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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY PROJECT APPRAISAL DOCUMENT ON A PROPOSED CREDIT IN THE AMOUNT OF SDR 13.9 MILLION (US$2 1 MILLION EQUIVALENT) TO SERBIA AND MONTENEGRO IN SUPPORT OF THE SECOND PHASE OF THE US$ 1,000 MILLION Report No: W ENERGY COMMUNITY OF SOUTH EAST EUROPE (APL) PROGRAM - SERBIA AND MONTENEGRO COMPONENT - SERBIA PROJECT Infrastructure and Energy Sector Unit South East Europe Country Unit Europe and Central Asia Region June 8,2005 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS (Exchange Rate Effective May 1,2005 ) Currency Unit = Dinar (CSD) CSD63.32 = US$1 US$1.51 = SDR1 FISCAL YEAR January 1 - December 3 1 APL CIDA EAR EBRD EC ECSEE EIB EMP EMS EPS ERAC ETSO EU FMR IAS IASB ICB IFAC IFRS ISA KfW LAP PCBs QCBS TSMO UCTE USAID ABBREVIATIONS AND ACRONYMS Adaptable Program Loan Canadian International Development Agency European Agency for Reconstruction European Bank for Reconstruction and Development European Commission Energy Community of South East Europe European Investment Bank Environmental Management Plan Elektro Mreza Sribje Elektro Privreda Srbije Electricity Regulatory Agency Council European Transmission System Operators European Union Financial Monitoring Reports International Accounting Standards International Accounting Standards Board International Competitive Bidding International Federation of Accountants International Financial Reporting Standards International Standards on Auditing Bank for Reconstruction (Germany) Land Acquisition Plan Polychlorinated Biphenyls Quality and Cost-Based Selection Transmission, System, and Market Operator Union for Coordination of Transmission of Electricity in Europe United States Agency for International Development Vice President: Country Director: Sector Manager: Task Team Leader: Shigeo Katsu Orsalia Kalantzopoulos Henk Busz Mohinder Gulati

3 FOR OFFICIAL USE ONLY EUROPE AND CENTRAL ASIA Energy Community of South East Europe APL 2-Serbia CONTENTS. Page A. STRATEGIC CONTEXT AND RATIONALE... 1 B. Program. Country and Sector Issues... 1 Rationale for Bank Involvement... 4 Higher Level Objectives to which the Project Contributes... 5 PROJECT DESCRIPTION... 6 Lending Instrument... 6 Program Objective and Phases... 6 Project Development Objective and Key Indicators... 7 Project Components... 7 Lessons Learned and Reflected in the Project Design... 8 Alternatives Considered and Reasons for Rejection... 9 C. IMPLEMENTATION... 9 D. ECSEE Partnership Arrangements... 9 Institutional and Implementation Arrangements Monitoring and Evaluation of OutcomesResults Sustainablllty Critical Risks and Possible Controversial Aspects Credit Conditions and Covenants APPRAISAL SUMIVIARY Economic and Financial Analyses Technical Fiduciary Social Environment Safeguard policies... Policy Exceptions and Readiness This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. 17

4 Annex 1: ECSEE Program and Serbia Power Sector Background Annex 2: Major Related Projects Financed by the Bank and/or other Agencies Annex 3: Results Framework and Monitoring Annex 4: Detailed Project Description Annex 5: Project Costs Annex 6: Implementation Arrangements Annex 7: Financial Management and Disbursement Arrangements Annex 8: Procurement Arrangements Annex 9: Economic and Financial Analysis Annex 10: Safeguard Policy Issues Annex 11: Project Preparation and Supervision Annex 12: Documents in the Project File Annex 13: Statement of Loans and Credits Annex 14: Country at a Glance... 67

5 SERBIA AND MONTENEGRO ENERGY COMMUNITY OF SOUTH EAST EUROPE (APL) PROGRAM - SERBIA AND MONTENEGRO COMPONENT - SERBIA PROJECT PROJECT APPRAISAL DOCUMENT EUROPE AND CENTRAL ASIA ECSIE Date: June 8, 2005 Country Director: Orsalia Kalantzopoulos Sector ManagedDirector: Hinderikus Busz Project ID: PO88867 Lending Instrument: Adaptable Program Loan Team Leader: Mohinder P. Gulati Sectors: Power (100%) Themes: Regional integration (P);Regulation and competition policy (P);Trade facilitation and market access (S) Environmental screening category: Partial Assessment Safeguard screening category: Limited impact [ ]Loan [XI Credit [ ] Grant [ ]Guarantee [ ] Other: For Loans/Credits/Others: rota1 Bank financing (US$m.): Borrower: Ministry of Energy and Mining Nemanjina Belgrade, Serbia and Montenegro Tel: Fax: Ministry of Energy and Mining Nemanjina Belgrade, Serbia and Montenegro Tel: Si-.gov. yu Responsible Agency: Electric Power Industry of Serbia Balkanska 13 Belgrade, Serbia and Montenegro Tel: Fax:

6 Expected effectiveness date: September 28,2005 Expected closing date: February 28,2010 Does the project depart from the CAS in content or other significant respects? Ref. [ ]Yes [XINO PAD A.3 Does the project require any exceptions from Bank policies? Ref. PAD D.7 Have these been approved _- by Bank management? Is approval for any policy exception sought from the Board? [ ]Yes [ IN0 Does the project include any critical risks rated substantial or high? [ ]Yes [XINO Ref. PAD C.5 Does the project meet the Regional criteria for readiness for implementation? Ref. [XIYes [ ]No PAD 0.7 Project development objective Ref. PAD B.2, Technical Annex 3 Within the overall ECSEE APL objectives/context, the project (ECSEE APL2-Serbia) would provide investment support and technical assistance for Serbia, and complement the donor assistance for creation and institutional development of TSMO and the regulatory agency - obligations Serbia has to fulfill under Athens Memorandum. The objective of the project is to improve electricity market access for consumers and suppliers through increase in the quantity, quality, reliability, safety and efficiency of the bulk power transmission system. Project description [one-sentence summary of each component] Ref. PAD B.3.a, Technical Annex 4 The Project consists of two components: Component 1: 110 kv Substations and Related Activities for construction of five new 110 kv substations. The construction of these five 110 kv substations will be carried in two phases. Component 2: 110 kv Interconnecting Transmission Lines and Related Activities for construction of new 110 kv interconnecting transmission lines for the substations selected for investment under Component 1 of the project. The construction of these 110 kv interconnecting transmission lines will also be carried in two phases coordinated with the implementation of the two phases of Component 1. Which safeguard policies are triggered, if any? Ref. PAD D.6, Technical Annex 10 Environmental Assessment; and Involuntary Resettlement. Significant, non-standard conditions, if any, for: Ref. PAD C.7 Board presentation: None. Serbia already meets the initial ECSEE APL eligibility conditions and the proposed project complies with Bank safeguard policies. Loadcredit effectiveness: The standard Bank requirements shall apply. In addition: (a) the Government of Serbia to register the Energy Regulatory Agency with the Trade Court, and the TSMO with the Business Registration Agency; and (b) the Borrower submits to the Bank a signed Sub- Credit Agreement between the State Union of Serbia and Montenegro and the Republic of Serbia, and a signed EPS Sub-credit Agreement between the Republic of Serbia and the EPS. Covenants applicable to project implementation: (a) within 60 days of effectiveness of the credit, the borrower will inform IDA of the implementation arrangements for Component 2 of the project by EMS; and (b) withdrawals from the Credit for the second phase will be subject to satisfactory progress in the implementation of the first phase of the project by EPS and EMS.

7 A. STRATEGIC CONTEXT AND RATIONALE Program, Country and Sector Issues Overall ECSEE APL Program. The improvement of the performance of the energy sector is crucial to improve and sustain economic development in South East Europe (SEE). The power supply situation is projected to tighten significantly during the next few years and threatens to constrain economic activity and quality of life if not addressed with determined regional action. Apart from Turkey, investment over the past years has been limited, with the average age of generation capacity now in excess of thirty years, Significant capacity additions (of the order of 12,000-15,000 MW) and plant rehabilitations (of the order of 8,000-9,000 MW) will be required during the next ten years, along with matching transmission and distribution system investments if demand is to be met and severe power shortages and supply interruptions are to be avoided. The SEE countries have acknowledged that solutions to these regional issues based on isolated national markets are neither desirable nor feasible as a means to attempt to close investment gaps and emerging demand and supply imbalances. Building upon their experience to cooperate in the power sector, in recognition of potential gains from increased trade, and as part of a wider movement to strengthen regional cooperation, the Governments of the SEE countries and the European Commission signed the Athens Memorandum - the Memorandum of Understanding on the Regional Energy Market in South East Europe and its Integration into the European Community Internal Energy Market - on December 8, 2003 in Athens, Greece, whereby they formally expressed their commitment to what is currently called the Energy Community of South East Europe (ECSEE). ECSEE s current membership is as follows: 9.. ECSEE s State Parties are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, Romania, Serbia and Montenegro, and Turkey; The United Nations Interim Administration Mission in KOSOVO, administering Kosovo pursuant to the United Nations Security Council Resolution 1244, is an Adhering Party; The State Parties and the Adhering Party together are ECSEE s Regional Members (also referred to as the Contracting Parties); EU Member States Austria, Greece, Hungary, Italy, and Slovenia are Participants. Any other EU Member States can also request to become participants; and Neighboring Non-EU Member States can request to participate as Observers. Currently, Moldova is participating as an observer. Negotiations are underway to convert the Athens Memorandum into a legally binding international Treaty (Section (2.2) between the European Commission (on behalf of the European Union) and the Contracting Parties. This project appraisal document reflects the December 3, 2004 version of the ECSEE Treaty. The Athens process including the ECSEE Treaty and the ECSEE implementation mechanism i s presented in Section 1 of Annex 1. The ECSEE APL program is directly linked to ECSEE and is explained in Section 2 of Annex 1. The main issues relating to the Serbia power sector are described in Section 3 of Annex 1, and are summarized hereunder. Serbia Power Sector. Growth in electricity demand is driven by resumption in economic growth. During the 1990s, a period characterized by armed conflicts, international sanctions, and trade shocks stemming from the break-up of the Socialist Federal Republic of Yugoslavia, Serbia faced severely reduced output and foreign trade, high I Review of Power Demand and Supply in South East Europe, Working Paper No. 17, World Bank, October 2003 and separate Bank staff estimates for Turkey. 1

8 inflation, large hidden fiscal deficits, and large external and fiscal obligations. Since the political changes in 2000, Serbia began to implement reforms and has made remarkable progress in a range of areas. Its broad ranging structural reforms include a new market-oriented and regionally-focused energy sector strategy, industry and market restructuring, and electricity tariff reforms. Since 2000, it has achieved four successive years of solid economic growth (averaging over 4 percent per year), inflation in single digits, a broadly stable exchange rate, declining external and public debt as a share of GDP, increased foreign reserves, and significant reduction in the energy sector related quasi-fiscal deficits. With resumed economic growth, demand for electricity is expected to grow at an annual average of 2% per annum in the medium term such that by 2010 the electricity demand is expected to reach a level of 35 TWh, up from about 3 1 TWh in Power sector infrastructure is old, inadequately maintained, and requires rehabilitation beyond what has been achieved so far. The total effective installed generation capacity in Serbia is 7,120 MW, of which about 40% is hydropower, 55% is lignite-fired thermal power plants, and the remaining 5% is oil or coalfired combined heat and power plants2 The two principal indigenous sources of primary energy are proven reserves o f about 2.5 billion tons (reserves to current production ratio of about 75 years) of low sulfur lignite deposits and about 3,000 MW of hydroelectric potential (including about 500 MW of small hydro). Serbia is in the geographic center of South East Europe, and its power system is interconnected to that of neighboring countries through 400 kv and 220 kv transmission lines. Economic decline during 1990s and the war damages in 1999 contributed to inadequate maintenance and insufficient rehabilitation of ageing facilities and networks in the electricity sector. All power generation plants and most of the transmission and distribution network are more than 20 years old. Sustained tariff adjustments and efficiency improvements have reduced the quasi-fiscal deficit and improved the sector s financial performance. The energy sector was among the main sources of fiscal and quasi-fiscal deficits of the economy on account of its low operational efficiency, high levels of financial losses, and debt service defaults caused in part by energy prices being lower than the cost of supply. Low energy prices (0.9 US cents / kwh electricity in October 2000) caused the quasi-fiscal deficit to soar to about US1.1 billion or 10 percent of GDP in the beginning of A strong commitment by the Government to implement public expenditure management and energy pricing reform has since then virtually eliminated the quasi-fiscal deficit from the energy sector. The average electricity tariff reached 3.7 US cents / kwh in July 2003 and is currently 4.3 US cents equivalent / kwh.3 The tariff structure has been rationalized to improve end-use efficiency. Although rising tariffs have caused predictable affordability concerns, in 2001 Serbia introduced an innovative block tariff structure with a range of targeted subsidy mechanisms. The introduction of the three-block tariff system created an incentive for households to use electricity efficiently, by reducing the consumption of electricity for heating, while keeping the price of non-heating electricity consumption within the financial reach of most households. To address the issue of the public affordability of electricity due to tariff increases, Elektro Privreda Srbije (EPS) has introduced two subsidy mechanisms targeting low income families and individual^.^ Bill collection has improved but problems remain. While significant improvements since war damages and economic sanctions have been made, problems with operational performance remain. Collections as a percentage of billing have improved from 60% in 2000 to about 90% in 2003 and this level has been sustained through Collections from residential and commercial consumers have improved Figures provided exclude Kosovo. Tariff is 2.55 Dinars (3.5 Euro cents / kwh, or 4.33 US cents ) The first scheme gives designated low income families and individuals a 30 percent discount on electricity bills up to 450kWh/month, and a variant of this scheme enables Child Allowance recipients a further 100 per cent relief from the fixed portion of their monthly bills. A second scheme gives a monthly subsidy o f about 500 YUD to those who are dependent on electricity for heating and who fulfill certain income, consumption and personal criteria, 2

9 significantly, but collections from high voltage consumers, in particular the state owned manufacturing enterprises continue to be low. EPS is implementing debt work-outs with debtors, including a combination of write-offs and rescheduling, as a reward for being current on existing billings. Transmission and distribution losses in the range of 18% are high by Western European standards but investments in rehabilitation and augmentation are targeted at reducing losses to 14% by Major challenges faced by the power sector. Energy sector restructuring relates to two of the three goals of the recent CAS ( ) - creating a smaller, more sustainable, more efficient public sector, and creating a larger, more dynamic private sector. Improving the performance of the power sector is essential to achieve fiscal sustainability and encourage private sector-led growth. A comprehensive economic reform agenda of the government, premised on the European Union Stabilization and Access Program for eventual EU integration and a poverty reduction strategy, includes inter-alia (i) deepening Serbia s integration with the regional energy market; (ii) reform and restructuring of the energy sector; and (iii) functional unbundling, corporatization and commercialization of the sector entities. However, the institutions do not have adequate capacity to manage post-conflict stabilization while implementing an ambitious reform agenda. This weakness is being addressed through comprehensive institutional development support being provided by the JFIs and the donors (Annex2). Major challenges faced by the power sector in Serbia are to: Implement the new legal and regulatory framework through development of secondary legislation, and creation and institutional development of a regulatory agency; Restructure, corporatize and commercialize the industry by creation of an independent Transmission, System and Market Operator (TSMO), and functional separation of mining, generation, and distribution; Tariff reforms and adjustments, and improving financial and operational efficiency of EPS and its successors to restore creditworthiness of the sector entities and attract investments; Rehabilitate and augment the old and deteriorated generation assets and the network; Upgrade and modernize the transmission, distribution, dispatch, and telecommunications systems to effectively participate in the regional electricity market and strengthen institutional capacity for deregulating the market in accordance with Serbia s obligations under the Athens Memorandum; Improve end-use efficiency and promote rational use of electricity; and Encourage commercial development of renewable resources. Government is implementing a comprehensive strategy to address these challenges. The recently finalized energy sector strategy of Serbia provides a framework for addressing some of these challenges and for providing donor assistance (Annex 2). Serbia has adopted an Energy Law, compliant with the requirements of the Athens Memorandum, in August EAR funded consultants shall provide assistance in developing the secondary legislation and institutional development of the Serbian Energy Regulatory Agency; creation of an independent TSMO, development of its organization structure and business plan, development of technical codes of operation i.e. Grid Code, Market Code, Metering Code etc; and corporatization and functional separation of other functions of EPS. Progress has been made on commercialization of EPS by spinning off non-core assets. Further unbundling will be achieved through separation of transmission and system operation function into an independent TSMO. At present, Elektroistok - a subsidiary of EPS - operates the transmission system while the system control and dispatch is managed by the Department of Power System control of EPS. When registered, the TSMO will take over all these functions. In effect, Elektroistok will get transformed into a separate legal entity as TSMO. The assets, liabilities, contracts, concessions, and staff will be transferred to the TSMO after its organization structure and a business plan has been developed. 3

10 As described in the preceding paragraphs, Serbia has not only rationalized the power tariff structure but also carried out regular tariff adjustments while protecting the poor through social protection programs. Programs for reduction of losses and improvements in billing and collection have started yielding results. Bill collections are affected primarily by the unsatisfactory payment record of state owned manufacturing enterprises which are being restructured and privatized in a phased manner. Privatization and restructuring of state owned enterprises is supported by the Bank through a proposed Programmatic Development Policy Loan currently under preparation. To meet the projected load growth EPS is implementing a plan for (i) rehabilitation of generation capacity to improve its efficiency and availability; (ii) rehabilitation and augmentation of transmission facilities to fully restore and strengthen links to adjoining systems and transmission capacity within the country; (iii) rehabilitation of transmission and distribution facilities to reduce losses, reduce theft and improve reliability; and (iv) end use efficiency improvements and demand-side management. The European Bank for Reconstruction and Development (EBRD), German Bank for Reconstruction (KfW), European Investment Bank (EIB), and the Government of Switzerland have provided assistance for rehabilitation of mines and generating stations, environmental improvement of some thermal plants, rehabilitation of most large hydro plants except Zvomik, augmentation of transmission capacity, upgradation of telecommunication system compatible with the regional market requirements, and a new SCADNEMS. The Bank has financed emergency reconstruction of power plants and transmission lines damaged during the 1999 war and, with co-financing from SIDA, installation of a new financial management system in EPS. EAR is funding technical assistance for training and skill up-gradation of the transmission and system dispatch staff. The proposed Bank project will support the construction of five selected 110 kv sub-stations and associated transmission lines by financing the supply of goods and equipments for the substations and the civil and installation works for the transmission lines, that would help open the market by enabling the eligible customers access competitive suppliers.. For improving efficiency of energy use in Serbia and reducing the use of electricity for space heating, EAR, KfW, and the Bank are providing assistance to the District Heating companies and to the Serbian Energy Efficiency Agency to promote efficiency of both supply as well as consumption. Further, costcovering electricity tariffs and rationalization of the tariff structure being implemented by EPS will have an impact on end-use efficiency. To develop and commercialize renewable resources of energy, in particular the small hydro generation plants, through public-private partnership, the Bank is exploring the possibilities of grant funds to assist Serbia develop a regulatory, institutional, and commercial framework. Rationale for Bank Involvement Overall ECSEE APL Program. The Bank is participating in regional efforts to promote cooperation and integration in South East Europe and inter alia supports the Stability Pact. The Bank is an active participant in the Athens process, at the request of the European Commission. The Bank has supported individual countries of South East Europe in their efforts to rehabilitate and restructure their power sectors through policy dialogue, technical assistance and financing since the early 1990s (in some cases even earlier). This deep country knowledge and participation in the development of ECSEE in the Athens process, including a regional trade strategy work puts the Bank in a strong position to provide regional lending, policy advice and technical assistance to further support the Athens process for ECSEE. The ECSEE APL program was approved by the Bank on January 27, It is a key component of the Bank s support for the Stability Pact and its working partnership with the European Commission. A regional investment facility for gas and power generation, similar to the ECSEE APL for electricity, will also be considered. 4

11 In March 2004, the Bank published a strategy paper for energy trade in South East Europe. The framework paper outlines the Bank s vision for regional energy market development and defines its role in supporting the evolution of regional energy trade. It describes the Bank s role in supporting policy reform and institutional development, and in lending for power generation, transmission and distribution. This role is to:. a Promote a phased approach to market opening, starting with trading based on bilateral contracts and third party network access, and moving to a more sophisticated model after the institutional framework is sufficiently developed; Apply regional benchmarking in policy support work with individual counties and as a trigger for investment financing; Develop a special regional instrument - the proposed ECSEE APL - and finance priority investments to support development of the regional market; Carry out analytical work to assess the economics of increasing the use of gas in the SEE countries and costs of compliance with EU environmental standards; and Complete a Regional Power Generation Investment Study, financed by the European Commission. ECSEE APL2-Serbia. Serbia is an important and major participant in the regional electricity market. It was responsible for operating the former federal Yugoslav power system in the past and would continue to be a major transmission route for the flow of electricity within the region and with Western Europe. To implement deregulation of the market effectively, Serbia needs to put in place the necessary infrastructure for the consumers to access competitive suppliers. Through financing infrastructure to improve market access for the customers, the proposed project will complement the donor assistance for creation and institutional development of the TSMO and the Regulatory Agency, augmentation of the transmission network, and telecommunication system to link Serbia to the regional electricity market. By its extensive involvement in Serbia s energy sector through programmatic and investment lending, technical assistance, development and implementation of sector strategy, and donor coordination, the Bank has developed a good understanding o f the sector and has been requested by the Government to help in enabling Serbia s integration with the regional electricity market. Higher Level Objectives to which the Project Contributes All SEE countries have the prospect of EU membership. Bulgaria and Romania expect to join in 2007, and Croatia and Turkey are also candidate countries. The countries of Western Balkans - the other Regional Members of ECSEE - are potential candidates to accession (European Council - Copenhagen, December 2002). The Thessaloniki Agenda for the Western Balkans: Moving towards European Integration, which was endorsed by the European Council in Thessaloniki in June 2003, encourages the region to adopt a legally binding energy market agreement. Accordingly, the Member Countries and the Commission are determined to establish integrated energy markets in electricity and gas based on a common solidarity and consistent with the rules applicable within the European Union. ECSEE is an integral element of the efforts of the Regional Members and the European Commission for all states in South East Europe to have access to stable and continuous energy supply which is regarded as essential for economic development and social stability. The creation of an area without internal frontiers for energy contributes to economic and social progress and a high level of employment as well as balanced and sustainable development. These higher level objectives are expressed in the draft ECSEE Treaty. 5 World Bank Framework for Development of Regional Energy Trade in South East Europe, EMT Discussion Paper No. 12, March

12 The Stability Pact has made regional energy cooperation one of its core objectives in its efforts to strengthen regional cooperation and to foster the conditions for peace, stability and economic growth in South East Europe. The Stability Pact has characterized ECSEE as a unique chance for the SEE region to consolidate reconciliation and provide a driver towards a more comprehensive economic and political integration into the European Union. The Bank supports regional efforts to promote cooperation and integration in South East Europe. ECSEE is one of the most prominent of current regional programs. The ECSEE APL facility is a key component of the Bank s support for the Stability Pact and the working partnership with the European Commission. The project (ECSEE APL2-Serbia) is consistent with the Bank s CAS ( ) which supports the goals of the government s reform agenda - creating a smaller, more sustainable, and more efficient public sector; and creating a larger more dynamic private sector - both requiring restructuring, market reforms, and deepening of regional integration in the electricity sector. B. PROJECT DESCRIPTION Lending Instrument ECSEE is a regional program and the Bank investment support is being provided on a regional basis using the adaptable program lending (APL) instrument, horizontally to support ECSEE s Regional Members (up to eight countries and Kosovo) and vertically (each Regional Member can in principle receive support from more than one APL installment over the APL program period). The APL instrument enables the Bank to provide support in a flexible manner - when individual countries have met the policy triggers (country criteria under the Athens process) and when individual projects are ready to receive Rank support. All ECSEE Regional Members might not actually borrow under the APL program. However, countries would know up-front that they can rely on the Bank to support them in achieving the goals of the ECSEE if they meet specific eligibility criteria and if they need Bank support. The approved size of the APL lending facility is US$l,OOO million, of which US$ 21 million equivalent is proposed for Serbia under APL2. The ECSEE APL is detailed in Annex 1, Section 2. Program Objective and Phases ECSEE. The key objectives of the Energy Community of South East Europe (ECSEE) are:. Create a stable regulatory and market framework capable of attracting investment in gas networks and power systems so that all states in the region have access to the stable and continuous energy supply that is essential for economic development and social stability; 9 Establish integrated regional markets in South East Europe, closely linked to the internal energy market of the European Union, and complying with the rules applicable within the European Union; Enhance the energy security of South East Europe and the European Union by providing incentives to connect the Balkans to Caspian and North African gas reserves; and Improve the environmental situation in relation to energy in the region. The Member States are committing themselves under ECSEE inter alia to:. Implement the EC Directives 2003/54 (electricity) and 2003/55 (gas) of the European Parliament and of the Council, June 26, 2003, in full but with a delayed schedule for market liberalization compared to the schedule applicable to EU Member States; Progressively align their environmental standards to a high common level, including the requirement that all generating plants starting to operate after the entry into force of the forthcoming ECSEE Treaty comply with EC standards; and 6

13 All Regional Members are also expected to accede to the Kyoto Protocol within one year of the Treaty s effectiveness. The Bank supports ECSEE in a number of ways, through active participation in ECSEE s implementation organization (described in Annex 1, Section 1); analytical work including the March 2004 framework paper, the recently completed generation investment study and the proposed gasification study; and country-level policy dialogue and project work. The ongoing regional investment and technical assistance support under the ECSEE APL is an integral element of this comprehensive program of support. ECSEE APL phasing and triggers (presented in Annex 1, Section 2), are directly linked to ECSEE and utilize both the horizontal and vertical features of the APL instrument in a regional context. ECSEE APL. The objective of ECSEE APL is the development of a functioning regional electricity market in South East Europe and its integration into the intemal electricity market of the European Union, through the implementation of priority investments supporting electricity market and power system operations in electricity generation, transmission and distribution. Project Development Objective and Key Indicators Within the overall ECSEE APL objectiveshontext, the project (ECSEE APL2-Serbia) would provide investment support for Serbia, and complement the donor assistance for creation and institutional development of TSMO and the regulatory agency-obligations Serbia has to fulfill under Athens Memorandum. The objective of the project is to improve electricity market access for consumers and suppliers through increase in the quantity, quality, reliability, safety and efficiency of the bulk power transmission system. The ECSEE APL program would be considered successful if the countries in the region achieve their commitments under the Athens process and are able to: (a) develop a functioning electricity market including the agreed market liberalization targets; and (b) integrate it into the intemal electricity market of the European Union in accordance with the ECSEE Treaty. To accomplish this, the countries will have to continue ongoing restructuring and reform measures, build up their institutions and improve their power systems including interconnections so that regional trade can increase. The key performance indicators that would be used to assess the fulfillment of the project s development objectives in terms of outcomes and outputs are described in Annex 3. Project Components Eligible ECSEE APL Project Components. The Bank s March 2004 framework paper concluded that significant investments in power generation, transmission and distribution and technical assistance are required for a well-functioning power market. Priority investments and technical assistance would be financed under the ECSEE APL program so that the ECSEE Regional Members can effectively participate in the regional electricity market (Annex 1, Section 2). ECSEE APL-2 (Serbia) Project consists of two components: Component 1: I I O kv Substations and Related Activities The ECSEE APL 2 (Serbia) project will support the construction of five new 110 kv substations. The construction of these five 110 kv substations will be carried in two phases: 0 Component 1-A: The first phase of this component includes the construction of two new 110 kv substations, through the financing of goods and consultants services. The consultants services include hiring an international consultant(s) to provide implementation supervision services to the two substations implementing agency. 7

14 0 Component l-b: The second phase of this component includes the construction of three new 110 kv substations and carrying out additional related investments andor services. Component 2: 11 0 kv Interconnecting Transmission Lines and Related Activities The ECSEE APL 2 (Serbia) project will support the construction of new 110 kv interconnecting transmission lines for the substations selected for investment under Component 1 of the project. The construction of these 110 kv interconnecting transmission lines will also be carried in two phases coordinated with the implementation of the two phases of Component 1. 0 Component 2-A: The first phase of this component includes the construction o f two new 110 kv interconnecting transmission lines for the substations under Component 1 -A, through the financing of civil and installation works necessary for the construction of the two lines and consultants services. The consultants services will include hiring consultants to provide implementation supervision services to the implementing agency of the two 110 kv interconnecting transmission lines. 0 Component 2-B: The second phase of this component includes the construction of the new interconnecting transmission lines for the substations under Component 1 -B through the financing of civil and installation works of the interconnecting transmission lines and carrying out any additional related investments andor services. Annex 4 provides the technical justification and a description of the new 110 kv substations and associated transmission lines to be financed under the project. For any additional related investment to be eligible for financing through the Credit, the proposed investment schemes will be required to meet the following criteria: (a) submission to the Association of a satisfactory project report demonstrating technical feasibility and economic viability of the proposed investments and confirms that these investments are a part of the medium term investment plans of EPS or EMS; and (b) an Environmental Management Plan and a Land Acquisition Plan, satisfactory to the Association, are submitted if safeguards policies are triggered by the proposed investments. Lessons Learned and Reflected in the Project Design ECSEE APL. The best known regional power market is the Nordic power market, known by the name of its operator NordPool. It operates in Finland, Norway and Sweden and part of Denmark. Portugal and Spain have recently launched a joint market, and regional power markets are also under development in Southern Africa, South-East Asia and Central America, and they are under discussion in Eastern and Western Africa. A key lesson learned from other markets elsewhere, including NordPool, and from the association of European Transmission System Operators (ETSO) is that the progressive integration of energy markets in SEE and the implementation of common security of supply policies require close attention to be paid to the design and operation of subsidiary electricity markets (e.g. balancing and ancillary services) which are best administered by Transmission System Operators (TSOs). ECSEE s implementation organization includes the SEE Transmission System Operators Task Force, which interacts with ETSO and UCTE to ensure smooth integration and coordination. The role of the ECSEE Task Force of TSOs is critical in all phases of ECSEE s development and operation. Political commitment and adequate financial support are key ingredients of successful reform programs. ECSEE s development is premised on the political commitment of the SEE countries as expressed in the Athens Memorandum and the forthcoming ECSEE Treaty, and it is backed by an exceptionally strong donor involvement. The investment component included in APLl and the proposed components of 8

15 APL2-Serbia are (and components to be supported under other APL installments will be) of proven design and streamlined approaches emphasizing turnkey contracting will be employed in their implementation. ECSEE APLZ-Serbia. EPS has successfully implemented the Electric Power Emergency Rehabilitation Project funded by IDA, and several other projects financed by other donors and lenders. The proposed investments are technically relatively simple. Similar equipment and construction designs have been used by EPS in the past. Some of the lessons learnt from similar projects and incorporated in the project design are: use of proven designs, close supervision of construction, a fully funded program and upfront actions for mitigation of social and environmental impacts, and ensuring availability of counterpart funds. Sustainable benefits from these investments can be realized only in the context of sustained improvements in utility s performance and sector reforms. These reforms, as explained in the preceding paragraphs, are reinforced through political commitment to regional integration and strong donor involvement. Alternatives Considered and Reasons for Rejection A regional approach and the use of the APL instrument give the Bank the flexibility to match its commitments to the pace of its clients. The rationale for this approach in comparison with alternatives such as self-standing non-apl investment projects in individual countries is presented in detail in the Project Appraisal Document for the ECSEE APL-Romania Project approved by the Bank s Executive Directors on January 27,2005. Of the alternative investments and technical assistance needs of EPS considered for financing, the proposed investments are considered high priority since these complement the donor funded programs in high voltage transmission network and telecommunication links. Alternative investments considered for financing were: Serbia-Macedonia transmission interconnection; technical assistance for the Regulatory Agency and the TSMO; and distribution system strengthening. Consideration of the Serbia-Macedonia interconnection, though a good candidate, was deferred to a future APL if it becomes clear that financing for it is not available from the Hellenic fund to which the project had been proposed for financing more than a year ago. The technical assistance and institutional development needs of the Regulatory Agency and the TSMO are funded by EAR for the next two years (see Section A- Government strategy and Annex 2) and are therefore not considered for funding through the APL. Distribution system strengthening, though necessary for the utility, was considered a lower priority, compared to the selected investments, for meeting the objectives of the regional electricity market. In the last five years, EPS has performed a series of development and planning studies to determine the priority investments necessary to expand its power networks to improve their performance and to meet the growing demand of electricity. Based on technical and economic analyses the studies have recommended inter-alia the proposed investments in substations and associated transmission lines which are considered high priority and have been included in EPS Investment Plan for C. IMPLEMENTATION ECSEE Partnership Arrangements First and foremost, ECSEE is a partnership among the SEE countries. They have acknowledged that solutions to pressing regional issues based on isolated national markets are neither capable nor desirable as a means to attempt to close investment gaps and emerging demand and supply imbalances. Second, ECSEE is a partnership between the SEE countries and the European Union. The European Commission signed the Athens Memorandum as a participant and will also be a signatory to the ECSEE Treaty. Neighboring Austria, Italy and, Greece signed the Memorandum as political participants to the Athens process and Hungary and Slovenia (which signed as observers ) have since joined the EU and become political participants. Finally, ECSEE is a partnership between the SEE countries and the donors, 9

16 including the Bank. Financial institutions and bilateral donors include the European Bank for Reconstruction and Development (EBRD), the European Investment Bank (EIB), the German Development Bank (KfW), the United States Agency for International Development (USAID), the Canadian International Development Agency (CIDA), and France, Greece, Italy, and Switzerland. Institutional and Implementation Arrangements ECSEE. A comprehensive coordination and implementation mechanism has been established for the development of ECSEE. The mechanism covers and brings together political and administrative leadership, regulators, transmission system operators and other utilities, the European Commission, international financial institutions and bilateral donors in ECSEE s Ministerial Council, Permanent Highlevel Group, Task Forces, and the Forum. This mechanism is detailed in Annex 1, Section 1. ECSEE APL2-Serbia. Component 1 will be implemented by Elektro Privreda Srbije (EPS), which operates the entire power system in Serbia through its 19 subsidiaries6 (2 coal mining, 6 power generation, 1 transmission, and 10 distribution). General management and support functions are assigned to its Head Office in Belgrade. The corporate EPS departments include Economy and Finance, Trade and Treasury, Human Resources, Corporate Finance and Accounting, Information Technology as well as a number of planning departments for generation, transmission and distribution. The transmission system is operated by Elektroistok which will transfer its assets, liabilities, staff, and functions to the new Transmission, System and Market Operator (TSMO) in Serbia when it obtains license from the regulatory agency and becomes functional, expected at the latest by mid July The EPS will designate a small team of staff (project implementation team) for the implementation of the proposed Project to work under a Director of the EPS who will be responsible for overall project implementation. This team s main function will be to coordinate with other corporate departments to ensure effective implementation of procurement, contracting, contract administration and disbursement, financial management and accounting, reporting. This team will be responsible for submission of Financial Management Reports to the Bank. The project accounts will be maintained by the Finance department of EPS. No new arrangements, or creation of any new unit, are proposed for project implementation since the existing organization structure and business processes of EPS are considered adequate and satisfactory for this project. Component 2 will be implemented by the TSMO, which is in the process of being legally established and registered. IDA will be informed of the detailed implementation arrangements for Component 2 of the proposed Project no later than sixty days after the Development Credit Agreement is declared effective. More details of implementation arrangements are provided in Annex 6. The legal arrangements governing the Project will be established through provisions in the Development Credit Agreement between Serbia and Montenegro (as the Borrower) and IDA. The proceeds of the. proposed Credit will be on-lent to the Republic of Serbia through a Sub-credit Agreement between Serbia and Montenegro and the Republic of Serbia on the same terms and conditions on which Serbia and Montenegro receive the Credit from IDA. The Republic of Serbia will on-lend the proceeds of the Credit to EPS (US$18.5 million equivalent) and to the TSMO (US$2.5 million equivalent) through the EPS Sub- Credit Agreement and the EMS Sub-credit Agreement, respectively, on the same terms and conditions on which it receives the Credit from Serbia and Montenegro. Excluding Kosovo, where 7 more subsidiaries currently operate. EMS means Elektromreza Srbije, which is the expected new name of the TSMO. The EMS is a public enterprise owned by the Republic of Serbia and established by the Republic of Serbia Government Decision 05 No. 10

17 Monitoring and Evaluation of Outcomes/Results ECSEE APL. At the regional level, the ECSEE APL program is included in the established mechanism for ECSEE coordination - Ministerial Council, Permanent High-level Group, Task Forces, and the Forum (Annex 1, Section 1). The project will benefit from this elaborate, active and well-functioning mechanism for coordination, monitoring and evaluation. ECSEE s Regulatory Secretariat will provide an institutional mechanism for the regular monitoring of the countries performance against agreed benchmarks. At the country level, investment projects will be included in national programs which will be monitored by the ECSEE coordination mechanism. The Bank will continue to participate in the Athens process including the Forum and will also directly supervise the individual country projects. ECSEE APLZ-Serbia. The project implementation team will monitor progress against agreed performance indicators specified in Section B3 and Annex 3. EPS will provide, on a quarterly basis, 45 days after the end of each quarter, consolidated reports on project implementation progress in a format agreed with the Bank. Sustainability ECSEE APL. ECSEE market vision and sustainability is discussed in Annex 1, in terms of ECSEE market participants, market sophistication, competition and integration with the European Union internal energy market. It is important to note that though additional transmission links are required and will be developed, South East Europe (except Turkey) was synchronously interconnected with the main European power system on October 10, Turkey is also expected to be interconnected with UCTE in near future. Through integration, the region secures access to a major trading partner and an important import source to meet possible electricity shortfalls and emergency support. This highlights the electricity/economy dimension in ECSEE s integration into the European Union internal energy market. ECSEE APLZ-Serbia. The development benefits of the project will be sustained if Serbia continues to follow a policy of regional integration and participation in regional energy market institutions, and opens the market in accordance with the agreements among the ECSEE participants. Serbia is expected to deepen its integration with the region and.eventually with the EU. The physical benefits of the project will be sustained if EPS continues to maintain these assets, serve the customers, and improves its financial performance. Critical Risks and Possible Controversial Aspects ECSEE has been developed and is being implemented through a comprehensive coordination and implementation mechanism. It has gone through extensive discussion and debate. The Bank s work in the ECSEE context, published in the March 2004 framework paper on development of regional energy trade in South East Europe, has highlighted risks and contributed to risk mitigation measures. Risks are being minimized by adopting a gradual approach to market opening and a voluntary approach to trading. Though the market is being opened, meaning an increasing number of electricity consumers will become eligible to choose their electricity supplier, trading is not mandatory but voluntary between willing sellers and willing buyers - countries and customers in individual countries need not and are not expected to move at the same pace. The pace of liberalization may nevertheless trigger controversy. Adjustments can be accommodated in the final ECSEE Treaty, including derogations and subsequent modifications in accordance with the practice of the European Commission. Other potential ECSEE-related controversies are discussed in Annex 1. They include the development of new generation capacity, progressive upgrading and implementation of environmental legislation and impacts of competitive pressures particularly on higher cost and less competitive suppliers and the less attractiveheliable customers. It must be emphasized that the SEE region faces a fundamental risk of not being able to meet the growing 023/ /1, published in Gazette no. 12, dated February 8,2005, and is to be registered by the Republic of Serbia Business Registration Agency. 11

18 demand for electricity. If such a situation develops, it would threaten the economic growth prospects and affect the quality of life in the region. ECSEE is regarded as the best possible mitigation measure for this risk. Through ECSEE - a regional market of countries with harmonized and EU-compatible legislation and institutions underpinned by a legally binding international Treaty - the region will develop an EUcompatible regional market and thereby also represent a much larger and more attractive investment destination to prospective investors. All APL investment projects are expected to use proven designs and are not expected to involve any particular risks or controversial aspects. This would be the case for the APL2-Serbia project, which would involve installation of new substation facilities and associated transmission lines. The benefits from the proposed investments depend, in part, on upstream investments in rehabilitation and augmentation of the transmission system financed by EBRD and Em. This risk is mitigated by the fact that both projects are already under implementation and on track. Credit Conditions and Covenants As detailed in Annex 1 Section 2, the ECSEE APL is directly linked to the countries commitments under ECSEE. No other triggers would be applied (including non-compliance with undertakings under ongoing national projects as long as they do not directly affect countries participation in ECSEE). Triggers would not be applied to loans/credits already approved. As an example, the ECSEE APLl loan to Romania approved in January 2005 does not have conditions (equivalent to dated covenants) about Romania having to meet future triggers (that apply to APL2-5) and a possible failure to meet such future triggers would not jeopardize the implementation of the investment project there that is under implementation. By signing the Athens Memorandum Serbia has already met the basic eligibility criteria to qualify for the Bank support. Serbia has taken steps to establish and make operational an electricity sector regulatory agency, and an independent Transmission, System and Market by July 2005, much ahead of the deadline of mid-2006 under the Athens Memorandum. The Government of Serbia has appointed members of the Energy Regulatory Agency Council and it has appointed the General Manager and the Board of Directors of the Transmission, System and Market Operator (TSMO). The specific Credit covenants applicable to the ECSEE APL2-Serbia project are summarized below: For effectiveness, in addition to the standard Bank requirements, the following conditions shall be fulfilled: (a) legal establishment and registration of EMS, and receipt by IDA of a legal opinion from EMS to that effect and (b) legal establishment and registration of the energy regulatory agency and receipt by IDA of a legal opinion from the energy regulatory agency to that effect. Further, (a) within 60 days of effectiveness of the credit, the borrower will inform IDA of the implementation arrangements for Component 2 of the project by EMS; and (b) withdrawals from the Credit for the second phase will be subject to satisfactory progress in the implementation of the first phase of the project by EPS and EMS. D. APPRAISAL SUMMARY Economic and Financial Analyses ECSEE APL. The benefits of regional power trade in general and trade benefits in the SEE region specifically have been studied by Argonne National Laboratories sponsored by USAID and the sector work underpinning the APL program. A preliminary estimate is that if ECSEE were to operate as a regionally integrated system dispatching on a least cost basis, operating costs could be reduced by 11-15%. There would be additional cost savings relating to capital, for example, through exports from surplus to deficit countries, and sharing of reserve capacity. In the short term, savings would be reflected in lower prices where these are currently relatively high, and increased net revenues for utilities with the potential for increased exports. In the longer term, integrated operation would lead to lower prices than in a limited trade scenario. 12

19 Some benefits from electricity trade are already being realized in the region. The main exporters in the region are Bosnia and Herzegovina, Bulgaria and Romania. Some of the countries have substantial hydro power capacity, while others rely more on thermal, and two have also nuclear power plants. The March 2004 fkamework paper discusses the country-by-county situation. This mix of hydrohhermal generation enhances the prospects for efficiency improvement and cost savings through regional cooperation. There is also scope for power trade between ECSEE and its neighbors, and indeed, one of ECSEE s key objectives is that the ECSEE energy market will be integrated into the EU internal energy market. From a technical point of view, this would be feasible given that power systems in Europe and SEE operate according to common technical standards established by UCTE, and that SEE has been recently reintegrated with the UCTE (ie. the West European grid). Significant additional potential benefits exist given non coincidental peak load periods between Russia and SEE, but synchronizing system operation between the eastem neighbors such as Ukraine/Russia and SEE would be a major challenge. A near-term option to increase trade would be to develop links through Moldova, to allow power transfer at least initially with asynchronous system operation, and this is being discussed between Romania and Moldova. ECSEE APLt-Serbia Project Economic Analysis (see Annex 9). The economic internal rate of retum (EIRR) for the project is estimated to be 29 percent. The net present value for the proposed Project is estimated to be US$33 million, based on a 12 percent discount rate which is considered to be the economic opportunity cost of capital in the Republic of Serbia, The analysis includes the investment costs of US$19 million, net of taxes and duties, and associated O&M costs of about 2.0 % of the investment for the five new substations and associated transmission lines. The analysis compares with- and without-project cases. The with-project case assumes that the investments will be completed over a period of three years, following the procurement schedule in Annex 8, and begin operation in 2009, continuing for 20 years to The figures presented are in real terms using 2004 as the base year. Three key benefits are estimated in the analysis: Reduction in energy losses. The first estimated benefit is a reduction in energy losses. The savings from a reduction in energy losses are valued at the average Serbian electricity tariff as additional sales of electricity to consumers. The average Serbian electricity tariff is US$43.8/MWh (e 32.9MWh). The savings estimate amounts to about US$524 thousand per year, or about US$11 million over the twenty year period. Reduction in Energy Interruptions. The second benefit in this analysis is derived from the reduction in energy interruptions caused by equipment failure and forced outages. The reduction in energy interruptions is valued at the cost of unserved energy. Methodologies to calculate this cost vary from country to country and depend on several factors such as demand structure, quantity of undelivered electricity and duration of interruption. In Serbia the cost of back-up diesel generation to meet the unserved energy due to unscheduled interruptions is estimated to be about US$ 610/MWh. However, for the economic analysis, a more conservative value of US$ SOOMWh, based on the estimates used for a Generation Investment Study currently being performed for the South East Europe region, has been assumed. It is estimated that the reduction in energy interruptions due to the construction of the new 110 kv substation will result in savings of about US$ 1.3 million per year, or about US$26 million over the twenty year period. Supply of new load. The installation of new substations will increase the installed capacity of the transmission and distribution networks, enabling distribution companies to serve new load. About 35 MW of new load will be served as a result of the proposed Project investments. The savings to consumers accruing from electricity service is valued at the cost of altemative power supply less the average electricity tariff. It is assumed that diesel generators are used as the main source of altemative supply. The analysis uses the equivalent of about US$9OMWh for average operating and 13

20 capital cost o f diesel generators. It is estimated that the benefit from connection of new load to the new substations will be about US$ 8 million per year, or about US$ 152 million over the twenty year period. Unquantified benefits. While the benefits quantified above are large and substantial, additional direct and indirect benefits from the project were difficult to estimate and were not included in the rate of retum estimate. In addition to the direct benefits noted above, the quality and reliability of electric service will be improved through improved voltage performance, which is expected to contribute to the growth and development of the serviced areas. EPS Financial Performance (See Annex 9). Since 2000 average tariffs have increased from some US$ 0.9 cents to the current level of US$4.3 cents (2.53 din/kwh equivalent to 3.5 euro cent). This is still low by the standards of the region but a considerable improvement. As a result of this and also significant increases in collection efficiency (now around 90%) EPS is now able to cover its operating costs and some debt service. The 2004 draft accounts show a 2% operating loss and a 9% net loss (after deduction of interest and other financing costs). In 2004 total sales of EPS are estimated to have been about 78 billion dinars ( 1 billion; US1.3 billion) and EPS invested about 12 billion dinars principally for the Kolubara lignite mine. While many of the challenges faced by EPS are similar to those faced by other power utilities in the region, there are certain special factors in the Serbian situation which present unique difficulties for the power company. Perhaps the most significant in terms of economic impact in the medium and longer term is the company s dependence on lignite-fired thermal stations (67% of generation in 2004, a proportion which is likely to rise) which are supplied with fuel by relatively inefficient open-cast mines. The company s ability to control and reduce costs in this area is constrained by social and political factors. They are also continuing to pay salaries to some 6500 staff from Kosovo. The other factor having a major bearing on EPS financial resources and requirements is the burden of mainly pre-war debt, which amounts to US$1 billion, excluding any debt incurred for assets in Kosovo. The Paris Club group of creditors has agreed to a 65% write-down of the outstanding balance with the government, and EPS is assuming this write off although they have not yet received formal confirmation that this benefit will flow to them. The current business plan for the future prepared by EPS necessitates steep tariff increases to support the level of investment. An analysis of the underlying numbers shows that it is possible for EPS to tum around financially, but this will require a balance of improving operational efficiency (cost control in operations including mining, reduction of distribution losses, improvement of collections); agreement on rescheduling or canceling old debt; adoption of a sustainable path of tariff increase; and development of an affordable investment program based on priority investments needed to maintain and increase current production and improve quality of supply. EPS and Government of Serbia are currently in the process of finalizing the business plan and this is expected to be available in the next few months. A tariff increase is anticipated on lst July Subsequent tariff increases will be subject to review by the regulator. Annex 9 shows further details, Technical ECSEE APL. The transmission system in the SEE region meets the minimum physical requirements for a regional market, now that the rehabilitation projects in Croatia and Bosnia and Herzegovina (the latter under the Third Electric Power Reconstruction Project financed by IDA and other donors) have been completed facilitating the synchronous interconnection of the whole region with the main European power system on October 10, Additional interconnections, within the region and with the European Union, will be required to accommodate the projected increasing power flows. The APL program will 14

21 support some of these additional projects, and other donors participating in the Athens process will support others - active donor coordination i s aimed at ensuring that highest priority projects will get funded. The countries and their utilities, even with the help of the donors, will not by themselves be able to fund all necessary generation investments required to meet the growing demand for electricity in the region. Private investment will have to be mobilized and that is one of ECSEE s fundamental goals -the creation of a functioning regional market, with a stable regulatory and market framework capable of attracting private investment. ECSEE APL2-Serbia. The transmission system of Serbia consists of about 1,500 km of 400 kv lines, 2200 km of 220 kv lines and 6400 km of 110 kv lines. Most of these lines, including the associated high voltage substations, are more than 20 years old. This outdated, run-down state of the transmission system has significantly worsened as a result of lack of investment and of damages inflicted on these networks during the Kosovo conflict in While most of the damages have been repaired, the reliability of the high voltage transmission lines and their associated substations remains limited due to the lack of investment in maintenance, up-gradation and expansion of the power system to meet the growing electricity demand and the regional power market integration requirements. This lack of investment in the power networks has caused the Serbian power system (especially the transmission network at 110 kv and below) to suffer from inadequate power transfer capability, bad voltage performance, unacceptably high technical losses, poor power quality and reliability of supply, frequent interruptions in supply and inability, in certain regions of Serbia. The construction of the new 110 kv substations and associated transmission lines will (i) provide the distribution companies, eligible customers, and competing energy producers with adequate and reliable access to the Serbian transmission grid and the future ECSEE regional wholesale power markets; (ii) ensure the reliability and availability of the energy supply to existing and future consumers in their service areas; and (iii) improve the voltage performance and reduce the technical losses and equipment failures and hence improve the quality of electricity supply to the consumers. Such reliable access to the local and regional transmission systems is crucial for successful development of the future regional electricity market and wholesale energy trading. In addition, the construction of the new 110 kv substations and the associated lower voltages switchyards will also facilitate the development of small hydro power plants and their interconnection to the transmission and distribution networks. Fiduciary ECSEE APL. The Bank s standard fiduciary requirements apply also to the projects and utilities supported under the ECSEE APL program. Lending under the ECSEE APL program will be through IBRD loans and IDA credits to individual countries. The Bank will review the financial management systems of the executing agencies and audit reports will be required to be submitted. Procurement will be in accordance with the Bank Guidelines for Procurement under IBRD Loans and IDA Credits (except for components under parallel co-financing) and Bank Guidelines for the Selection and Employment of Consultants will apply. It is possible that, within applicable guidelines, the Bank may agree that borrowers FMS and/or procurement systems be utilized, taking into account experience from other projects where such approaches are piloted. ECSEE APL2-Serbia Procurement. A Country Procurement Assessment Report for Federal Republic of Yugoslavia was prepared by the Bank in June 2002, which found environment for conducting public procurement in Yugoslavia as high risk. A fiduciary update of this report is in progress and expected to be delivered to the Borrower by June However based on the experience of procurement personnel in EPS Corporate Power Distribution Department, it should be possible for EPS to carry out procurement and selection of consultants following the Bank Guidelines. 15

22 Financial Management and Disbursement. The financial management arrangements of the project are acceptable to the Bank. As of the date of this report, the Borrower is in compliance with the audit covenants of existing Bank-financed projects. EPS s previous and current project financial statements and auditing arrangements are satisfactory and it has been agreed that these will be replicated for Component 1 of the project (to be implemented by EPS). Component 2 of the project will be implemented by the TSMO, a company not yet legally established and registered. It has been agreed that, not later than 60 days after the date of effectiveness, the TSMO will inform IDA of the arrangements related to the implementation of component 2, including financial management and disbursement arrangements, The annual audited project financial statements will be provided to the Bank within five months of the end of each fiscal year and also at the closing of the project. Social ECSEE APL. ECSEE s overall social impact is positive. The common objective of the parties adhering to the Athens Memorandum is to stimulate economic growth and investment in South East Europe by improving the availability, efficiency and reliability of network energy sources at reasonable cost. The ECSEE Treaty states that the Regional Members and the Commission are determined to achieve economic and social progress and a high level of employment as well as balanced and sustainable development through the creation of an area without internal frontiers for energy. All SEE countries have the prospect of EU membership and the European Commission had made participation in ECSEE a defacto accession condition. The Stability Pact has characterized ECSEE as a unique political chance for the SEE region, to consolidate reconciliation and provide a power driver towards a more comprehensive economic and political integration into the European Union. The overall social impact of improving power supply; mitigating environmental impacts of the power sector; supporting growth, investment and employment; and facilitating EU accession is positive. All countries in the SEE region are implementing reforms in their energy and power sectors, which inter alia involve tariff adjustments towards full cost recovery and financial discipline including bill collection. This raises the issue of social protection, to ensure that low-income households have access to electricity. ECSEE does not contain additional financial targets or conditions, but reinforces these ongoing national efforts. The Treaty calls for the provision of electricity to all citizens at a reasonable price level that nevertheless allows for adequate cost recovery and reinvestment. ECSEE APLZ-Serbia. This investment will have significant positive impact on people in the areas served by the new substations. Currently, their electricity supply is erratic and unreliable, voltage is low and interruptions are frequent. The magnitude of visible improvement will vary from one station to another, as some areas suffer worse conditions than others. An important secondary impact will be to stimulate further residential and industrial development in the areas served by some new substations, once reliable energy supplies are available. Customers will experience tariff increases as part of the larger scheme of obtaining full cost recovery, not as a result of project investments, as such. The project triggers OP/BP 4.12, Involuntary Resettlement, because some land will be acquired for one of the five substations and the footprints for transmission towers associated with each of the substations, For four out of five substations the company already has land in its possession, and for the remaining one it would need to acquire about 0.2 hectares (See Annex 10). The total land required is minimal and no resettlement will occur as the result. Transmission towers will be placed on the edge o f cultivated areas, reducing impacts on agricultural activities to an absolute minimum. EPS has prepared a modified land acquisition plan, which is being reviewed by the Bank. EPS will implement the plan, following its normal land acquisition procedures that are based on negotiation and rarely result in expropriation, as such. The Bank s safeguards specialists will closely monitor implementation of the land acquisition plan and its impacts. 16

23 Environment ECSEE APL. ECSEE s overall environmental impact is positive. ECSEE accelerates the introduction of EU-compatible environmental legislation and standards in the SEE region. Two specific requirements are particularly noteworthy: (a) new generation plants starting to operate after the ECSEE Treaty is in effect have to comply with the relevant EC standards; and (b) all Regional Members are expected to accede to the Kyoto Protocol within one year of the Treaty s effectiveness. This is an area where the region will require assistance from the international community. The APL program is one potential source of such assistance, for example for the rehabilitation and upgrading of power generation facilities to improve their operational and environmental performance. New generation projects will not be financed under the APL program, but the World Bank Group will consider such projects separately, in parallel with the APL program. ECSEE APLZ-Serbia. The Project is in compliance with the environmental policies and regulations of the Govemment of Serbia and the World Bank (OP : Environmental Assessment). In accordance with OP 4.01, the project has been assigned Environmental Assessment Category B and Environmental Management Plans (EMPs) have been prepared for each of the sub-stations and the associated transmission lines to mitigate the environmental impacts. The Borrower has agreed to implement these EMPs. Through appropriate technical specifications in the bidding document and the contract signed with the equipment suppliers and the contractors the implementing agency of the 110 kv substations will ensure that no PCBs are used in the equipment, and that the noise and electro magnetic field levels generated by the sub-projects are below the Serbian standards (or WHO criteria) and appropriate measures will be taken to mitigate impact of any of leakage of transformer oil in the soil. These measures are included in the EMP a summary of which is provided in Annex 10. Safeguard policies Safeguard Policies Triggered by the Prqject Yes No Environmental Assessment (OP/BP/GP 4.0 1) [XI [I Natural Habitats (OP/BP 4.04) [ I [XI Pest Management (OP 4.09) [I [XI Cultural Property (OPN 11.03, being revised as OP 4.1 1) [I 1x1 Involuntary Resettlement (OP/BP 4.12) [XI [I Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [XI Forests (OP/BP 4.36) [I [XI Safety of Dams (OP/BP 4.37) [I [XI Projects in Disputed Areas (OP/BP/GP 7.60) [I [XI Projects on Intemational Waterways (OP/BP/GP 7.50) [I [XI As described in Section B (Project Components), additional related investments in substations, associated transmission lines, and meters, amounting to approximately US$ 6 million would be proposed for financing by the project. The eligibility criteria, for financing the selected investments, include submission of an EMP and a LAP, satisfactory to the Association, if safeguards policies are triggered by the proposed investments. These criteria are included in the Development Credit Agreement. Policy Exceptions and Readiness No policy exceptions are being sought. The project complies with the Bank safeguard policies and is ready for financing. 17

24 1. ECSEE Annex 1: ECSEE Program and Serbia Power Sector Background ECSEE APL 2-SERBIA The countries o f South East Europe have acknowledged that solutions to these regional issues based on isolated national markets are neither capable nor desirable as a means to attempt to close investment gaps and emerging demand and supply imbalances. Building upon their experience to cooperate in the power sector, in recognition of potential gains from increased trade, and as part of a wider movement to strengthen regional cooperation, the governments of SEE countries and the European Commission (EC) signed the the Athens Memorandum - the Memorandum of Understanding on the Regional Energy Market in South East Europe and its Integration into the European Union Internal Energy Market - on December 8, 2003 in Athens, Greece, whereby they formally expressed their commitment to what is currently called the Energy Community of South East Europe (ECSEE). ECSEE s Membership ECSEE s current membership is as follows: ECSEE s State Parties are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, Romania, Serbia and Montenegro, and Turkey; The United Nations Interim Administration Mission in KOSOVO, administering Kosovo pursuant to the United Nations Security Council Resolution 1244, is an Adhering Party; The State Parties and the Adhering Party together are ECSEE s Regional Members (also referred to as the Contracting Parties); EU Member States Austria, Greece, Hungary, Italy, and Slovenia are Participants. Any other EU Member States can also request to become participants; and Neighboring Non-EU Member States can request to participate as Observers. Currently, Moldova is participating as an observer. ECSEE s Regional Members and the European Commission are currently negotiating to formalize their partnership into a legally binding international Energy Community of South East Europe Treaty (ECSEE Treaty). The Council of the European Union authorized the Commission in June 2004 to open such negotiations, on behalf of the European Union. The negotiations started in July ECSEE s Ministerial Council concluded on December 13, 2004 that there is broad agreement on the substance of the Treaty and directed their negotiators to conclude remaining details as soon as possible. The current time-table calls for the signing of the Treaty in mid-2005 and ratification is expected by mid The Treaty is proposed to become effective when the European Union and a majority of the Regional Members have ratified it. This schedule is reflected in the proposed vertical triggers of the ECSEE APL, with 6-month contingency provisions: signing by end-2005 and ratification by end-2006 (Section 2). Upon accession to the EU, Regional Members (signatories of the Treaty) will automatically cease to be Regional Members and become participants. As members of the European Union, participants are required to meet more demanding electricity market liberalization targets than those set for ECSEE and they will remain eligible to borrow under the ECSEE APL facility. This project appraisal document reflects the December 3,2004 version of the ECSEE Treaty. ECSEE s Objectives The key objectives of the Energy Community of South East Europe (ECSEE) are: Create a stable regulatory and market framework capable of attracting investment to the region in gas networks and power system so that all states in the region have access to the stable and continuous energy supply that is essential for economic development and social stability; 18

25 . Establish integrated regional markets in South East Europe, closely linked to the internal energy market of the European Union, and fully complying with the rules applicable within the European Union; Enhance the security of energy supply of South East Europe and the European Union by providing incentives to connect the Balkans to Caspian and North African gas reserves; and. Improve the environmental situation in relation to energy in the region. The Regional Members are committing themselves under ECSEE inter alia to:... Implement the EC Directives 2003/54 (electricity) and 2003/55 (gas) of the European Parliament and of the Council, June 26, 2003, in full but with a delayed schedule for market liberalization compared to the schedule applicable to EU Member States; and Progressively align their environmental standards to a high common level, including that all generating plants starting to operate after the entry into force of the forthcoming ECSEE Treaty comply with EC standards. All Regional Members are also expected to accede to the Kyoto Protocol within one year of the Treaty s effectiveness. This level of market opening is a highly ambitious target - the EU Member Countries themselves were required to reach this target only by July and may well still be adjusted before the Treaty is finalized. In the EU Member States, all customers including households are to be eligible to choose their supplier by July In ECSEE, this deadline is currently set for January beyond the ECSEE APL program. ECSEE Implementation Mechanism A comprehensive coordination and implementation mechanism has been established for the development of ECSEE. The mechanism covers and brings together political and administrative leadership, regulators, transmission system operators and other utilities, the European Commission, international financial institutions and bilateral donors: ECSEE s Ministerial Council takes place annually with the participation of the Ministers of Energy of the countries and the Commissioner for Energy and Transport of the European Commission. The Council takes strategic decisions and gives guidance to ECSEE and, where necessary, formally reviews the conclusions of other ECSEE bodiedmeetings including the Forum. Once the ECSEE Treaty is in effect, the Council will report annually on ECSEE s activities to the European Parliament and to the Parliaments of ECSEE s Regional Members; ECSEE s Permanent High Level Group is composed of representatives of the Ministers of Energy of the countries and the European Commission. The group meets, when necessary, on the initiative of the Commission and the Presidency in Office, in order to prepare the Ministerial Council and to ensure the follow-up of its decisions; Two Task Forces have been established for ECSEE preparatory work and day-to-day coordination and cooperation: (a) the SEE Energy Regulators Task Force, which works closely with the Council of European Energy Regulators (CEER); and (b) the SEE Transmission System Operators Task Force, which interacts with the European Transmission System Operators (ETSO) and the Union for the Coordination of Transmission of Electricity in Europe (UCTE); ECSEE Forum meets at least twice yearly. It comprises of representatives of the governments, regulators and transmission system operators of the countries, CEER, ETSO, UCTE, producing companies, consumers, the European Commission, the Stability Pact, and donors including the Bank; 19

26 m Donors are members of the ECSEE Forum and usually the donor agencies also meet separately in connection with the Forum meetings. The Stability Pact assigned the role of coordinating the donors to the European Commission in The Commission retains the overall co-ordination, setting political/technical goals and organizing donors. The Commission is funding an Athens Process secretariat, based in Athens, to support the process, inter alia, benchmarking and monitoring; and The Ministerial Council, the Permanent High Level Group and the Forum are already operational and they would be recognized in the ECSEE Treaty. In addition, two new bodies, a Regulatory Board and a Regulatory Secretariat, are to be set up under the Treaty: 0 The Regulatory Board would monitor the implementation of all statutory, technical and regulatory rules and would report directly to the Council. The Regulatory Board would be composed of one representative each of the energy regulators of the Regional Members. The European Commission would represent the European Union, assisted by one regulator of each Participant; and The Regulatory Secretariat would monitor ECSEE s development, in particular the functioning of the energy market and the promotion of common security of supply policies. The Secretariat would assist the Council, the High Level Group, the Forum and the Regulatory Board. ECSEE Market Vision and Sustainability The current situation and the key dimensions of the short- and long-term vision for a sustainable electricity market can be briefly outlined as follows: ECSEE Participation: The main utilities in the region are already engaged in power trading, which provides the basis for further development. The next steps will be bilateral contracts involving unbundled utilities and large customers; followed by expanding trade as electricity markets in each country are further opened and additional customers become eligible and start exercising the freedom to choose their electricity supplier; Market Sophistication: Some of the countries are already developing day-ahead markets (operated by market operators) and real-time balancing mechanisms (operated by system operators). Over time such markets and mechanisms will become increasingly standard; and further sophistication will be developed, including intra-day and real-time balancing markets and financial instruments (possibly starting with a contract exchange); Competition: Current utility-to-utility contracts and other exchanges are typically cooperative and competition is not their key objective. As industry unbundling deepens and in line with market opening across the region, contracting and trading will become increasingly competitive. However, transmission system operators will continue to coordinate on a cooperative basis, as members of ETSO and in the framework of the UCTE; and Integration of ECSEE into the European Union Internal Energy Market: Croatia and a part of Bosnia and Herzegovina had already been interconnected and their power systems operated synchronously and as a part of the main European power system administered by UCTE. The rest of South East Europe (except Turkey) was synchronously interconnected on October 10, 2004, following the completion of rehabilitation in Croatia and Bosnia of facilities required for the synchronous interconnection of the whole region with the main European power system. Additional transmission links to the EU countries will be developed. They include a second connection between Romania and Hungary (with EBRD financing for implementation), and second connections between Serbia and Hungary and Croatia and Hungary, and a connection between Croatia and Italy/Slovenia (the last three interconnections are candidates for financing under the ECSEE APL). Through integration the region secures access to a major trading partner and an important import source to meet possible electricity shortfalls and emergency support. This highlights the electricity/economy dimension in ECSEE s integration into the European Union internal energy market. 20

27 ECSEE Risks and Potential Controversial Aspects ECSEE has been developed and is being implemented through a comprehensive coordination and implementation mechanism. It has gone through extensive discussion and debate. The Bank s work in the ECSEE context, published in the March 2004 framework paper, has highlighted risks and contributed to risk mitigation measures. Risks are being minimized by adopting a gradual approach to market opening and voluntary approach to trading. Though market is being opened, meaning an increasing number of electricity consumers will become eligible to choose their electricity supplier, trading is not mandatory but voluntary between willing sellers and willing buyers - customers in individual countries need not and are not expected to move at the same pace. The pace of liberalization may nevertheless trigger controversy. Adjustments can be accommodated in the finalization of the ECSEE Treaty, including derogations and subsequent modifications in accordance with the practice of the European Commission. Potential controversies can be occasionally expected in the development of new generation capacity, where individual countries may propose projects that are not necessarily optimal choices in the regional context, in terms of size, fuel choice, location or commissioning schedule. ECSEE implementation mechanism provides a number of venues to discuss and resolve such issues, including the Ministerial Council as the final step. The Bank-administered currently ongoing generation investment study is expected to help identify the highest priority regional projects, in part facilitating the resolution of potential disputes. Another potential area for controversy, also mainly in the area of power generation, is the progressive upgrading and implementation of environmental legislation in countries that do not have short-term prospects of EU accession. The Regional Members are to progressively align their environmental standards and specifically, new generation plants starting to operate after the ECSEE Treaty is in effect have to comply with the relevant EC standards, and the countries are expected to accede to the Kyoto Protocol. The potential controversy is not about the desirability of these objectives but their affordability - this is an area where the region will require assistance from the intemational community. It must be emphasized that the SEE region faces a fundamental risk of not being able to meet the growing demand for electricity. ECSEE is regarded as the best possible mitigation measure for that risk, which if it materializes, would threaten the economic growth prospects and affect the quality of life in the region. Through ECSEE - a regional market of countries with harmonized and EU-compatible legislation and institutions underpinned by a legally binding intemational Treaty - the region will develop an EUcompatible regional market and thereby represent a much larger and more attractive investment destination to prospective investors. Integration of ECSEE into the intemal energy market of the European Union will not only provide the region opportunities to export energy into the Community, but to also import energy to help meet shortfalls, including system emergency situations. Plant-by-plant costs of electricity generation vary within countries and across the region. In a regional market and as market liberalization advances, customers who exercise their fkeedom to choose their supplier will naturally seek competitive suppliers. This will put pressure on higher cost and less competitive suppliers to improve their performance. But there is also potential for controversy: (a) some of the most uncompetitive plants may be forced to close; and (b) some of the less attractive/reliable customers may end up paying more for their electricity as generators/suppliers will prefer to sell to more creditworthy clients, possibly located in other countries. In principle these kinds of potential controversies are part of any functioning market. However, it is expected that countries will seek to mitigate some of the impacts in the transition period by managing the initial power contracting process. The projected tightening electricity demand and supply situation in the region will also provide more time for the higher cost generators to improve their performance before competition increases along with new investment. However, for the same reason, tightening demandsupply outlook, less creditworthy 21

28 consumers will find it increasingly difficult momentum to improve payment discipline, to secure power supply. This should provide a powerful 2. ECSEEAPL The Use of Adaptable Program Lending (APL) for ECSEE. The key policy and institutional elements for an APL program have been defined and established. The Energy Community of South East Europe (ECSEE) is a regional program, with strong country commitment and with well-established coordination mechanisms at the highest political level, at the level of regulators and transmission companies in the region, as well as among donors supporting the program, plus the ECSEE Forum which brings them all together with other stakeholders. ECSEE is a regional program and the Bank investment support is being provided using the APL instrument, horizontally on a regional basis (to support up to eight countries and Kosovo) and vertically (each country can in principle receive support from more than one APL installment over the APL program period). An APL enables the Bank to provide regional financial support to a regional program, yet financing could be tailored to the needs of individual countries to help them meet their commitments to ECSEE. APLl presented the ECSEE program and the first country project in Romania that the Bank would finance. APLl was presented to the Board on January 27,2005 -the Board approves all first-phase APLs under regular procedures. The approval of subsequent APL phases was delegated to the President and exercised by the Regional Vice Presidents under the oversight of the Managing Director. Subsequent country projects would be processed each at its own pace and when ready, each PAD would be submitted for approval by ECA s Vice President. Each PAD would be circulated to the Board for information after Management approves the follow-on operation in principle. Management approval becomes effective 10 working days thereafter, unless at least three Executive Directors request a regular Board discussion during the 10-day time period. Each country/project could proceed at its own pace and not be held back by the Bank needing to combine several projects for the purpose of processing or approval, APLs typically have 3-5 phases. In the case of the ECSEE APL, APLl presented the first country project in Romania together with the APL program. APL2 phase would cover other country projects approved within FY05, APL3 phase would cover country projects approved in FY06, and APL4-5 phase projects approved in FY this phasing provides for a four-year program (FY05-FY08). Each APL installment would have an implementation period up to five years. The implementation of some of the projects in APL5 could continue until FYO13. APL Triggers. Two sets of triggers apply under the APL. Policy triggers determine the eligibility of an individual country to receive Bank assistance under the APL program. Project triggers determine when an individual investment is eligible to receive Bank funds. Policy Triggers A fundamental eligibility criterion for a country to qualify for Bank support is the signing o f the Athens Memorandum - all prospective clients signed the Memorandum on December 8, 2003 and thereby they all meet this requirement (the Athens Memorandum is the base document of the ECSEE). Horizontally under the regional APL, a country becomes eligible to borrow once it has met ECSEE s basic entry conditions as they were defined in the Athens Memorandum - the ECSEE APL requirements are that an electricity sector regulator and a transmission system operator have been established and are operational. It is currently expected that all Regional Members would meet this condition by mid-2006 at the latest. Vertically, a country remains eligible for Bank support under the ECSEE APL program as long as the country signs and ratifies the ECSEE Treaty and meets its key obligations under the Treaty: 22

29 \. signs the ECSEE Treaty; a ratifies the Treaty; establishes distribution system operators; and. opens its electricity market to non-household customers. For a countryborrower to be or remain eligible for Bank support under the APL program the Bank also needs to be satisfied that the countryborrower has the ability to effectively participate in the regional market. With this trigger, the Bank would reserve the right to defer or withhold ECSEE APL support in cases where a country might have complied with the letter of its ECSEE Treaty commitments but not have implemented or launched credible programs of other critical measures that are needed for market participation such as, for example, reasonable tariffs, adequate bill collection, and systems for electricity market and power system operations. The current version of the ECSEE Treaty calls for the establishment of distribution system operators by January 1, 2007, and for the opening of the electricity market to all non-household customers by January 1, It is possible that in the course of the final negotiations of the ECSEE Treaty, these ambitious deadlines are adjusted - the Athens Memorandum contained even more aggressive targets which have since been reviewed and adjusted. The target dates that will be applied as triggers under the ECSEE APL program will be those incorporated in the final version of the Treaty including derogations and subsequent modifications agreed by the European Commission and ECSEE Regional Members. Triggers will not be applied to loans/credits already approved. As an example, the loan approved as part of APL1 to Hidroelectrica SA in Romania does not have conditions (equivalent to dated covenants) about the country having to meet future triggers (that apply to APL2-5) and a possible failure to meet such future triggers will not jeopardize the implementation of projects that are under implementation, CAS Framework Bank assistance to the individual projects will be committed through loans and credits to individual countries within the Country Assistance Strategies:. By signing the Athens Memorandum, countries have signaled their commitment to the regional market. This does not automatically mean that each country would be interested in borrowing from the BanWIDA - as of September 2004, Bulgaria and Croatia have not shown strong interest;. There might be cases where the country program cannot accommodate additional projects. IDA countries are expected to be able to get additional IDA resources for their participation in a regional program. Apart from such possible additional allocations due to the regional nature of the APL program, all IBRD loans and IDA credits will have to be considered in the CAS frameworks and limits of the country programs. Compliance by the country/utility of its commitments under ongoing Bank operations in the powedenergy sector will not be an additional trigger. The use of the APL program as an additional leverage to address issues under ongoing operations will be limited to areas where non-compliance affects the utility s ability to participate in the regional electricity market, for two reasons: (a) to retain strong regional approach and focus on ECSEE; and (b) to keep the implementation of the APL program manageable. This approach is in line with the IDA pilot program for regional projects, which calls for flexibility even when a country is in arrears to the Bank, if its participation is crucial to the success of a regional project. Components for Bank Financing. The Bank has prepared a strategy for Bank support for regional energy trade under an ongoing ESW activity. The ESW highlights that significant investments are required in power generation, transmission and distribution for a well-functioning power market. The Bank would be prepared to consider a broad range of investments for support under the APL program: 23

30 (a) Power Generation. Major new generation projects are not proposed for Bank financing under this APL program: (a) Regional prioritization of possible projects is not yet available. It will be established under a recently launched study (one of the Bank s contributions to ECSEE is the administration of this study, at the request of the European Commission); and (b) Bank Group participation in such large projects is better dealt with on a case-by-case basis due to their large financing needs. However, the Bank would be prepared to consider plant rehabilitations in cases where the priority and cost-effectiveness of the renovations can be readily established. Such projects offer one of the best approaches to provide ancillary services to power system operators (ancillary services include all services other than the production of energy provided by generators necessary for the operation of the power system, such as frequency support, reactive power, and spinning reserve), by restoring capacity and improving plant availability and load-following capability (ability to follow dispatch instructions from system operators). This is in line with the Athens Memorandum, which highlights the inclusion of plant rehabilitations among regional investment priorities. (b) Power Transmission and System Operations. The region requires additional interconnections including links to UCTE. These main projects have been studied and prioritized by USAID as part of ECSEE preparations. Albania-Montenegro, Serbia-Hungary, Croatia-Hungary, Macedonia-Albania, Hungary-Romania and Bulgaria-Greece are among the highest priority links. Interconnection of Turkey (expected to be developed in ) and the Kosovo-Albania interconnection (being studied under Bank financing) were beyond the scope of the USAID study, but both are clearly also high priority items. Other high priority transmission investments will also include transmission line and substation reinforcements within individual countries - a link between two countries or between the region and UCTE will be useful only if power can be moved across countries with reliability. Transmission system operators in the region are typically also responsible for system operations. This is an area where several countries will need to upgrade their facilities and install new load dispatch and communication systems. A study carried out for USAID recommended the following projects for submission to international financing and commercial credit institutions: Croatia, Macedonia, and Serbia and Montenegro. The EBRD and EIB are currently considering financing the project in Serbia, but Croatia, Macedonia and Montenegro are yet to confirm financiers. (c) Power Distribution. Power distribution projects are typically local undertakings and Bank Group support would continue to be provided mainly under individual country projects, for example, distribution reinforcement projects to modernize aging systems and reduce system losses. However, the Bank would support metering and/or telecommunications programs, which are designed to quickly enhance revenue realization and/or coordination and communications capabilities of distribution utilities so that they can more effectively participate in the regional power market. (d) Technical Assistance. Along with investments, APL projects can finance a wide range o f technical assistance: 0 Institutional Development - establishing and/or strengthening the regulators, transmission companieshystem operators/market operators, and distribution system operators to implement the required rules, codes and regulations, power exchanges and settlement systems, etc.; and 0 Project Preparation and Implementation - engineering and environmental services to (1) prepare projects for financing by the Bank under alter APL installment and/or by other financiers and (2) help implement projects. Environmental Considerations. The Bank s standard environmental requirements would apply to projects supported under the APL program. An environmental management plan acceptable to the Bank would be finalized and disclosed in the country and submitted to the InfoShop prior to project appraisal of category B projects. More comprehensive environmental impacts assessments would be required for category A projects, if any. Most projects to be financed under the program are expected to be category B projects, but some generation renovation projects might receive category A ratings. The APL instrument 24

31 is well suited to dealing with the uncertainties and delays that environmental management plans, assessments and consultations often cause in Bank projects. Unlike a regular multi-component investment project, which gets delayed if any of its components get delayed, under the APL program, other APL projects can proceed and only the one APL project that is delayed is affected. Therefore, it does not appear necessary to automatically exclude all generation projects from further consideration but it is important to identify potential projects early and then launch preparatory work including environmental assessmentdmanagement plans to avoid delays on that account later. The US$l.O Billion ECSEE APL Lending Program Finance Perspective. The US$1 billion size of the ECSEE APL facility approved by the Bank may appear to be very large, and it represents a significant commitment in ECSEE by the Bank. However, the financial requirements of power development in the region are very large, and the Bank s US$ 1.O billion has to be seen in this perspective. The SEE region faces a fundamental risk of not being able to meet the growing demand for electricity. Significant capacity additions (of the order of 12,000-15,000 MW) and plant rehabilitations (of the order of 8,000-9,000 MW) will be required during the next ten years, along with matching transmission and distribution system investments if demand is to be met and severe power shortages and supply interruptions are to be avoided. Financing requirements are of the order of some US$30-40 billion and these are conservative estimates. The bulk of such financing, particularly in power generation, can not be raised in the public sector alone, without significant private sector participation. Through ECSEE - a regional market of countries with harmonized and EU-compatible legislation and institutions underpinned by a legally binding international Treaty - the region will develop an EUcompatible regional market and thereby represent a much larger and more attractive investment destination to prospective investors. ECSEE APL Country Programs. A tentative country breakdown is given below: Bank Financing under the ECSEE APL Program NJS$ million) APLI APL2 APL3 APL4 APL5 FY05 FY05 FY06 FY07 FY08 TOTAL ALBANIA BOSNIA AND HERZEGOVINA BULGARIA CROATIA KOSOVO MACEDONIA ROMANIA SERBIA AND MONTENEGRO TURKEY Unallocated TOTAL ,000 The above APL financing plan includes a proposed unallocated portion of US$lOO million (about lo%, in principle available any time when needed in the FY05-08 period), which could be used to fund projects in Bulgaria and Croatia (which have not expressed strong interest in the APL facility) and/or provide higher volumes to others, or if not needed, would simply not be committed. 25

32 3. Serbia Power Sector During the 1990s, a period characterized by armed conflicts, international sanctions, and trade shocks stemming from the break-up of the Socialist Federal Republic of Yugoslavia, Serbia faced severely reduced output and foreign trade, high inflation, large hidden fiscal deficits, and large external and fiscal obligations. Since the political changes in 2000, Serbia began to implement reforms and has made remarkable progress in a range of areas. Its broad ranging structural reforms include a new marketoriented and regionally-focused energy sector strategy, industry and market restructuring, and electricity tariff reforms. Since 2000, it has achieved four successive years of solid economic growth (averaging over 4 percent per year), inflation in single digits, a broadly stable exchange rate, declining external and public debt as a share of GDP, increased foreign reserves, and significant reduction in the energy sector related quasi-fiscal deficits. With resumed economic growth, demand for electricity is expected to grow at an annual average of 2% per annum in the medium term such that by 2010 the electricity demand i s expected to reach a level of 35 TWh, up from about 3 1 TWh in The energy sector was among the main sources of instability in the Serbian economy for several years. The state-owned energy sector entities were significant contributors to fiscal and quasi-fiscal deficits of the economy on account of their low operational efficiencies, high levels of financial losses, and debt service defaults caused in part by energy prices being lower than the cost of supply. Low energy prices (0.9 US cents I kwh electricity in October 2000) caused the quasi-fiscal deficit to soar to about US$1.1 billion or 10 percent of GDP in the beginning of Damages fiom the war in 1999 and economic sanctions were also contributors to instability in the sector. A strong commitment by the Government to implement public expenditure management and energy pricing reform has since then virtually eliminated the quasi-fiscal deficit from the energy sector. The average electricity tariff reached 3.7 US cents / kwh in July 2003 and is currently 4.3US cents equivalent I kwh.* The quasi-fiscal deficit arising from the energy sector has since declined to about 4 percent in 2002 and is expected to be eliminated by The Government has implemented an innovative block tariff structure since 2001 and since then has adjusted it to strengthen incentives for efficient end use. The rates for non-household consumers are set for different voltage levels reflecting supply of cost differentials, and are disaggregated into capacity costs, energy costs and reactive energy costs. The energy costs have been further disaggregated into day and night time energy costs. Rates for residential customers are structured in three blocks, with the highest block tariff over three and half times that of the lowest block. Prior to 2004, over 70 percent of consumers were in the lowest block (600 kwh). This large first tariff block discouraged energy efficient behavior. However, effective July 2004 the lowest block has been reduced to 350kWWmonth. Although rising tariffs have caused predictable affordability concerns, a range of targeted subsidy mechanisms have helped to cover basic needs. Power Sector Physical Infrastructure. Serbia is in the geographic center of the South East European electricity network. The total effective installed generation capacityg in Serbia is 7,120 MW, of which 2,831 MW (40%) is hydropower, 3,936 MW (55%) is lignite-fired thermal power plants, and 353 MW (5%) is oil or coal-fired combined heat and power plants." The two principal indigenous sources o f primary energy are proven reserves of about 2.5 billion tons (reserves to current production ratio of about 75 years) of low sulfur lignite deposits with a calorific value of about 7,500 KJlkg and about 3,000 MW of hydroelectric potential (1,050 MW of planned capacity, 1,502 MW of possible new capacities larger than 10 MW each, and 492 MW of capacities smaller than 10 MW each). The Serbian power system i s interconnected to power systems of neighboring countries through 400 kv and 220 kv transmission tie lines. Serbia will need to import a modest amount of electricity, mainly to offset variations in water flows and weather severity in winter Tariff is 2.55 Dinars (3.5 Euro cents i kwh, or 4.33 US cents ). Serbia has a name-plate capacity o f 7,495 MW but several generation units have been de-rated. lo Figures provided exclude Kosovo. 26

33 ~ months. These imports are not expected to exceed 620 MW or 3,500 GWh, representing about 10 percent of total electricity demand under optimistic scenarios. Economic decline and war damages during the 1990s contributed to inadequate maintenance and insufficient rehabilitation of ageing facilities and networks in the electricity sector of Serbia. The average age of the thermal power units and hydropower units are 22 years and 27 years, respectively and that of transformers and switching equipment in high voltage (400 kv, 220 kv, and 110 kv) substations is about 20 years. The transmission network was not upgraded for a period of 20 years preceding While significant improvements since war damages and economic sanctions have been made, problems with operational performance remain. Although the system load factor is relatively low at about 55 percent, problems in reliabilityhtability and quality of supply persist. Transmission and distribution losses in the range of 18 percent are high by Westem European standards. Collections to billing have improved to about 90% in 2003 from 60% in 2000, and this has been maintained in Despite improvements especially in collections from residential consumers, collections from high voltage consumers continue to be low. EPS is also implementing debt work-outs with debtors including a combination of write-offs and rescheduling as reward for being current on existing billings. POWER SECTOR REFORMS IN SERBIA After the end of the conflict, Serbia and Montenegro succeeded to the Bank's membership of the former Socialist Federal Republic of Yugoslavia in May 2001 and launched a broad ranging program of economic and institutional reforms. The TSS , and the current CAS , support the government strategy of implementing the European Union Stabilization and Access Program (SAP), and Poverty Reduction Strategy paper (PRSP). The medium-term goals of this reform agenda - which include inter-alia creation of a smaller, more sustainable, more efficient public sector, and creation of a larger, more dynamic private sector-provide a back drop in which energy sector reforms in Serbia are being implemented. In the power sector, Serbia has decided upon a policy of deepening integration with the region and eventually with the EU internal electricity market. The passage of the new Energy Law of August 2004 by the Serbian Parliament and the adoption of an Energy Strategy by the Government in December 2004 put in place a basis for optimizing the benefits competition would bring from the enlarged regional market for Serbia. The Energy Law introduced a framework for energy sector restructuring and liberalization which in the power sector is as follows: unbundling of the vertically-integrated EPS into generation, transmission and distribution entities; operation of the transmission and dispatch system, market operation and settlement by an independent Transmission, System and Market Operator; regulated non-discriminatory third party access to the transmission and distribution system; and the creation of an independent Regulator to regulate tariffs and oversee the proper functioning of the market. The Energy Law envisages a phased liberalization of the electricity market, in which initially large nonhousehold consumers would be allowed to contract directly with domestic or foreign generatars or energy traders for their supply and buy electricity at market prices. Such consumers are designated as eligible consumers and the threshold for their annual consumption would be gradually reduced so that by a target date" all non-household consumers would become eligible consumers and buy electricity at market prices.'* Consumers other than eligible consumers are designated as tariff customers and they will buy " To be determined by ECSEE in consultation with the regional members. l2 All eligible consumers will have the freedom to remain as tariff customers, if they so desire. 27

34 electricity from the distribution company serving their area at regulated prices. The distribution companies and generation companies separated from EPS would be classified as public companies with an obligation to first meet the requirements of tariff customers at regulated prices before selling any part of their generated or purchased electricity at market prices to eligible consumers or for export sales. New investor-owned generation companies in Serbia will not have such obligations and can sell their entire output at market prices. To ensure security of supply to tariff customers and to insulate them substantially from price volatility and sustained high prices, a state owned non-profit wholesale trading company would be established which would have an obligation to meet the needs of the tariff customers on a least cost basis. It would be obliged to buy the power requirements of tariff customers from domestic public generation companies at regulated prices, and from private generation companies (domestic or foreign) at market prices based on least cost considerations and sell power to public distribution companies on the basis of pooled average prices. It can sell any part of its purchased power at market prices to eligible customers only after meeting fully the requirements of tariff customers. The public distribution companies would be obliged to buy all the requirements of their tariff customers from the said wholesale trading company. Thus domestic generation companies would face competition from foreign suppliers, tariff customers would have security of supply and relatively stable prices,13 while the eligible customers would enjoy a choice of their supplier. An independent regulatory agency is expected to be established and registered in the Trade Court no later than beginning of July The Serbian Energy Regulatory Agency would be governed by an Agency Council consisting of five members including a Chairman, appointed by the National Assembly for a four year term, which can be extended for a maximum of another four years. The five members will be appointed by the Serbian Parliament and would include experts in generation, transmission, law, and economics. The regulatory agency will regulate retail tariffs for tariff customers, tariffs for transmission and distribution services and generation tariffs for sale to the wholesale trading company based on the cost of service methodology with a level of retum approved by the government. As a licensing and monitoring agency for energy-related businesses (mainly power, gas and mining) it would ensure third party access to the transmission and distribution systems and function as an authority to resolve disputes within the sector. In addition to developing secondary legislation for transmission tariff methodology and Grid Code consistent with ECSEE requirements, key challenges for the regulatory agency will be the oversight of transactions of the wholesale trading company to ensure transparency and the company's compliance with the least cost purchase criterion, promote efficiency of operation and improvement in customer service by the distribution companies, monitor compliance by the licensees with their license obligations, and facilitate market deregulation and new investments. For establishing the envisaged TSMO, the necessary Foundation Act was approved by the Government in December The name of the TSMO is expected to be Elektromreza Srbije (EMS). The EMS is a public enterprise owned by the Republic of Serbia and established by the Republic of Serbia Government Decision 05 No , published in Gazette no. 12, dated February 8, 2005,' and is expected to be registered by the Republic of Serbia Business Registration Agency and operational from July 2005, much ahead of the ECSEE deadline of mid The TSMO will be a government-owned company, independent of EPS. The EAR has engaged consultants to help develop the TSMO organizational structure, business plan, Grid Code, Market Code, Metering Code, and contracts between the TSMO and other market participants, a fully operational system and market operation software and training of staff in management and operational skills. At present, Elektroistok - a subsidiary of EPS- operates the transmission system while the system control and dispatch is managed by the Department of Power System control of EPS. When registered, the l3 Such a protection of tariff customers is considered prudent in the context of projected regional market capacity deficits in the medium term. 28

35 TSMO will take over all these functions. In effect, Elektroistok will get transformed into a separate legal entity as TSMO. The assets, liabilities, contracts, concessions, and staff will be transferred to the TSMO after its organization structure and a business plan has been developed. While significant progress has been made in stabilizing performance, further progress in reforming the sector structure to position it to take full advantage from regional competition is needed in the short and medium term. The introduction of regional competition is expected to be a key driver for greater efficiency improvements in the power sector. Given the heterogeneity of regional resources, noncoincidental peak demand, and sharing of reserve capacity, regional competition could spur greater efficiency in EPS. It could provide an opportunity for reduced electricity costs and increased exports. Over the medium term, the rehabilitation of hydro power stations will position the Serbian power providers to provide high value ancillary services, improving the reliability of the regional power system. To meet projected load growth and improve reliability and quality of supply, the EPS is implementing a plan for the (i) rehabilitation of generation capacities to improve efficiency and availability; (ii) rehabilitation and augmentation of transmission facilities to fully restore links to adjoining systems and transmission capacity within the country; (iii) rehabilitation and augmentation of distribution facilities to reduce losses, theft and improve reliability; and (iv) end use efficiency improvements and demand-side management. Removing bottlenecks, upgrading control systems and improving stability of the power system are critical to expanding the role of competition in the early stages of implementing the ECSEE in all countries. In Serbia, the European Agency for Reconstruction, European Investment Bank and European Bank for Reconstruction and the donor community have made investments in the high voltage transmission lines and control systems and software. The proposed Project complements these investments by rehabilitating or upgrading the transmission-distribution interface at key bottlenecks in the system. Large, nonhousehold customers (eligible customers) connected to the distribution networks will benefit from these investments by gaining access to the competitive suppliers. 29

36 ECSEE Annex 2: Major Related Projects Financed by the Bank and/or other Agencies ECSEE APL 2-SERBIA The following is a selective listing of related projects and highlights of those that are directly supporting ECSEE s development. The World Bank has ongoing projects in the electricity sector in most ECSEE countries, and technical assistance in Kosovo. These projects support various aspects of power sector reform and restructuring, including financial aspects, and inter alia help build the foundation for the development of a regional electricity market and participation by the respective countries/utilities. The Third Power Reconstruction Project in Bosnia and Herzegovina is instrumental for the resynchronization of the second UCTE zone (Eastern part of Bosnia, plus Albania, Bulgaria, Macedonia, Romania, Serbia and Montenegro) with the Westem part of Bosnia and Croatia, and the main UCTE Western Europe power system. The European Union supports power sector reform and restructuring under its technical assistance operations in the region. Through its PHARE program, in a large project co-financed with EXB and EBRD, it is also providing investment support to Transelectrica in Romania. EBRD has ongoing power sector projects in Albania, Bosnia and Herzegovina, Bulgaria, Macedonia, Romania and Serbia and Montenegro, including private sector power generation in Bulgaria. EBRD has just approved a project that will implement the second interconnection between Hungary and Romania. This interconnector will be one of the means for the integration of ECSEE into the intemal market of the European Union. EIB has ongoing power sector projects in Bosnia and Herzegovina, Bulgaria, Macedonia, Romania and Serbia and Montenegro, often in co-financing arrangements with EBRD and/or the Bank. KfW has ongoing power projects in Albania, Bosnia and Herzegovina, KOSOVO, Serbia and Montenegro, and Turkey. Technical Assistance. Several Bank projects also provide technical assistance. Most noteworthy in this context are the ongoing projects in Romania and Turkey, which support the development of electricity markets. CIDA of Canada is providing regional technical assistance (the SEETEC project) for the development of regional electricity market in South East Europe. USAID is providing technical assistance on legal and regulatory aspects of power reforms and restructuring, including institutionbuilding support to the regulatory agencies, throughout South East Europe, as well as regional studies on power trade and required communication facilities for the development of ECSEE. Annex 5 of the Bank s March 2004 framework paper contains a comprehensive listing of technical assistance in the ECSEE context. The Italian Government may provide technical assistance for ECSEE preparatory work to ECSEE Regional Members. The Spanish Government has provided support through a trust fund to help the Bank review ECSEE investment projects. All of these agencies/countries except Spain are members of the ECSEE Forum. Serbia. The following is a listing of relevant energy projects that have been funded by the World Bank and other IFIs and bilateral donors: International Development Association The Association has provided funding for the following projects: P Electric Power Emergency Reconstruction Project ($6 million), co-financed by SIDA for development of a financial management system in EPS. P Serbia Energy Efficiency Project ($21 million). 30

37 European Agency of Reconstruction (EAR) Since 2000 EAR has provided 300 million of assistance to the energy sector for rehabilitation of assets and technical assistance for: P establishment of an electricity market in Serbia; o establishment and operation of the Serbian Energy Regulatory Agency; P preparation o f EIB loan for transmission, through preparation of technical specifications, tendering and procurement assistance; P management training program for EPS; and o provision of hardware and software ( 3 million) necessary for system and market operation. European Bank for Reconstruction and Development (EBRD) EBRD is providing financing for the following projects: o Rehabilitation projects (Power I Project of 100 million) in both generation and transmission. Power system control and communication upgrades (Power I1 Project of 60 million). Canadian International Development Agency (CIDA) CIDA has provided funding for the following technical assistance: o blueprint for the unbundling of the power transmission function from EPS and the establishment of an independent Transmission System and Market Operator (TSMO); and business plan and the financial engineering for the rehabilitationheconstruction of the broadband fiber optics telecommunication network for EPS. State Secretariat for Economic Affairs of Switzerland (SECO) SECO has provided funding ( 10 million) for a new EMS/SCADA to be installed at the Control Center of EPS. European Investment Bank (EIB) EIB has approved funding a loan of 56 million for rehabilitation of 4 substations. United States Agency for International Development (USAID) USAID has prepared the blueprint for the development of the conceptual market design for Serbia. 31

38 Annex 3: Results Framework and Monitoring ECSEE APL 2-SERBIA Results Framework PDO ECSEE APL. The ECSEE APL establishes the ECSEE APL facility for the implementation of priority investments in electricity generation, transmission and distribution and technical assistance for institutionalisystems development and project preparation and implementation for the development of a functioning regional electricity market in South East Europe and its integration into the internal electricity market of the EU. ECSEE APL2-Serbia. Improve electricity market access for consumers and suppliers through increase in quantity, quality, reliability, safety and efficiency of the bulk power transmission system, and strengthen capacity o f the institutions to participate in the regional electricity market. Outcome Indicators Electricity markets in South-East Europe are liberalized in accordance with the ECSEE Treaty (including derogations and subsequent modifications, if any) and a regional electricity market is functioning. Satisfactory implementation of commercial agreements between TSMO, distribution companies, and the eligible customers, Use of Outcome Information An increasing number o f electricity consumers are free to choose their electricity supplier. Provide inputs into the decision for opening the market for eligible customers. Intermediate Results One per Component Construction of new 110 kv substations and the associated transmission lines Results Indicators for Each Component (i) Satisfactory completion of substations and the associated transmission lines; (ii) One year after the substations are hlly operationalized, in their local service area (a) losses are reduced by at least 15%, (b) voltages are within their operating limits, and (c) energy interruptions are reduced by at least 40%. Use of Results Monitoring Facilitate implementation of commercial agreements between the TSMO, the distribution companies, and the eligible customers when the market is opened for them, and provide information for regulatory review, monitoring customer service. 32

39 a d v) a w x s VI B M C L 0.I c).li E s m c c) I 0: L e I m 5 3 M C E * * m N C m * N 4 I I *

40 Annex 4: Detailed Project Description ECSEE APL 2-SERBIA Construction of New 110 Kv Substations And Interconnecting Transmission Lines Background The development of a well functioning regional electric market in South East Europe by 2006 is a goal of the participating countries in the Energy Community of South East Europe (ECSEE). When such a market is developed, the regional transmission system will be called upon to transfer power in levels and directions not experienced to date. In a regional transmission planning study prepared in 2002 by the Interconnection Study Task Group (ISTG) of the South East Europe Cooperation Initiative (SECI) and funded by USAID, it was found that constraints in the Serbian transmission network exist in both the base case of the regional transmission system and in the new interconnection scenarios. Results of the study have shown that constraints in the intemal network of Serbia and in other counties as well, have limited their ability to increase the power transfer capacity of regional interfaces to their maximum potential that the new interconnection scenarios can bring. Due to its location in the middle of the ECSEE regional market and at the center of the East to West and South to North regional interfaces, congestion in the internal network of the Serbian transmission system will impact the level of power transfers in these interfaces and hence the efficiency of the wholesale power market in the region. Therefore, the transmission system in Serbia must be operated, maintained and planned in such a manner as to enable the transport of power and energy from power plants to energy consumers within Serbia as well as to support the expected levels of the regional electricity transfers and trade. The transmission system of Serbia consists of 1559 km of 400 kv lines, 2187 km of 220 kv lines and 6445 km of 110 kv lines. The network is old and run-down and its condition significantly worsened as a result of lack of investment and of damages inflicted on these networks during the war in While most of the damages have been repaired, the reliability of the high voltage transmission lines and their associated substations remains limited due to the lack of investment in maintaining, upgrading and expanding the power system to meet the growing electricity demand and the regional power market integration requirements. This lack of investment in the power networks has caused the Serbian power system (especially the transmission network at 110 kv and below) to suffer from inadequate power transfer capability, bad voltage performance, unacceptable high technical losses, poor power quality and reliability of supply, frequent interruptions in supply and inability, in certain regions of Serbia, to meet the growing demand of existing consumers and electricity demand of new consumers. Furthermore, if replacement of aging equipment is not undertaken soon the failure rate as well as the operation and maintenance costs of this equipment will increase substantially. Therefore, effective operation of the Serbian transmission system with adequate power transfer capability at all voltage levels (400 kv, 220 kv and 110 kv) is crucial to the ability of the Serbian power system to reliably supply energy to its wholesale and retail consumers and to support efficient regional energy trading. EPS has recognized the need to invest in expanding the transmission system infrastructure focusing on priority investment needs to achieve these goals. In the last five years, EPS has performed a series of development and planning studies to determine the priority investments necessary to expand its power networks to improve their performance and to meet the growing demand of electricity. The studies have recommended, based on technical and economic analyses, the following investments, among others, in the Serbian power networks, which EPS has also included in its Work and Development Plan for

41 Construction of 400 kv transformer substations, that include Beograd 20, Jagodina 4, Somber 3 and S. Mitrovica substations and their associated interconnecting transmission lines. This project will be financed through a loan fi-om EBI2D. Reconstruction o f 220 kv transformer substations, that include Beograd 3, Srbobran, N. Sad, Beograd 4, Krusevac, Nis and Leskovac substations and their associated interconnecting transmission lines. This project will be financed by EIB. Construction of new 110 kv transformer substations, that include Arilje, Vranje 2, Jagodina 3, Macvanska Mitrovica, Nis 8 and Mosna substations and their associated interconnecting transmission lines. EPS has proposed these substations for financing through the proposed APL. The construction of the 400 kv and 220 kv substations will strengthen the power transfer capacity of the Serbian high voltage transmission network and its regional interfaces. The advantages of the construction of the new 110 substations are threefold: first, the new substations will provide the distribution companies, eligible customers and competing energy producers with adequate and reliable access to the Serbian transmission grid and the future ESCEE regional wholesale power market; second, the constmction of the new substations will improve the voltage performance and reduce the technical losses and equipment failures and hence improve the quality of electricity supply to the consumers; third, the new substations will ensure the reliability and availability of the energy supply to existing and future consumers in their surrounding areas. Such reliable access to the local and regional transmission systems is crucial for the successful development of the future regional market and wholesale energy trading. In addition, the construction of the new 110 kv substations and the associated lower voltages switchyard will also facilitate the development of small hydro power plants and their interconnection to the transmission and distribution networks EPS has performed detailed engineering and feasibility studies to develop the engineering and technical design for the new substations and to determine their construction costs and expected benefits, ECSEE APL-2 (Serbia) Project consists of two components: Component 1: 1 I O kv Substations and Related Activities The ECSEE APL 2 (Serbia) project will support the construction of five new 110 kv substations. The construction of these five 110 kv substations will be carried in two phases: 0 Component l-a: The first phase of this component includes the construction of two new 110 kv substations (Mackvanska Mitrovica and Anlie), through the financing of goods and consultants services. The consultants services include hiring an international consultant(s) to provide implementation supervision services to the two substations implementing agency. 0 Component l-b: The second phase of this component includes the construction of three new 110 kv substations and carrying out additional related investments and/or services. Component 2: I I O kv Interconnecting Transmission Lines and Related Activities The ECSEE APL 2 (Serbia) project will support the construction of new 110 kv interconnecting transmission lines for the substations selected for investment under Component 1 of the project. The construction of these 110 kv interconnecting transmission lines will also be carried in two phases coordinated with the implementation of the two phases o f Component 1. 35

42 0 Component 2-A: The first phase of this component includes the construction of two new 110 kv interconnecting transmission lines for the substations under Component 1 -A, through the financing of civil and installation works necessary for the construction of the two lines and consultants services. The consultants services will include hiring consultants to provide implementation supervision services to the implementing agency of the two 110 kv interconnecting transmission lines. 0 Component 2-B: The second phase of this component includes the construction of the new interconnecting transmission lines for the substations under Component 1 -B through the financing of civil and installation works of the interconnecting transmission lines and carrying out any additional related investments andor services. Scope of Work The construction of the following 1 10 kv substations and their associated interconnecting transmission lines will be financed through the project: 1. Macvanska Mitrovica 110/20/35 kv Substation: This new substation will be constructed in northwestern Serbia in an area supplied by a 35/10 kv substation with limited transfer capacity (8 MVA) constructed thirty eight years ago. In addition to the limited capacity of the existing 35/10 kv substation, the 35 kv transmission line connecting the substation to the transmission grid has suffered from bad voltage performance, excessive power losses and frequent failures causing energy interruptions to the consumers. The development of the new Macvanska Mitrovica kv substation will include the construction of: Substation: The 110/20/35 kv substation will include a 110 kv bay input for the 110 kv interconnecting line, installation of a 110/20 kv power transformer rated at 31.5 MVA and seven 20 kv bay extensions. The substation will also include an 8 MVA 20/35 kv power transformer to connect the new substation with the existing Modran 35 kv substation. Transmission Line: The substation will be connected to the transmission grid by a new 9.5 km, single circuit, 110 kv transmission line connecting the substation with Macvanska Mitrovica-II400/200/110 kv substation. 2. Nis 8 110/10 kv Substation: This new substation will be constructed northwest of Nis City, located in southeastern Serbia in an area currently supplied by the Nis 8 35/10 kv substation with a limited installed capacity of 8 MVA. The substation is connected to the gnd by a radial 35 kv transmission line. Both the Nis 8 35/10 kv substation and its connecting 35 kv transmission line are loaded to their maximum capacity. This limited capacity has resulted in high voltage drops and excessive power losses in the distribution facilities in Nis City. As a result, this situation has impeded the ability of the distribution company to provide reliable energy supply to its existing consumers and to satisfy the growing electricity demand in the area. The development of the new Nis 8 110/10 kv substation will include the construction of: Substation: The 110/10 kv substation will include a 110 kv switchgear with two 110 kv bay inputs for the 110 kv interconnecting lines and two 110 kv bay inputs for two 110/20 kv power transformers, each rated at 31.5 MVA. The substation will also include one 10 kv switchgear with 34 cells for outgoing feeders, transformation, connection and measurement. 36

43 Transmission Line: The substation will be connected to the Nis kv substation by a 10 km, single circuit, 110 kv transmission line. 3. Jagodina 3 110/20 kv Substation: This new substation will be constructed in the area of Jagodina City, located in central Serbia. The area is supplied by two 35/10 kv substations (Jagodina I and Jagodina 11) with limited installed capacity. The two substations are fed from one 110 kv substation (Jagodina 2). The total load supplied by Jagodina 2 to the two distribution substations i s about 41 MVA, which is much higher than its installed capacity. Due to this limited and outdated installed capacity, the distribution network in the Jagodina area has suffered from high technical losses, bad voltage performance, fi-equent equipment failures, and energy interruptions. The construction of the new Jagodina 3 substation will include a 110 kv switchgear with one 110 kv bay input for a 110 kv cable and one 110 kv bay input for a 1 10/20-10/10 kv power transformer rated at MVA. The substation will also include a 20 kv line feed with 8 switchable cubicles. The new Jagodina 3 110/10-20 kv substation will not require construction of any new transmission line to connect the substation to the transmission system. The substation will be connected by a 200 meter cable to an existing 35 kv transmission line, designed to operate at 110 kv voltage. 4. Vranje 2 110/35 kv Substation: This new substation will be constructed in the southwestern part of Vranje City, located in southeastern Serbia. The area is supplied by the Vranje 3 35/10 kv substation with a transformation capacity of 2x8 MVA. The substation is supplied by an existing 35 kv transmission line connected to the Vranje 1-Bujanovac 1 35 kv transmission line. Both the 35 kv lines were constructed 40 years ago and are already loaded to their maximum capacity suffering from bad voltage performance, excessive power losses and frequent faults resulting in interruptions in the electricity supply to consumers in the Vranje and Bujanovac areas. The development of the new Vranje 2 110/35 kv substation will include the construction of Substation: The new substation will include a 110 kv switchgear with one 110 kv bay input for the 110 kv interconnecting line and two 110 kv bay inputs for two 110/35 kv power transformers, each rated at 31.5 MVA. The substation will also include a 35 kv switchgear to supply power to the local 35 kv substations. Transmission Line: In the first phase the new Vranje 2 110/35 kv substation will be connected to the transmission system by a 6.1 km, single circuit, 110 kv transmission line connecting the new substation to the Vranje kv substation. In the second phase (not funded by this APL) the substation will be connected to the Ristovac 110/10 kv substation by a 3.04 km, double circuit, 110 kv transmission line. 5. Arilje 110/35 kv Substation: This substation will be constructed in the area of the municipality of Arilje, located in the center of western Serbia. The area is currently supplied by the Arlije 35/10 kv substation. This substation is supplied by an existing 13.5 km 35 kv line connected to the Pozega 220/110/35 kv substation. Due to the limited installed capacity and outdated network infrastructure, the power system in Arilje has suffered from high technical losses, bad voltage performance, frequent equipment failures, and energy interruptions. In addition, the growth of the electricity demand by industries in Arilje has outpaced the supplying capacity of the Arlije 35/10 kv substation and its interconnecting 35 kv transmission line. The development of the new Arilje 110/35 kv substation will include the construction of: Substation: The new Arlije 1 10/35 kv substation will include a 110 kv switchgear with two 110 kv bay inputs for the 110 kv interconnecting lines and one 110 kv bay input for a 110/35 kv power transformer rated at MVA. The substation will also include a 35 kv switchgear. 37

44 Transmission Line: The new Arlije kv substation will be connected to the transmission system by a 1.4 km, double circuit, 110 kv transmission line connecting the new substation to Pozega - Ivannica 110 kv transmission line. For any additional related investment to be eligible for financing through the Credit, the proposed investment schemes will be required to meet the following criteria: (a) submission to the Association of a satisfactory project report demonstrating technical feasibility and economic viability of the proposed investments and confirms that these investments are a part of the medium term investment plans of EPS or EMS; and (b) an Environmental Management Plan and a Land Acquisition Plan, satisfactory to the Association, are submitted if safeguards policies are triggered by the proposed investments. Benefits The construction of the new 110 kv substations and their interconnecting transmission lines will fundamentally (a) improve the performance of the 110 kv transmission system and distribution systems (b) improve the quality of power supply to retail and direct customers, (c) enhance the capacity of the Serbian transmission system interfaces with the regional markets and (d) provide the supplying companies and eligible customers a reliable and adequate access to the Serbian transmission system and regional power markets. EPS has performed detailed feasibility and engineering studies to assess the needs, impacts and benefits of the construction the new substation on the performance of the transmission and distribution systems and quality of power supply. The subsections to follow quantitatively summarize these benefits. (i) Lower Energy losses: The construction of the new substations will lower the energy losses in the outdated and overloaded existing 35 kv distribution systems in the areas where the new substations will be constructed. Table 1 shows the losses in the areas surrounding the new substations before and after their construction. The table shows that significant reduction in the energy losses will be achieved, which will result in substantial savings in the system operating cost and increase in revenue. The construction of the new substations will reduce the annual energy losses by a net of MWH/yr. The economic benefits realized from lowering energy losses are discussed in Annex 9. Table 1: Estimated Losses Before and After the Construction of the New Substations Source of Information: EPS (ii) Improve Voltage Performance: In addition to lowering the level of energy dissipated in the network, the construction of the new substations will significantly improve the voltage performance of the distribution network as illustrated in Table 2 showing the voltage drops before and after the construction of the new substations during periods of peak demand in the distribution networks. The table shows the percentage voltage drops at the networks in the areas where the new substations will be constructed will improve by a range of 30 percent to 80 percent during periods of peak demand. It may be difficult to estimate the actual economic and financial benefits of the improvement of the voltage performance of the distribution network. Nevertheless, this improvement will definitely have positive impact on the quality 38

45 of electric service to existing and future consumers and will, as a result, positively influence the growth and development of the service territories where the new substations are located. Table 2: Voltage Drops Before and After the Construction of the New Substations During Periods of Peak Demand Construction Construction Source of Information: EPS ' (iii) Reduce Energy Interruptions: The construction of the new substations will reduce the duration and amount of energy interruptions caused by frequent failures of equipments and facilities of the outdated and overloaded existing 35 kv distribution systems in the areas where the new substations will be constructed. Table 3 shows that the construction of the new substations will reduce the duration and amount of total energy interruptions by 81 percent and 87 percent, respectively. The economic benefits realized from lowering the level of energy not served due to the reduction in the energy interruptions will be evaluated in Annex 9. Table 3: Energy Interruptions Before and After the Construction of the New Substations Source of Information: EPS (iv) Increase Electricity Supply to Customers: The increase in the installed capacity of the transmission and distribution networks resulting from the construction of the new substations will enable the distribution companies to provide higher quality electric service to its existing and new consumers, Table 4 shows that the construction of the new substations will enable the distribution companies to connect to and serve by the new substations approximately of new consumers consisting of about 70 MW of load. Significant portion of these new customers are already being supplied by existing overloaded and outdated 35 kv substations located in the areas where the new 110 kv substations will be constructed. This new load will be transferred to the new substations to relieve the loading of the substations they are currently connected to. The transfer and supply of the new load is expected to occur gradually over a period of five to ten years and not immediately after the energization of the new substations. In addition, portions of this new load will be transferred to the new substations after the completion of their phase 2 expansion (not financed by this Serbia APL-2). Phase 2 expansion of these substations can only 39

46 commence after the construction of the new substations (phase 1) is completed and the financing of phase 2 becomes available. Table 4: Energy Supplied Before and After the Construction of the New Substations Substation MW Load Served Percent Increase Source of Information: EPS Project closing date is set at October 31,2009, and Credit closing date will be February 28,2010. Mid term review for the project is targeted for November 30,

47 ~~~ Annex 5: Project Costs ECSEE APL 2-SERBIA Project Cost by Component Local Foreign Total US$ US$ US$ million million million ComDonent 1 1 I O kv Substations Phase 1 Two 110 kv Substations (supply o f goods) Phase 2 Three 110 kv substation (supply of goods) Total for the 110 kv Substations (supply o f goods) Implementation Supervision Consultants services Total Additional Related Investments (to be identified) I 6.0 World Bank Financing 2.5 I 18.5 I 21.0 Substations Civil and Installation Works Identifiable Taxes and Duties for Substations Total EPS Financing EMS Financing I Interconnecting Lines Civil and Installation Equipment & Materials 1.o o Tdentifiable Taxes and Duties for Transmission Lines Total EMS Financing 1.75 I TOTAL PROJECT COST I I

48 Annex 6: Implementation Arrangements ECSEE APL 2-SERBIA ECSEE APL. A comprehensive coordination and implementation mechanism has been established for the development of ECSEE. The mechanism covers and brings together political and administrative leadership, regulators, transmission system operators and other utilities, the European Commission, international financial institutions and bilateral donors in ECSEE's Ministerial Council, Permanent Highlevel Group, Task Forces, and the Forum. This mechanism is detailed in Annex 1, Section 1. ECSEE APL2-Serbia Component 1 of the proposed Project will be implemented by Elektro Privreda Srbije (EPS), which provides electricity services to approximately 3 million customers. It operates the entire power system in Serbia and has 19 s~bsidiaries'~ (2 coal, 6 power generation, 1 transmission, 10 distribution). General management and support functions are assigned to a Head Office, located in Belgrade, the capital of Serbia. The corporate EPS departments include Economy and Finance, Trade and Treasury, Human Resources, Corporate Finance and Accounting, Information Technology as well as a number of planning departments for generation, transmission and distribution. The transmission system is operated by Elektroistok which will transfer its assets, liabilities, staff, and functions to the new Transmission, System and Market Operator (TSMO) in Serbia when it obtains license from the regulatory agency and becomes functional, expected at the latest July The existing organization structure and the business processes of EPS, which have been found adequate for implementation of this project, would be used. No new arrangements or implementation units are proposed to be created. However, EPS will establish a small team of staff (project implementation team) for the implementation of the proposed Project and coordinate with the Bank. The team will be headed by the Director of the EPS corporate Power Distribution Department who will be responsible for overall project implementation. The team's main function will be to coordinate with relevant departments and subsidiaries to ensure effective implementation of procurement, contracting, contract administration and disbursement, financial management and accounting, and reporting. The preparation of bid documents, user specifications, technical designs and technical supervision will be done in coordination with the EPS power distribution subsidiaries and transmission staff responsible for the operation and maintenance of the proposed Project assets. Component 2 of the proposed Project will be implemented by the TSMO (or EMS), which is in the process of being legally established and registered. IDA will be informed of the detailed implementation arrangements for Component 2 of the proposed Project no later than sixty days after the Development Credit Agreement is declared effective. The arrangements will include information regarding the management and staffing capacity of EMS, including technical, environmental/safeguard, procurement, contract management, financial management and monitoring and evaluation capacity, The legal arrangements governing the Project will be established through provisions in the Development Credit Agreement between Serbia and Montenegro (as the Borrower) and IDA. The proceeds of the proposed Credit will be on-lent to the Republic of Serbia through a Sub-credit Agreement between Serbia and Montenegro and the Republic of Serbia on the same terms and conditions on which Serbia and Montenegro receive the Credit from IDA. The Republic of Serbia will on-lend the proceeds of the Credit to EPS (US$18.5 million equivalent) and to the TSMO (US$2.5 million equivalent) on the same terms and conditions on which it receives the Credit from Serbia and Montenegro. Credit Conditions and Covenants: The specific Credit covenants applicable to the ECSEE APL2-Serbia project are described in Section C of the Project Appraisal Document. l4 Excluding KOSOVO, where 7 more subsidiaries currently operate. 42

49 Annex 7: Financial Management and Disbursement Arrangements ECSEE APL 2-SERBIA COUNTRY ISSUES The 2002 S AM CFAA report noted that there are a number of risks on the management of public funds in SAM. The risks to the public funds include: (a) poor public sector financial management in the past, (b) unfinished reforms - the new governments that were elected have commenced a process of major reform, which looks good as designed, but it is still too early to say if the reforms will be totally successful, (c) capacity constraints in both the Federal and Republic governments, (d) weak banking sectors, (e) weak audit capacity, (0 poor implementation capacity in line ministries, and (g) the lack of recent Bank implementation experiences within SAM. Since rejoining the membership of the World Bank, S AM has been using individual implementation units for each investment project (traditional PIU model), located within the relevant line ministries or project beneficiaries, to mitigate some of these risks. During the period since the CFAA was published, the number of commercial banks assessed as acceptable to hold Special Accounts has increased from 3 to 5 and the number of firms assessed as acceptable to audit Bank-financed projects has increased from 2 to 4, indicating an improvement in the fiduciary environment. Experience in implementing Bank-financed projects i s increasing but the lending portfolio is still too young to be able to conclude that the Borrower has a thorough understanding of Bank operations. STRENGTHS AND WEAKNESSES. The major strengths of the project are; (1) its simplicity - the project will finance 100% of eligible expenditures; and (ii) in terms of implementation, component 1 of the project (representing 85% of all allocated expenditures) is a repeat of the previous Electric Power Emergency Reconstruction Project (EPERP). The major fiduciary weakness lays in the fact that the implementing agent for component 2 will be the TSMO, an entity that has not yet been legally established and registered, and hence the implementation arrangements have not yet been agreed upon. However this risk is mitigated through the use of a dated covenant requiring the TSMO, when established, to inform IDA of the implementation arrangements, such arrangements to be satisfactory to IDA. FUNDS FLOW The IDA Credit will be made available to the State Union of Serbia and Montenegro (SaM) under a Credit Agreement, governing the terms and conditions of the Credit. The Government of SaM would onlend the funds on IDA terms to the Republic of Serbia based on a Sub-credit Agreement with terms and conditions satisfactory to IDA. The Republic of Serbia will on-lend the funds to EPS and the TSMO under EPS and TSMO Sub-credit Agreements with terms and conditions satisfactory to the World Bank. The following legal agreements will define the flow of funds and the respective parties' roles and responsibilities: The Development Credit Agreement, between IDA and Serbia and Montenegro (SAM); The Sub-credit Agreement, between S AM and GOS; The EPS Sub-credit Agreement, between GOS and EPS; The TSMO Sub-credit Agreement, between GOS and the TSMO Project funds will flow from the Bank, either via two Special Accounts (one for each of components 1 and 2) established in a commercial bank acceptable to the Bank or by direct payment on the basis of direct payment withdrawal applications. 43

50 STAFFING OF THE ACCOUNTING/FINANCE FUNCTION The accounting and finance function of EPS is adequately staffed. The TSMO will be provide IDA with details of the implementation arrangements, including details related to the staffing of the finance function, relating to component 2. ACCOUNTING POLICIES AND PROCEDURES EPS maintains its accounts in accordance with the Law on Accounting and Auditing which governs the accounting policies and practices for the corporate sector. The Law is broadly in line with IAS but is by no means fully compliant. The TSMO will also be subject to the same legal reporting requirements, The project accounts will be maintained using the accounting policies generally applicable to the operations of EPS and the TSMO. The progress in implementation of the project and disbursement will be reported to the Bank through FMRs and quarterly progress reports. EPS and the TSMO will each separately maintain accounting records related their respective components, including records related to transactions on the Special Accounts. The TSMO will provide, on a timely basis, such reports as required by EPS to enable EPS to provide the IDA with a single consolidated set of FMRs and progress reports each quarter. EXTERNAL AUDIT As of the date of this report, the Borrower is in compliance with the audit covenants of existing Bankfinanced projects. EPS s previous and current project financial statements and auditing arrangements are satisfactory and it has been agreed that these will be replicated for the proposed project. EPS and the TSMO will each prepare annual project financial statements for their respective components, EPS and the TSMO will independently appoint auditors to audit their respective annual project financial statements. Both sets of annual audited project financial statements will be provided to the Bank within five months of the end of each fiscal year and also at the closing of the project. EPS s annual corporate financial statements have been heavily qualified in recent years. EPS has been working with its external auditors, and consultants appointed under the Electric Power Emergency Reconstruction Project, to improve the quality of its financial reporting. However, it is not clear whether the auditor will be able to issue an unqualified opinion on EPS s 2004 financial statements. The audit report will be available before the end o f July REPORTING AND MONITORING EPS will prepare a single set of consolidated financial monitoring reports (FMRs) on a quarterly basis. The FMRs include: Project Sources and Uses of Funds Uses o f Funds by Project Activity Special Account Statement Project progress report Procurement report The first Financial Monitoring Report will be fumished to the Bank not later than 45 days after the end of the first calendar quarter after the Effective Date, and will cover the period from the Effective Date to the end of the first calendar quarter. 44

51 DISBURSEMENT ARRANGEMENTS It is expected that the proceeds of the Credit will be disbursed over a period of four and a half years, which includes six months for the completion of accounts and the submission of withdrawal applications. Adequate counterpart funds are available for the first year of operations. Disbursements from the Credit Account will follow the transaction based method, i.e. EPS and the TSMO will support requests for withdrawal of funds from the Credit Account with Statements of Expenditure (SOE s) and Summary sheets. Given the small number of contracts and transactions anticipated under the project and EPS s familiarity with the use of SOE s, this method is considered to be the most efficient. To facilitate timely project implementation, EPS and the TSMO will open and maintain, in Euro, separate special deposit accounts in a bank, acceptable to the Association, on terms and conditions satisfactory to the Association, including appropriate protection against set-off, seizure or attachment. The Authorized Allocation is 1,000,000 in respect of the EPS Special Account and 500,000 in respect of the TSMO Special Account. However, the Authorized Allocation will be limited to 500,000 in respect of the EPS Special Account and 250,000 in respect of the TSMO Special Account, until: (i) in respect of the EPS Special Account, the aggregate amount of withdrawals from the Credit Account of amounts allocated to Categories (1) and (3), exceed the equivalent of SDR2,900,000; and (ii) in respect of the TSMO Special Account, the aggregate amount of withdrawals from the Credit Account of amounts allocated to Category (2) ofthe Project shall exceed the equivalent of SDR500,OOO. Allocation of Credit Proceeds Category (1) Goods: (a) under Part A. 1 of the Project (b) under Part A.2 of the Project (2) Works: (a) under Part B. 1 of the Project (b) under Part B.2 of the Project (3) Consultants services for Part A.l and Part B.l (4) Unallocated TOTAL Amount of the Credit Allocated Expressed in SDR 3,000,000 6,900, , , ,000 2,125, % of Expenditures to be Financed 100% 100% 100% 100% 100% SUPERVISION PLAN The reports o f the progress of the project implementation will be monitored in detail during supervision missions. FMRs will be reviewed on a regular basis by the Belgrade-based FMS and the results or issues followed up during the supervision missions. Audited financial reports o f the Project will be reviewed. 45

52 A. General: Annex 8: Procurement Arrangements ECSEE APL 2-SERBIA Procurement for the proposed project would be carried out in accordance with the World Bank s Guidelines: Procurement under IBRD Loans and IDA Credits dated May 2004; and Guidelines: Selection and Employment of Consultants by World Bank Borrowers dated May 2004, and the provisions stipulated in the Legal Agreement. The general description of various items under different expenditure category is described below. For each contract to be financed by the Credit the different procurement methods or consultant selection methods, the need for prequalification, estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank project team are given in the Procurement Plan. The Procurement Plan will be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. Procurement of Goods: Goods procured under this project would include: supply and supervision of installation, testing and commissisning of new 1 lokv substations and interconnecting transmission lines at five locations. The procurement will be done using Bank s Standard Bidding Document Selection of Consultants: Consultancy is envisaged for tasks related to design and supervision implementation consultant for the first two substations and connected transmission line. Bank s standard request for proposal document shall be used. Operational Costs: Not envisaged. B. Assessment of the agency s capacity to implement procurement: (1)Procurement activities will be carried out by EPS Corporate Power Distribution Department (PDD) for Part A and by ENS (transmission) for Part B EPS is staffed by two experienced procurement officers. An assessment of the capacity of the Implementing Agency to implement procurement actions for the project has been carried out by Devesh Chandra Mishra on April 22, 2005.The assessment reviewed the organizational structure for implementing the project and the interaction between the project s staff responsible for procurement officer and relevant central unit for finance. (ii)the relevant staff has experience of Bank-funded procurement for goods and services and supply installation. Further these staff have worked recently for similar projects financed by European Bank for Reconstruction and Development (EBRD), European Investment Bank (EIB) and KfW (Bank for Reconstruction, Germany). Most of the issues/ risks concerning the procurement component for implementation of the project have been identified and include continued availability of these experienced staff. The corrective measures which have been agreed are: Training of staff on Supply of the goods document (May 2004 version) by working together on the first bidding document. One PIU team will work for whole project is established with EPS and ENS staff. As concluded in the CPAR of June 2002, the environment for conducting public procurement in the country is high-risk. (iii) EPS stated during negotiations that they would need to revisit the procurement arrangements that were discussed during pre-appraisal in Dec 2004 and during appraisal in April After intensive discussions the following as at iv) was agreed. (iv). EPS would implement the 5 substations in two phases - with 2 substations in the first phase and three other substations in the second phase. The unallocated funds will be used in the second phase too, 46

53 For the first phase, EPS would have one bidding document for supply contract(s) (financed by the Bank) with 6 lots and one bidding document for works contract(s) with 2 lots (financed by EPS for substation and financed by the Bank for transmission line) (ii) The supply contract(s) will be awarded under ICB for procurement of various equipment components for the substations and 1-6 contracts will be signed, The (Bank-financed) equipment supply contractor will in addition be responsible for supervision of all works, testing and commissioning. of the relevant equipment. EPS may carry out the complete detailed design and engineering for the first phase, or outsource part or all of it to other parties. v) ENS would build 5 transmission lines, 3 in the first Phase and 2 in the second phase. For the first phase ENS would have one tender with three lots for works contract(s) for transmission lines will be awarded under National Competitive Bidding procedures for procurement of civil works and installation. (equipment and material already available in stock) and 1-3 contracts will be signed, vi) EPS will appoint a Design and Supervision of Implementation Consultant with adequate experience to assist EPS and ENS in the implementation of the first phase for both substation and transmission, The above procurement strategy reflects the flexibility that shall be exercised based on the outcome of first phase of implementation C. Procurement Plan The Borrower, at appraisal and after discussions at negotiations, developed a Procurement Plan for project implementation which provides the basis for procurement methods. This plan has been agreed between the Borrower and the Project Team on June 06, 2005 and is available at the office of EPS. It will also be available in the Project s database and in the Bank s external website. The Procurement Plan will be updated in agreement with the Project Team annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. D. Frequency of Procurement Supervision: In addition to the prior review supervision to be carried out from Bank offices, the capacity assessment of the Implementing Agency has recommended frequency of supervision as 6-months and to visit the field to carry out post review, if any, of procurement action. E: Attachment -Details of Procurement Arrangement 1. Prior Review Threshold: Procurement Decisions subject to Prior Review by the Bank as stated in Appendix 1 to the Guidelines for Procurement: Procurement Method 1. International Competitive Bidding(1CB) (Goods) Supply with supervision of installation, testing and commissioning of the relevant equipment 2 National Competitive Bidding ( each contracts less than $1.5 Million) Prior Review Threshold All All 1 2 Procurement Packages with Methods and Time Schedule Substation Part (Phase I- First two Substations and Phase 11- Remaining three substations) 47

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58 Annex 9: Economic and Financial Analysis ECSEE APL 2-SERBIA Economic Analysis 1. The economic intemal rate of retum for the project is 29 percent. The net present value for the proposed Project is estimated to be US33 million, based on a 12 percent discount rate which is considered to be the economic opportunity cost of capital in the Republic of Serbia. The analysis includes the investment costs of US$ 19 million for the five new substations and associated transmission lines, excluding taxes and duties. 2. The analysis compares with- and without-project cases. The with-project case assumes substations are constructed over a period of three years following the procurement schedule in Annex 8 and begin operation in 2009, continuing for 20 years to The figures presented are in real terms using 2004 as the base year. 3. Three key benefits are estimated in the analysis: 3.1 Reduction in energy losses. The first estimated benefit is a reduction in energy losses. The savings from a reduction in energy losses is valued at the average Serbian electricity tariff as additional sales of electricity to consumers. The average Serbian electricity tariff of US$43.76/MWh ( I MWh). The savings estimate amounts to about US$524 thousand per year, or about US$10.5 million over the twenty year period, 3.2 Reduction in Energy Interruptions. The second benefit in this analysis is derived from the reduction in energy interruptions caused by equipment failure and forced outages. The reduction in energy interruptions is valued at the cost of unserved energy, which is difficult to quantify in exact terms. Methodologies to calculate this cost vary from country to country and depend on several factors such as demand structure, quantity of undelivered electricity and duration of interruption. A Generation Investment Study currently being performed for the South East Europe region is assuming $500/MWh for the cost of undelivered energy. Consistent with the GIS study, the analysis takes the US$500/MWh as the cost of unserved energy in Serbia. It is estimated that the reduction in energy interruptions due to the construction of the new 110 kv substation will result in savings of about US$1.3 million per year, or about US$ 25.5 million over the twenty year period. The assumption of $5OO/MWh is considered a conservative estimate. It is estimated that the costs of backup diesel generation required to cover energy interruptions are much higher. The variable cost of diesel generation for small consumers is estimated at about US$80.8 / MWh, The capital cost of diesel generation was amortized over the number of hours of operation per year (given in Annex 4) assuming a fifteen year life cycle. The average capital cost amounts to US527 /MWh, assuming a capital cost of US$500 kw for diesel generators. This is an average cost calculated as the total annual capital cost with 15 year amortization divided by the annual net MWh saved due to a reduction in energy interruptions. The rate of return for the project would be higher if the cost of backup diesel generation of US$607/MWh is used as the cost of unserved energy, compared to the base case assumption of US$500/MWh. 3.3 Supply of new load. The installation of new substations will increase the installed capacity of the transmission and distribution networks, enabling distribution companies to serve new load. The estimated new load served for each substation is shown in Table 4 of Annex 4. It is assumed that the new substations financed through the project will reach their technical optimum capacity in five years, after which additional capacity will need to be added to serve load growth. The analysis does not include the benefit of load growth after five years and the incremental investments required to meet this load. Based on this assumption, about 34.5 MW of incremental new load will be served as a result of the proposed 52

59 Project investments. Assuming a load factor of 60%, the five new substations will serve an additional 1 8 1,000 MWh of electricity per year by The estimated savings to consumers accruing from the avoided cost of alternative electricity supply is included as the third benefit in this analysis, The estimated savings to consumers is valued at the cost of alternative power supply less the average electricity tariff of US$43.76NWh ( I MWh). The analysis uses diesel generators as the source of alternative supply. Average capital costs and O&M are estimated at the equivalent of US$ 90MWh. This assumes a capital cost of US$ SOOkW for diesel generators amortized over 10 years and a diesel fuel cost of US$7.67 I GJ. It is estimated that the benefit from connection of new load to the new substations will result in savings of about US$ 7.6million per year, or about US$ 152 million over the twenty year period The analysis takes into account the following: The analysis uses performance data provided by EPS for with- and without- project scenarios, This performance data is described in more detail in Annex 4. Investment figures include only substation and connection line costs plus physical contingencies. Figures exclude VAT (1 8 percent) and adjusted for inflation (base year is 2004). US$l,33 I is used as the real exchange rate for end of year The estimates are based on constant prices as of end The analysis also uses a constant tariff of US$43.76 / MWh assuming no real growth in the tariff. The US$ equivalent tariff is based on the average tariff of I MWh given by EPS. The Operation and Maintenance costs are assumed to be 2.0 percent of investment costs (provided by EPS). 5. Sensitivity Analysis. The estimated project EIRR is fairly robust. The EIRR is relatively sensitive to a decrease in new load served and increase in investment costs. A twenty percent decrease in incremental new load served by the substations brings down the EIRR to 25 percent. A twenty percent increase in investment costs yields an EIRR of 26 percent. The EIRR would be 22 percent assuming a 20 percent decrease in incremental new load served and a 20 percent increase in investment costs. 6. Unquantified benefits. While the benefits quantified above are large and substantial, additional direct and indirect benefits from the project were difficult to estimate and were not included in the rate of return estimate. In addition to the direct benefits noted above, the quality and reliability of electric service will be improved through improved voltage performance, which is expected to contribute to the growth and development of the serviced areas. Financial Analysis EPS Financial Performance Since 2000 average tariffs have increased from some US$ 0.9 cents to the current level of US$ 4.3 cents (2.53 dinkwh equivalent to 3.5 euro cent). This is still low by the standards of the region but a considerable improvement. As a result of this and also significant increases in collection efficiency (now around 90%) EPS is now able to cover its operating costs and some debt service. The 2004 draft accounts show a 2% operating loss and a 9% net loss (after deduction of interest and other financing costs). In 2004 total sales of EPS are estimated to have been about 78 billion dinars ( 1 billion; $1.3 billion) and EPS invested about 12 billion dinars principally for the Kolubara lignite mine. The following historic accounts have been derived from such information as is currently available, principally the 2003 accounts, the 2004 draft accounts and the business plan. 53

60 Historical Financial Performance Actual Actuai Estimated From 2003 From 2004 draft INCOME STATEMENTS accounts From 2003 accounts accounts million Dinars million Dinars million Dinars BUSINESS REVENUE 54,711 67,019 81,784 BUSINESS EXPENDITURES 63,648 65,415 83,057 Electricity purchases 4,586 3,875 na Materials and fuel 13,349 13,039 15,102 Maintenance 4,977 ' 5,061 14,863 Depreciation 15,639 16,944 18,082 Employee costs 16,876 18,483 21,535 Other 8,221 8,OI 3 13,475 OPERATING PROFIT - 8,937 1,604-1,273 FINANCIAL REVENUE 28,318 8,497 6,084 FINANCIAL EXPENDITURES 25,406 15,073 12,053 NET PROFlTlLOSS - 6,025-4,972-7,242 na = not available Operating profiffloss % -16% 2% -2% Net loss % -11 Yo -7% -9% BALANCE SHEETS ASSETS Total long-term assets Stocks Short-term receivables Cash and cash equivalents Other current financial assets Total current assets TOTAL ASSETS LIABILITIES Paid-in capital and reserves Undistributed profit /loss and adjustments Total capital and reserves Total long-term liabilities Current portion of long term loans Suppliers Other current liabilities Total current liabilities TOTAL LIABILITIES TOTAL CAPITAL AND LIABILITIES 2002 Actual 259,544 9,986 11,817 1,914 3,069 26, , ,402-83, ,028 38,194 21,433 9,861 19,814 51,I 08 89, Actual 266,491 10,988 15,383 1,978 4,281 32, , ,824 85, ,494 47,168 16,470 9,058 19,931 45,459 92, Estimated 286, , ,238 Current ratio 52% 72% 72% * 427,964 14,986 16,741 6,456 2,091 40, , ,725 35, ,556 68,030 20,827 8,394 26,431 55, ,682 54

61 While many of the challenges faced by EPS are similar to those faced by other power utilities in the region, there are certain special factors in the Serbian situation which present unique difficulties for the power company. Perhaps the most significant in terms of economic impact in the medium and longer term is the company's dependence on lignite-fired thermal stations (67% of generation in 2004, a proportion which is likely to rise) which are supplied with fuel by relatively inefficient open-cast mines. The company's ability to control and reduce costs in this area is constrained by social and political factors. They are also continuing to pay salaries to some 6500 staff from Kosovo. The other factor having a major bearing on EPS' financial resources and requirements is the burden of mainly pre-war debt, which amounts to $1 billion, excluding any debt incurred for assets in Kosovo. The Paris Club group of creditors has agreed to a 65% write-down of the outstanding balance with the government, and EPS is assuming this write off although they have not yet received formal confirmation that this benefit will flow to them. The current business plan for the future prepared by EPS necessitates steep tariff increases to support the level of investment. An analysis of the underlying numbers shows that it is possible for EPS to tum around financially, but this will require a balance of improving operational efficiency (cost control in operations including mining, reduction of distribution losses, improvement of collections); agreement on rescheduling or canceling old debt; adoption of a sustainable path of tariff increase; and development of an affordable investment program based on priority investments needed to maintain and increase current production and improve quality of supply. EPS and Government of Serbia are currently in the process of finalizing the business plan and this is expected to be available in the next few months. A tariff increase is anticipated on 1'' July Subsequent tariff increases will be subject to review by the regulator. INCOME STATEMENTS BUSINESS REVENUE Domestic electricity Sales Electricity sales to Montenegro; Coal sales Heat and steam sales Donations & subventions Consumer contributions Other business revenues EXPENDITURES Electricity purchases Materials and fuel Maintenance Depreciation Employee costs Insurance Local taxes and state obligations Other business expenditures Bad debts written off FINANCIAL REVENUE FINANCIAL EXPENSES NET PROFlTlLOSS million - million - million - million million - million Dinars Dinars Dinars Dinars Dinars Dinars 85, , , , , ,730 72,089 89, , , , ,880 1,700 2,495 1,734 1,271 2,156 3,721 87,272 5,517 9,295 12,042 20,097 19,609 2,600 1,700 2,662 1,851 1,338 5, ,656 4,222 10,245 14,424 23,952 23,949 3,098 1,700 2,801 1,947 1,338 5, ,988 5,099 11,390 17,992 25,509 26,454 3,259 1,700 2,927 2,034 1,258 6, ,165 7,601 12,122 18,704 26,912 29,027 3,406 1,700 3,053 2,122 1,181 6, ,819 10,735 12,806 19,713 28,123 31,789 3,552 1,700 3,175 2,207 1,105 6, ,528 13,514 13,528 20,075 29,248 34,713 3,694 6,721 8,343 9,633 11,144 12,396 13,705 4,311 8,004 8,875 9,885 10,755 11,703 7,080 8,419 9,777 11,364 11,950 12,348 3,701 2,861 2,753 2,635 2,522 2,411 11,714 11,058 11,858 12,073 11,775 11,322-10,118-10,473-3,068 8,943 8,466 9,291 55

62 BALANCE SHEETS ASSETS Long-term assets Intangible assets Real estate, plant and equipment Long-term investments Mi I i o n Dinars 4,972 3, , mi I i o n Dinars - 4,972 3, , million - Dinars 4,972 3, , million Dinars 4,972 3, , mi I i o n Dinars 4,972 3, , million Dinars 4,972 3, , Total long-term assets Stocks Short-term receivables Cash and cash equivalents Other current financial assets Other current assets Total current assets TOTAL ASSETS LIABILITIES Paid-in capital and reserves Undistributed profit /loss and adjustments Total capital and reserves Long-term borrowings Long-term reservations Delayed obligations Other long-term liabilities Total long-term liabilities Current portion of long term loans Taxation and related liabilities Suppliers Short-term borrowing Other current liabilities Total current liabilities TOTAL LIABILITIES TOTAL CAPITAL AND 430,105 13,159 15,849 1, , , ,724-21, ,324 31, , ,598 17,953 1,769 5,229 21,700 46,651 87, ,314 15,819 16, , , ,724-31, ,851 54, , ,974 21,785 1,769 5,229 2,853 21,700 53, , ,977 19,163 16, , , ,724-34, ,784 79, , ,773 22,975 1,769 5,229 9,332 21,700 61, , ,820 22,951 16, , , ,724-25, ,727 93, , ,203 24,222 1,769 5,229 6,986 21,700 59, , ,168 24,650 15, , , ,724-17, , , , , ,769 5,229 5,409 21,700 58, , ,174 26,379 12, , , ,724-8, , , , ,973 24,516 1,769 5,229 2,686 21,700 55, ,874 LIABILITIES 457, , , , , ,357 56

63 Key Performance Indicators Earnings before Int, Depreciation and Tax (EBITDA) D'M Operating Profit % Net Profit/loss % Current ratio Collection efficiency Receivables days Debt service coverage ratio 13,370 18,192 27,894 41,314 42,323-2% -2% 5% 12% 11% -12% -10% -2% 6% 5% 66% 62% 61 % 67% 69% 89% 90% 91 % 92% 93% a ,059 11% 5% 71 % 94% Assumptions - The following assumptions were used in the preparation of the preceding financial forecasts -based on ESP's draft business plan. % I2005 I2006 Period average % 1 10,60 1 6, ,20 4,50 I 4,30 4,OO EUR US Dollars ToDinar ,92 89,54 94,20 98,44 102,67 106,78 64,38 68,70 72,27 75,52 78,77 81,92 EUR centskwh DinkWh % price increase % 20% 20% 18% 5% 5% 57

64 Electricity Sales- established for every year on the basis of design demand in Serbia and anticipated growth of electricity price level. Coal sales for industry, consumer spending, heat and technological steam - increase by inflation. Consumer contributions - increased for the predicted inflation, and subsequently reduced for 5% in 2006 and 2007, and 10% in 2008,2009 and Other business revenue - in 2005 at the level of 70% of the amount in In 2006, increased for inflation, and subsequently reduced for 10% (on the basis of separation effects of non-electric power industry activities from EPS), and in the ffollowingg years increased for inflation. Electricity purchase - calculated in compliance with the electric power balances at the price of 3.8 Euro Cents. Material and fuel costs - adjusted on annual level in compliance with the inflation and projection of production programmes. Labour costs - established on the basis of employees and employees from public enterprises from Kosovo and Metohija territory receiving salary compensations. Salaries were calculated with real annual growth of 5%. Maintenance: - according to an assumed profile taking into account the backlog of maintenance in the early years and increasing investment in the later years Depreciation - is provided at around 6% in line with the newly revised asset value. Other business liabilities - adjusted in line with inflation, Liabilities for interest and debt - are calculated according to the agreed and assumed rescheduling terms Short term liabilities are expected to remain reasonably constant - reflecting a reducing proportion of costs incurred as normal business payment terms are gradually re-introduced. Collection: Collection efficiency is assumed:- e a a Electricity bills at 88.9% in 2005, 90% in 2006 and to increase by 1% per year thereafter: Coal assets for indsutry and consumer spending - 95% Heat and technological steam assets - 95% Other business assets with 97% For the purposes of this calculation amounts not collected at the end of the year are fully provisioned, Investments Are assumed to be funded with between 64% and 40% with debt depending on the availability of internal resources. 58

65 Annex 10: Safeguard Policy Issues ECSEE APL 2-SERBIA Environmental Safeguards Environmental Management Plans have been prepared for each of the sub-stations and the associated transmission lines to mitigate potential environmental impacts. Serbian language EMPs were made available to the public through the company s website as well as paper copies made available at the company s offices at location of each proposed substation. Public consultation was held at each of the five locations of proposed substations on April 26, Information about the public disclosure and public consultation was disseminated through multiple media. The potential environmental issues to be addressed are: avoidance of PCBs and minimizing electromagnetic fields in the equipment purchased under the project; ensuring that sewage water from substations is properly disposed of; movement of men, materials and equipment during construction (noise, dust); ensuring adequate protective measures against any leakage of transformer oils and minimizing noise during operation. Although the environmental impact is expected to be minimal, a Category B is being assigned to the project. Additional investments to be identified during the implementation of the project are likely to be either one or two substations with associated transmission lines or purchase of consumer meters. A key eligibility criteria for financing the new investments is submission of an Environmental Management Plan satisfactory to the Association, Social Safeguards The project triggers OP/BP 4.12 Involuntary Resettlement because land will be acquired for one of the substation sites and for the transmission towers associated with each substation. EPS has prepared a modified land acquisition plan which will be reviewed by the Bank prior to appraisal. The total amount of land required (0.2 Hectares for Jagodina substation) is minimal, however. Transmission tower footprints require the acquisition of tiny plots. To the extent possible, they are placed on the periphery of agricultural land, to minimize agricultural impacts, and their placement can be revised if EPS staff cannot successfully negotiate a land purchase from a particular landowner. The tables at the end of this annex give an indication of the magnitude of anticipated land acquisition. EPS has considerable experience in land acquisition following procedures that are acceptable to the Bank. EPS negotiates prices with landowners, based on local market levels, and rarely fails to negotiate successfully. Owners are paid for the land before civil works start on the land. A Land Acquisition Plan has been prepared and found satisfactory. This was disclosed to the public and consultations held at each of the five locations of the proposed substations along with the EMPs (see previous Section). Information about public disclosure and consultation was disseminated to the public through multiple media. The Bank s safeguards specialists will monitor implementation and impact of the land acquisition plan closely during regular supervision missions. 59