFCO) in the Ministry of Petroleum i s addressingenergy efficiency ina broad sense. IFCOprogramscover four areas: transport, industry, commercial & residential and CNG. The focus of their activities is building design, household appliances, fuel switching (adoption of CNG technologies in car manufactureand construction of CNG distribution stations) as well as cofinancingurbantransport investments such as expressways and the extensionof the metro system. However IFCOdoesnot include environmentalbenefits intheir cost-benefit analysisof investments. 31 INo. I Enerw Cvcle Geothermal) 7 Requiring investment inFlue Gas Desulphurisation equipmentat power plant. Production 8 Improvingemissionsperformanceof refineries (fugitive and energyrelated) Production 9 -Reductionof TransmissionandDistributionLosses inelectricitv . -.-. -- .. TransDort 10 Reduction inLosses fromoil and gas network Transport 11 Price reformfor Energy Products Consumption Taxis) 17 Energy Efficiency fund for the industrial sector Consumption 18 Energy efficiency fund for the residential and commercial sectors 19 DemandSide ManagementProgram Consumption 20 Buildingefficiency standards Consumption 21 Standards and labeling for amliances ConsumDtion Measures blockedingrey inthe Tablehavebeenevaluatedqualitatively. Measuresblockedinblackhavebeenevaluatedbasedoncase-studies. Other measureswere evaluatedquantitatively withCBA. 94. The benefidcost ratios calculated for specific projects within a measure cover a range as would be expectedandthere are always issues as to what extent a project is typical of its class. It i s thereforeinappropriateto quote exact B/C ratios for eachmeasure. Measureswere classified in the following groups: 0 A: Measurei s win-win: it hasbothnet economicbenefits (when damage costsare excluded) andalso reduces local damage 0 B: Measurei s cost-effective only when localdamage savings are included 0 C: Measureis cost-effective only when global damage savings are incorporated; suitable for CDM activities 0 D: Measureis not cost-effective 0 X: Eitherinsufficient data is available to conduct a CBA or the topic does not lend itself to the methodology. 32 95. The results of this analysis are presented in the Table 6.4. The classifications do not indicate the cost-effectiveness of the activity, but of the promotion of the activity by government, so promoting the switch to natural gas in the residential sector is not cost-effective because the substitution i s very attractive under present conditions and no policy incentives are needed. The shaded cells indicate the measures that were included in the subsequent forecasting exercise, because they could be quantified and modeled. The list contains no measures to promote major public transport systems such as new rail lines and metros. Some projects of this nature were examined, but the environmentalbenefits are normally only a small part of the benefits of such a project; the mainbenefit i s generally the saving in congestion. This i s not to say that the public transport has insignificant benefit to the environment, merely that the environmental benefits are generally not sufficient to justify such projects on environmental grounds alone. The damage costs savings from public transport savings should certainly be quantified and credited to the project. This task falls within the Mainstreaming measure. The appropriate Ministry should liaise with the Department of Environment to agree a methodology that ensures the environmental benefits are representedinthe analysis of such projects. 33 Table 6 4 CBA of sectoralmeasures I IMeasure IClass I I Mainstreaming the environment I X I c awarenessraising I x II I Reduction of flaring I C I I ~ e m e noftdrilling mudI fluids I X I 1 Flue GasDesulphurisation at power plant. I Reducing fugitive emissions at refineries II I Reduction inlossesfromoilandgasnetwork I I Congestionmanagementfor transport I Enhancing public transport II I Buildingefficiency standards I I Promotionof the switch to gas inresidential& commercial sectors I I Switching from diesel to electric pumps for ground water I 6.2.1 Modeling principles 96. Price reforms and sectoral measures are not mutually exclusive. The EER frrst created scenarios of price reform. The scenarios were modeled through constant annual percentage increasesin price over a defined periodand a behavioralresponsegovernedby a price-elasticity. Onto those price-reform scenarios were then imposed selected .sectoral policies. The key Major public transport projects tend only to be cost-effective when other extemalities are incorporated in the CBA, mainly congestioncosts. 34 parameters of the sectoral measures included in the model are summarized in the following Table 6.5. A detailed cost-benefit analysis of each measure is given in the Final Report of the EER. The account for eachpolicy includes: 0 Specification of the costs andperformanceof investmentsinducedby the measure. 0 The benefitkost ratios of investmentsunder marketprices andopportunity costs. 0 Anassessment of the technicalpotential. The Table includes a referenceto the appropriate sectionof the Annex to the Final Report of the EER. I Table 6-5: Key parametersofthe modeledpolicies 1 Measure Objective Potential Costing basis Comment Promote renewables (Wind, 5 GW $900 per kW, net of Installedprogressively land-fill gas, biomass) capacity savings onthe grid Reductionof 5% of total As describedindetailed Over the period electricity generation ICBA I Promote DemandSide Reductionof 5% of total $200 I k W of peak demand Over the period Management electricity consumption saved Promote appliance and Reductionof 8% of total $200 I kW of peak demand Over the period equipment standards electricity consumption saved rConvert to natural gas in 50% of furnace oil use As describedindetailed Over the period industry CBA Createincentives for energy 10%ofresidentialnatural Payback 2.5 years Over the period efficiency inhouseholds I -- gas use Create incentives for energy 21% of industrialenergy According to scenario Over the period efficiency inindustry use Oblige catalystsonnew cars All new cars $250 per car Introducedfrom 2005 Convert vehicles to CNG 20% of vehicles I$785 per car plus Over the period infrastructure costs I Require inspection and All vehicles $10per vehicle per year Introducedfrom 2005 maintenanceof existing vehicles ReduceS content of middle 100ppmindiesel As describedindetailed Introducedfrom 2009 distillates CBA 97. Twelve scenarios were examined. This set is formed from the possible combinations of four price-reformscenarios andthree sets of measures. These options for measures are: 0 Nomeasures 0 All measures 0 No class C measures, i.e. measures only justified by avoided global damage. The price-reform scenariosrequire that prices shall be brought to opportunity cost by the end of 2009, 2014 or 2019. There i s also a scenario with no price reform, but constant prices at their presentlevel. The combination of no price reformandno measures i s the referencescenario. 35 6.2.2 Impact onthe environment of measureswithout price reform 98. The EERestimatedhow the sectoralmeasures would change energy demand. The TPER in2019 is 1835mboe, comparedto 1947mboeinthereferencecase. The impact on emissionsis greater. The estimated annual damage cost savings induced by sectoral measures by 2019 is around 2 9 ~ 1 0Rials ($US3.5 billion). The Figure 6.4 shows the composition of damage by ' ~ pollutant. Sectoral measures by themselves are only partially effective. Damage continues to grow andi s higher ineach of the snapshot years than in2004. Figure6.4 Damagebypollutantovertime: measuresnopricereform 100 n -z VJ 80 F co 60 0 Y c 0 NOx u) 8aa 40 so2 p PMI0 20 0 2004 No Yes No Yes No Yes 2009 2014 2019 6.2.3 Impact onthe state budget of measureswithout price reform 99. The net economic performanceof the measuresi s shown inFigure 6.5, as the discounted cumulative net flow of economic costs and benefits. The curve "without damage" shows the cumulative opportunity cost saving, net of the cumulative investments, requiredby the measures. The curve "with damage" includes also the savings in damage costs. The package of measures pays back to the country in about 4 years, if the damage costs are not included, and in 2 years if damage i s included. Discounting inthe EERis performed at a discount rate of 10%. A dominant part of the economic benefits and environmental improvement comes from the win-win measures of class A. 36 Figure6.5: Cumulativenet benefitsto Iran (lo'* Rials) +Without damage +With damage 100. It i s instructiveto lookat the net financial flow to the state. The Figure 6.6 shows this for the first eight years of a programof measureswithout price reform. Figure 6.6: Net financial flows to the state of measures I 30 25 20 +Outlay E u) 15 +Energysubsidy P2 10 savings +Net balance (undiscounted) 5 0 2 -5 37 The outlay has beencalculatedby dividingthe measuresinto three groups: 0 Those fully funded by the private sector Thosepartially fundedby the state (i.e. efficiency andfuel conversionfunds) 0 Those fully funded by the state (i.e. T&D losses and renewable energy); this group is effectively state funded because the investments will be made in the power sector and electricity prices are determinedby the price reformscheduleso there is no possibility of incremental revenueto the power sector to cover the incrementalcosts. The outlay then comprises all investmentsinthe third group and an appropriate proportion of the investments in the second group. The state breaks even in three years. The maximum accumulated deficit inthe state outlay is 1.4~10'~Rials or around $US170 million. This then is the approximate amount required as start-up capital for a fund to implement these measures. We note that there has been some discussion within government of the possibilities of funded incentives to energy efficiency and fuel substitution from avoided subsidies. The status of the proposedfund i s not at present clear, but the forgoing analysis c o n f m the essentialmerit of the concept. 6.3 Sectoralmeasures, combined with price reform 101. The EER models price reform by 2009, 2014 and 2019. The Figure 6.7 shows the damage costs by pollutant in each of the snap-shot years 2009, 2014, 2019 for the three price reform scenarios including sectoralmeasures. The combined effect reducesdamage substantially below the 2004 value by 2009 in all three cases. Even by 2019 the damage i s less than in 2004. A comparisonwith the price reformcase (Figure 6.2) andthe sectoral measurescase (Figure 6.4) shows that only the combination of measuresandprice reformwill achieve acleaner environment in 2019 than now. Price reform by 2009 plus sectoral measures provides the cleanest environment over the period. 38 Figure 6.7: Damagecosts by pollutant: price reformplus measures(lo'* Rids) 1 100 90 80 70 60 co 50 NOx 40 so2 30 PM10 20 10 0 ~ 2004 No -09 -14 -19 No -09 -14 -19 No -09 -14 -19 2009 2014 2019 102. The Figure6.8 shows the cumulative net economic benefits of the measures inthe case of price reform by 2014. This is composed of the benefits of the energy saved measured at opportunity cost net of the cost of the measures. Two curves are shown one with the environmental damage addedto the benefit stream. The cumulative net benefit by 2019 i s around 50x 10l2Rials ($US 6.2 billion). Figure6.8: Cumulative economicbenefits(1012Rials) I 60 50 40 30 +Without damage 20 -With damage 10 0 2 9 -10 39 103. The Figure 6.9 shows the cumulative net financial flow to the state. The example i s for price reform achieved by 2014. The state effort is paid back in about six years and cumulative benefits are a maximum in 2012. After that date because the reform has brought prices close to opportunity costs there are no benefits in avoided subsidies and the cash-flow to the state fails. The logic of self-funding programsbreaksdown whenprice reformi s achieved. Figure6.9: Cumulativenetcash-flow tothestate (10l2Rials) 40 30 20 +Outlay 10 +Energysubsidy savings +Net balance 0 (undiscounted) 2 -10 -20 6.4 Optionsfor partialprice reform 104. Price reform requires political will. The inflationary impacts of price reform and the resentment of consumers might prevent the introduction of cost-effective prices even by 2019. The EER considered what energy prices should be addressed ina partial reformprocess. Figure 6.10 shows how environmental damage in 2019 falls as the price of fuels increases. The x axis shows the annualincreaseinprice to 2019 andthe y axis shows the damage in2019. Gas-oil and gasolinegive the most environmental benefit for a specifiedrateof price increase. 40 Figure 6.10: Damagereductionsfor single fuel price increases(2019) I 100 -t-Gasoline 90 --eKerosene -A- Gasoil ++FO 80 +NatGas -e-Elec(resicdntial) 70 0% 5% 10% 15% annual %price increase 105. The Figure 6.11 shows for each fuel the damage saved as a function of the avoided subsidy in 2019. Each point on the curve shows an increment of 2.5% in the annual percentage price increase applied to the fuel. So the end point of the gasoline trajectory, for example, representsa 7.5% per annum increasein fuel price between 2004 and 2019. This would bring a benefit by 2019 of 9 x 10l2Rials ($US 1.1billion) of avoided damage and 28 x 10l2Rials ($US 3.5 billion) of avoided subsidy. Transport fuels have good damage avoidance per unit of subsidy saved. I Figure6.11: Subsidy reductionsfor individualfuel price increases(2019) I +Gasoline +Kerosene +-Gasoil +FO ++ NatGas +Elm (residential] 0 10 20 30 40 50 subsidy trillion Rials 41 106. Ifpricereformstrategiescannotbe comprehensive,thentargetingtransportfuels appears to be a sensible compromise. There is a double gain in avoided subsidy and avoided damage. Roughly, they are comparable inmagnitude. Such a strategy has some other advantages, namely that there i s relatively little substitution of other fuels intransport, so leakages into other fuels not subject to price reform would be small. The most likely substitution would be an enhancedused of natural gas intransport, which is inany case a policy with much to recommendit. Moreover, natural gas i s fairly abundant in Iran and electricity as a product of natural gas is also easily available. There is somejustification infocusing price reformon fuels that are locally scarcer. 6.5 Conclusions 107. There are conclusions to be drawn from this work regarding both methodology and substance. In terms of methodology, the analysis shows the significant potential of the CBA techniquefor: 0 Dialogue with government concerning the magnitude of environmental damage and the politicalpriority that it deserves 0 Assessment of the contingentenvironmentalbenefits fromprice reform 0 Analysis, prioritization and design of sectoral policy instruments for environmental control. 108. It would be wrong not to recognize the weaknesses and limitations of the method. The limitations inthis application include: 0 The lack of country specific information on emissionfactors and damage costs 0 Inadequatedifferentiation inthe costs of different emissions, e.g. by location andaltitude 0 Excessively simple sectoralmodels, especiallyintransport. The appropriatetreatment of these limitations i s not to abandonthe methodology, but to carry out the work neededto make it more robust and reliable. Given the interest shown by the GOI, Iran may offer an opportunity for a case-study that would have wider application in other middle- income aridcountries, especiallyinthe MNAregion. 109. Interms of substancethe analysisshows: 0 Rapid price reform as recommendedby the CEM for economic reasons i s also the best strategy for the environment 0 Price reform by 2009 plus appropriate sectoral measures will rapidly improve the environment and keep damage below the damage experienced in 2004 up to 2019 and beyond 0 Only price reform plus appropriate sectoral measures can keep damage costs by 2019 below those assessedfor 2004 Ifthepoliticalwilltofullyreformpricesisnotpresent,thenthebeststrategyforthe environment is to loadprice increasesonto transport fuels. 42 7 Conclusions and Recommendations 7.1 Findings 110. The mainfindings fromthe analysisof Chapter6 are that: 0 The environmental damage of air pollution from the energy sector in Iran in 2001 was estimatedto be 3 8 ~ 1 0Rials ($4.7 billion), which is equivalentto 5.7% of nominal GDP ' ~ (1.6% of GDPinPPPterms). 0 Inthe absence of price reform and policy intervention the damage will grow to 9 4 ~ 1 0 ' ~ Rials ($12 billion) by 2019, equivalent to 6.6% of nominal GDP (1.8% of GDP in PPP terms). Of this total, 5 0 ~ 1 0Rials ($6.2 billion) arises from the transport sector. ' ~ 0 The most important measures to reach the objectives of improving energy performance and the environment is the elimination of subsidies in a suitable time frame, taking into consideration the political feasibility and social suitability of the energy reform. Energy sector measures are accompanying options inthe case that no or only partial price reform i s undertaken, however the effects on the reduction of damage costs i s limited and will not exceed 30% fromthe baseline scenario. 0 Ifpricereformandsectorreformstrategiescannotbecomprehensive,thentargeting transport fuels i s the best compromise. From the environmental point of view, gas oil and gasoline give by far the most environmental benefit for a specified rate of price increase. Fuel oil i s rather price insensitive and i s being substitutedanyway by natural gas. The environmental impacts are declining naturally. Electricity price increases give rather little local environmental benefit because it i s madeinthe mainfrom natural gas. 111. The challenges therefore is to recommend the necessary policy reforms and sectoral measures that will substantially reduce the damage costs from 5.7% of GDP in 2001 (1.6% in PPP terms) and from 6.6% of GDP in 2019 (1.8% in PPP terms), in the case that no reform or measures are introduced. Inorder to better define the options andtheir impacts, a total of twelve scenarioswere analyzed, characterizedby a combination of four price reformscenarios and three different sets of measures. The price reform scenarios were: no price reform or price reform implementedby 2009, 2014 or 2019 (end of 4th, 5th or 6th Plan). The different sets of measures were: with no measures, with all sectoralmeasures, or with only Class A ("win-win") and Class B (justified by local damage) measures i.e. omitting Class C measures, (only cost-effective when global damage is included). The mainresults are shown in Table 7-1. They can be summarized as follows: e Comparedto 2001, ina Business as Usual (BAU) Scenario, primary energy requirement and final energy consumption would more than double till 2019, with the corresponding detrimental effects on the amount paid as subsidies, on emissions and on damage costs. Subsidies and damage costs would not only increase in absolute terms, but also as percentage of GDP. 0 Applying sectoral measures without price reform would lead in 2019 to a certain, although not very substantial, reduction in energy consumption and damage costs from 6.6% of GDPto 4.6 % of GDP (1.8% to 1.2% inPPPterms). 43 e Elimination of energy subsidies in 2014 without sectoralmeasures would reduce energy consumption by half from 1556 mboe to 789 mboe, and result in a 50% decrease of damage costs from 6.6% of GDP to 3.3% of GDP (1.8% to 0.9% in PPP terms). However, both energy consumptionanddamage costs (47 trillion Rials or US$ 6 billion) would still be higher than in2001. The combination of price reform and sectoral measures would bringenergy consumption in 2019 almost to the level of 2001, and would actually result in a decreasing environmental impact, andtherefore inreduceddamage costs as comparedto 2001 from 5.7% of GDPto 2.2% of GDP (1.6% to 0.6% inPPPterms). The effects are the same for all price reformscenarios, becauseof the assumptionof immediateadjustmentto price. Table 7-1: Maineffectsofprice reformandsectoralmeasures 1 Year I 2001 ReferenceYear 2019 Scenario I BAU I Sectoral I EliminationI Elimination and sectoral measures Primary energy requirement I I 878 I measures I I 1,947 1,835 I 1,030 I 962 (mboe) Domestic energy consumption 720 1,556 1,460 789 737 (mboe) out of which ----- Natural gas 242 575 588 300 310 Gasoline 99 198 160 117 94 Gasoil 160 294 294 92 92 Fueloil 73 98 41 66 31 Electricity 60 197 183 120 114 Emissions (kt) ---- co* 352,00 708,000 649,000 358,000 332,000 so2 0 1,436 812 753 530 NOX 1,349 2,161 1,578 1076 747 co 1,106 10,790 7,67 8 5967 4135 - PMlO 5,435 228 214 80 72 131 Subsidies 10lLRials 118 288 267 0 0 bnUS$ 15 36 33 0 0 Subsidiesin % of GDP 17.8 20.3 18.8 0 0 DamageCosts 10" Rials - 37.7 94.3 65.2 47.5 31.0 bnUS$ 4.7 11.8 8.2 5.9 3.9 DamageCost in% of GDP II5.7 II6.6 II4.6 II3.3 1I 2.2 (nominal) DamageCost in% of GDP I 1.6 I 1.8 I 1.2 I 0.9 I 0.6 112. Fast price reform by 2009, as proposed in the CEM, would increase overall financial benefits to the state and bring bigger environmental benefits in the intervening period 2004 - 2019, but would have stronger impact on the consumer price index. Generally, the interests of the environment are congruentwith the recommendationsof the CEM. Inthe case that such rapid 44 price reform i s not envisaged, the EER studied a package of price reform by 2014 and sectoral measures. 0 Phasing out of energy subsidies by the end of the 5th Plan (i.e. 2014) with the provision of a social safety net for reducing the impact of the measureon the poorer segment of the population. 0 Implementation of sectoral policies alongside the subsidies reduction, since the combination of bothprovidesthe best environmentalandeconomicaleffects. 7.2 Recommendations: A New Energy-Environment StrategicFramework (2004-2014) 113. While initiating its transition towards a market economy, Iran has opted for sustainable development inits 4" Economic and Social Development Plan. The option of a market economy i s now seen as the key vehicle for achieving both sustained economic growth and significant environmental improvements. The economic reform process i s aimed at deregulating the economy and creating an enabling framework for private sector participation, focused on fiscal, trade, and price reforms, as well as the elimination of subsidies, and the introduction of cost recovery measures. To ensure good management of the environment, these reforms should be coupled with changes in incentives structures and the strengthening of environmental managementinstitutions. 114. The EER points to the need for clear articulation between environmental policies with overall economic policy. In this regard, environmental benefits will flow first from the deregulation of the economy, and which was aimed at dismantling the system of administrative management of the economy, including price and fiscal reforms, trade and foreign exchange liberalization, removal of subsidies, and adopting energy sector measures that are financially attractive. The environment should not be considered as a separate concem, but rather as a part of a systemof distorted resourceuse. 115. Based on a vision of sustainable development anchored in a thriving market-based economy with efficient institutions and strongregulatory oversight, the EERputs forward a three- pronged strategy for getting there (more details are given in the document itself). The package comprises a mix of price reform and sectoral measures. The EER clearly shows that reform of prices to the level of opportunity costs will bring significant benefits, but will still leave substantial environmental impacts that will increase thereafter as a consequence of increased energy use arisingfrom continued economic growth. Price reformin itself is not enough. Prices could be increasedabove the level of opportunity cost by taxes as i s done in many industrialised countries; such measures are normal driven by a combination of fiscal and environmental motives. Taxation should be bome inmindas a long-term option. The price reformneeds to be supplemented by the targeted sectoral measures described above to control emissions at source. These measures may be divided into two groups: one group that imposes certain minimum standards for example on vehicle performance; a second group that provides financial incentives to environmentally favourable investments in energy efficiency and fuel substitution. This last group can in tum be subdivided into two sub-groups: one sub-group of financial measures that aim to correct market distortions based in poor access to information and unrealistic perceptions of risk and a second sub-group that compensates for distorted prices of energy in absolute and relative terms (second-best solutions). The lifetime of this latter group of measures would normally be limited to the transitional period of price reform and would be withdrawn once price reformwas complete. 45 a) Improve human health and the quality of life of thepopulation through a reduction in theprevalence of respiratory diseases,through: 0 Better prevention andcontrol of air pollution from industrial sources; 0 The promotion of natural gas as the main domestic fuel; 0 The faster substitutionof natural gas inindustry andthe power sector; 0 The promotion of CNG invehiclestogether with the inspection andmaintenanceof other vehicles; 0 Decreaseof the sulfur content of middle distillates to 100ppmfrom 2009. b) Price the energy resource efficiently as to stimulate energy efficiency and competitiveness of the economy, through: Makingthe subsidiesto petroleumproductsexplicit inthe budget as recommendedby the CEM; Raising the prices of petroleum products other than kerosene to international levels by 2014. Fuel-oil should be included inthis programbecausethe substitution by natural gas inindustry is governedby the pricedifferential andthisis at presentnothighenough; Simplifying the electricity tariff structure to channel subsidies exclusively to the genuinely poor. Bringing electricity prices for other consumer categories to opportunity cost by 2014; Initiatinga similar processto makegas subsidies explicit andto reformgas prices starting from 2010. Improve theproductivity and sustainability of the country's energy capital, through: Sustainable demand side and supply side management, using participatory and community driven approaches, with strong linkages to electricity, natural gas, and transportfuels; Bringingan end to cold flaring, reducing fugitive emissions inrefineries, reducing T&D losses in electricity and from the oil and gas sector, and switching from diesel to electricity ingroundwaterpumps; Establishing an energy efficiency fund for the industrial and commercial sectors as such fund are financially rewarding to Iran because of the large savings in the opportunity costs of energy which is not reflected inmarket prices; Promoting renewable energy (either directly or through guaranteeby the State of power purchaseagreement). This should be pursuedwithin the Clean Development Mechanism (CDM) andthe Prototype CarbonFund(PCF) under the Kyoto Protocol; Financing system improvements for a combined energy policy in the oil, gas and electricity sectors. A mechanismto be consideredis to recycle the avoided subsidiesinto funds to promote efficiency and substitution of natural gas into industry and provide financial incentives for energy efficiency inhouseholdsand for conversion of vehicles to CNG. The Fundshouldterminate when price reformis complete. Improve the institutional and legal framework in energy and environment and strengthen information disseminationandpublic awareness-raising through: 0 Undertaking an assessment of the roles, functions and responsibilities of the Ministries of Oil, Energy, Transport and the Department of Environment and determine specific 46 actions inthe short, mediumand long-termfor the integration of environmental concerns inthe policy formulation andimplementationprocessintheenergy andtransport sectors. 0 Updating the legal and regulatory framework to implement modem concepts in environmental management namely the polluter-pays, and precautionary principles; public participation and disclosure, environmental liability, market based and voluntary mechanisms, environmentally-oriented permitting systems, and cooperation among stakeholders. The revision should also encompass an update of quality standards for air pollution, including the development of procedures and guidelines for compliance and enforcement. 0 Formulating a comprehensiveprogram for creating and enhancingenvironmental public awareness. This should not be limited too narrowly to the environment-energyinterface. On the contrary, at this level, it should envisage a very comprehensive approachto the subject, namely informing people about the policy options, the actions that would be undertaken under each and the long-term benefits expected to accrue to the economy from such measures. This will help in reducing the public antipathy towards the costs that it i s expectedto shoulder inthe courseof the policy time frame. 0 Building capacity and enhancing knowledge in damage cost analysis, policy design, trainingandadequateinformation pertaining to the best andcleantechnologies to require of pollutingindustries, their application, costs andperformance. 7.3 Action Plan 116. An Action Plan was prepared for the implementation of the main sectoral policies described above aiming at improving the environmental situation as far as it is related to the energy sector. This Action Plan will have to be developed further, and changed where required, since it can only be implementedwithin a coherent framework of Iranian environmental, energy and economic policies, which need to be defined and adopted by the Iranian Government. Therefore, the Action Plan, as presentedinthe EERreport, shouldbe consideredas abasis for the ongoing discussion with the GOI, which in any case must be continued for the further implementation of work that has been initiated by the EER. The Action Plan also indicates entities which should be involved in, or responsible for, implementing and monitoring of specific activities. An overview of the action plan is attached. There is an emphasis on air quality, because this i s the most widespread and acute environmental impact of energy use. Other important issues are marine pollution from oil spills and contamination of water from oil production and processing. Marine pollution is covered in the Action Plan. Refinery issues are better treated by normal processesof industrial pollution control. The policies recommendedwill generally lead to a more efficient use of energy and a diminution of other environmental impacts also. 117. Executing agencies named in the Action Plan are generally the Ministry responsiblefor the sector to which the policy is related. However, there will be a few instances where the measure will be cross-cutting across more than one ministry. For example, a policy of reducing subsidy on gasolinemay directly relate to the Ministry of Oil, but will also have relevanceto the Ministry of Finance because of its repercussions for the state finances and budget. It is thus proposed to set up a Task Force for each component policy with members drawn from the concerned ministries and other bodies, but functioning under one particular ministry so that the accountability is fixed. The Task Force should also have a member from the implementing agency to provide insights into what kind of mechanismi s required to actually put the policy in place. But sincethe overall objective of the EER is to improve the state of the environment inthe country, one overall executing agency responsiblefor overseeing and monitoring the action plan 47 i s also recommended. The DOE has already establishedan Energy-Environment Review (EER) Office and has also formed an EER Steering Committee. Both should continue to function until the Policy Support Unit which is envisaged under the World Bank co-financed Environment Management Support Project becomefully operationalwith staff and resources. At a later stage, whenever the decision of the Government will be to undertake substantial policy reforms in the energy sector, the High Council of the Environment, which i s responsible for the state of environment in the country should be responsible for overseeingthe Action Plan with the PSU acting as a secretariatfor monitoring, evaluatingandcoordinating the policy options executedand implemented by various agencies. 7.4 Role of the WorldBank 118. The Role of the World Bank will be to assist Iran in developing tools for meeting its MDGtarget #7 on environmental sustainability. The World Bank will focus on mainstreaming environment into target policies, programs andprojectsat the nationaland locallevels to promote sustainable development in the energy sector. This approach requires strong commitment and involvement from all departments and levels of government, including civil society and the private sector. 119. The Bankwill proposefive main tools inits supportfor the implementation of the EER: a) Priority Setting: Through assistingDOE andthe key energy ministries of oil, energy and transport, and Environment in setting their own environmental priorities and in improving their environment managementcapacity. Particular attention will be given to building a local capacity for understandinglinkagesbetweenenergy andenvironment, andto improving and disseminating methodsfor the economic evaluation of environmental externalities. Inaddition, Bank support is expected to further emphasize the environmental benefits of continued deregulation of the economy, the use of economic andmarket based instruments, trade policy, soundnatural resource management, and efficient public expenditures and service delivery with the highest impact on poverty reduction. b) StrengtheningDue-Diligence Capacity: Through assisting the DOE and other relevant institutions of government to strengthen capacity in environment and social assessment. The EER is a strategic environmental assessment (SEA) of the energy sector. This SEA should be followed up by a structuredlearning program aimed at building in-country capacity for upstream integration of environmentalconsiderations into planning andsectoraldecision making. c) Integrating Environmental Concerns into the Bank's Instruments. Through primarily supporting the environmental energy priorities through the Country Assistance Strategy (CAS), sector work, and program and project design in the energy sector. Particular emphasis will be through technical support on demand side management, energy conservation and efficiency, reduction of gas flaring and undertaking analytical work for establishing a National EnvironmentalProtection Fund.The Global Environment Facility (GEF), the Clean Development Mechanism and the Prototype Carbon Fund (PCF) should be further explored as potential financial mechanismsfor such support. d) Capacity Building. This will be achieved through strengthening the capacity of key sector ministries, local governments, and municipalities in technical and managerial matters, as well as policy planning and evaluation. The Environment Management Support Project will 48 establish the Policy Support Unit and will focus on strengthening the institutional and legal framework as well the monitoring of air quality. e) Regional Couperution incombatingmarinepollution from oil andgas, andprotection of marine resourcesin its Shatt ElArab waterway with IraqandKuwait andits downstreamzone of influence in the Persian Gulf. This will be undertakenthrough a design and implementation of a regional project that could be co-financed by GEF for the sustainable use and realization of the full economic andsocialbenefitsofthe waterway 7.5 Conclusion 120. The success of implementing the EER will require more than the proposed Bank assistance, which, although catalytic, is quite modest compared to the scope and severity of air pollution in Iran. Inthe end, GO1shouldtake the lead for a sustainablereformprogram on which much of the environmental improvements will depend. This will require time, patience and perseverance. After all, Iran i s publicly committed to sustainable development. However, because environmental sustainability requires a long-term view and an integrated systematic approach, its greatest benefits will happen in the longer term. It would be shortsightedto try to justify the continuation of Bank's assistance based only on its expected immediate tangible benefits, important as these may be. Sincethe GO1andthe Bank are committed to environmental sustainability, Bank assistance should therefore continue to be a long-term, forward-looking program that would help build the country's capacity by providing knowledge and the best intellectual and professional resources available to assist in addressing priority emerging and longstandingenvironment issues inthe energy sector. 121. Since the year 2000, the Bank has beenthe major environment policy interlocutor in Iran. Its presence i s needednow even more than in the past to play its catalytic role of addressingthe root causes of inadequateenvironmental management and in integrating environmental concerns into decision making and the management of the economy, providing tools for environmental policy analysisandlinkingproject preparationto investment. The EERis thereforethe beginning of a process. Accompanying Iran in this process of environmental sustainability i s a challenge that the Bank has accepted to assume in order to help Iran improve the quality of life of the Iranian peoplenow and inthe future. 49 m 0