FOR OFFICIAL USE ONLY

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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 6.0 MILLION (US$9 MILLION EQUIVALENT) TO THE REPUBLIC OF MONTENEGRO FOR AN Report No: YU ENERGY COMMUNITY OF SOUTH EAST EUROPE APL 3-MONTENEGRO PROJECT IN SUPPORT OF THE THIRD PHASE OF THE US$l,OOO MILLION ENERGY COMMUNITY OF SOUTH EAST EUROPE (APL) PROGRAM Sustainable Development Department South East Europe Country Unit Europe and Central Asia Region June 8, 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: January 18,2007) Currency Unit = Euro Euro = US$ EUR = US$1 FISCAL YEAR January 1 - December31 APL CIDA EAR EBRD EC ECSEE EPCG ELB EMP ERA ETSO EU FEAP FMR IAS IASB ICB IFAC IFRS ISA KAP KfW LAPF PDH PMU QCBS OPGW SDH 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 Elektroprivreda Crne Gore AD-Niksic European Investment Bank Environmental Management Plan Energy Regulatory Agency European Transmission System Operators European Union Framework for Environmental Assessment Procedures 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 KOMBINAT ALUMINIJUMA Kreditanstalt fur Wiederaufbau (Germany) Land Acquisition Policy Framework Plesiochronous Digital Hierarchy Project Management Unit Quality and Cost-Based Selection Optical Ground Wires Synchronous Digital Hierarchy Union for Coordination of Transmission of Electricity in Europe United States Agency for International Development Vice President: Country Director: Sector Director: Task Team Leader: Shigeo Katsu Orsalia Kalantzopoulos Peter Thomson Husam Beides

3 FOR OFFICIAL USE ONLY EUROPE AND CENTRAL ASIA Energy Community of South East Europe APL 3-Montenegro CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE Program. Country and Sector Issues Rationale for Bank Involvement Higher Level Objectives to which the Project Contributes... 4 B. PROJECT DESCRIPTION Lending Instrument Program Objective and Phases Project Development Objectives and Key Indicators Project Components Lessons Learned and Reflected in the Project Design Alternatives Considered and Reasons for Rejection C. IMPLEMENTATION ECSEE Partnership Arrangements Institutional and Implementation Arrangements Monitoring and Evaluation of OutcomesResults Sustainability Critical Risks and Possible Controversial Aspects Credit Conditions and Covenants D. APPRAISAL SUMMARY 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.

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5 Annex 1::ECSEE Program and Montenegrin Power Sector Background. 23 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 : Land Acquisition/ Expropriation Policy Framework Annex 12: Project Preparation and Supervision Annex 13: Documents in the Project File Annex 14: Statement of Loans and Credits Annex 15: Country at a Glance Annex 16: Map IBRD No

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7 THE REPUBLIC OF MONTENEGRO ENERGY COMMUNITY OF SOUTH EAST EUROPE APL 3- MONTENEGRO PROJECT Date: May 24,2007 Country Director: Orsalia Kalantzopoulos Sector Director: Peter Thomson Project ID: P Lending - Instrument: Adaptable Program - Loan PROJECT APPRAISAL DOCUMENT EUROPE AND CENTRAL ASIA ECSSD Project Financing Data [ ] Loan [XI Credit [ ] Grant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Total Bank financing (US$m): 9 Million equivalent Proposed terms: 10 years grace period, final maturity of 20 years. Task Team Leader: Husam Mohamed Beides Sectors: Power (1 00%) Themes: Regional integration (P) Environmental screening category: B Borrower: Republic of Montenegro, Government of the Republic of Montenegro Stanka Dragojeviba Podgorica Responsible Agency: Elektroprivreda Crne Gora AD-Niksic (EPCG) Does the project depart from the CAS in content or other significant respects? Re$ PAD A. 3 [ ]Yes [XI No

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9 Does the project require any exceptions from Bank policies? Re$ PAD D. 7 [ ]Yes [XI No Have these been approved._ by Bank management? 1 lyes IN0 Is approval for any policy exception sought from the Board? []yes [XI NO Does the project include any critical risks rated substantial or high? []Yes [X ]No Re$ PAD C.5 Does the project meet the Regional criteria for readiness for implementation? Ref: [ X ]Yes [ ] No PAD D. 7 Project development objective Re$ PAD B.2, Technical Annex 3 The objective of the ECSEE APL3 - Montenegro project is to improve the efficiency and reliability of the power system in Montenegro, through better supply security and closer integration into the regional markets. Project description Re$ PAD B.3.a, Technical Annex 4 Component 1 : Development of a modern telecommunications network, including links with regional utilities. Component 2: Construction of transmission line circuits from the transmission network to the Andrijevica substation and to the Mojkovac substation. Component 3: Installation of a new trash rack and trash rack cleaning equipment, and supply of spare turbine runners for Perucica Hydropower Plant. Which safeguard policies are triggered, if any? Re$ PAD 0.6, Technical Annex 10 Environmental Assessment (O.P. 4.01) and Involuntary Resettlement (O.P. 4.12) for s for short connector lines to substations. Significant, non-standard conditions, if any, for: Re$ PAD C.7 None Board presentation: None Credit effectiveness: The Borrower shall submit to the Bank a signed Sub-credit Agreement between the Republic of Montenegro and EPCG. Covenants applicable to project implementation: EPCG would be required to meet the following financial covenants: (a) Self financing ratio greater than or equal to 35% starting January 1,2008; and (b) maintain collection ratio of 90% or greater until January 1, 2008, a collection ratio of 92% or greater from January 1,2008 until January 1,2009 and 94% or greater from January 1,2009.

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11 A. STRATEGIC CONTEXT AND RATIONALE 1. Program, Country and Sector Issues 1. Overall ECSEE APL Program. The improvement of the performance of the energy sector is crucial to 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 (in the order of 12,000-15,000 MW) and plant rehabilitations (in the order of 8,000-9,000 MW) will be required over the period to 2020, along with matching transmission and distribution system investments; if demand i s to be met and severe power shortages and supply interruptions are to be avoided. 2. 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 desire 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. This Memorandum (followed by a Treaty, see below) formally expressed their commitment to what is currently called the Energy Community of South East Europe (ECSEE). 3. ECSEE s current membership is as follows: ECSEE s State Parties are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, Romania, Serbia, 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 a participant; and Neighboring Non-EU Member States can request to participate as Observers. Currently, Moldova is participating as an observer. 4. The Treaty establishing the Energy Community (the Treaty). The Council of the European Union authorized the European Commission in June 2004 to open negotiations on behalf of the European Union, with SEE countries. ECSEE s Ministerial Council concluded on December 13,2004 that there was broad agreement on the substance of the Treaty and directed Generation Investment Study for South East Europe, a joint project of the Bank and the European Commission. This study is posted on the ECA pages of the Bank s website. 1

12 their negotiators to conclude the remaining details as soon as possible. The Treaty was consequently signed on October 23,2005 by all of ECSEE s Regional Members (with the exception of Turkey) and the European Community. The Treaty is proposed to become effective when the European Union and a majority of the Regional Members have ratified it. Montenegro Power Sector and the Athens Process 5. The Montenegrin electricity system is a small one, serving about 250,000 customers. Total electricity demand in Montenegro in 2004 was about 3,800 GWh. Households account for 1,400 GWh, with the majority of households using electricity for heating. The country s industry includes an aluminum plant (KOMBINAT ALUMINIJUMA - KAP) whose demand consists of almost 50% of the country s total electricity demand. Other large customers include the steel and railway companies. Montenegro is unable to satisfy all this demand from its own generation capacity, and has to import 33% of its total needs. EPCG imported about 540 GWh in 2004, and KAP and the steel company imported a further 710 GWh on their own account. These imports come from various neighboring countries and are arranged on an annual contract basis as well as on shorter term basis. 6. In 2003, Montenegro signed the Athens Memorandum of Understanding on the creation of the regional electricity market and passed an Energy Law that established the Energy Regulatory Agency (ERA). In 2005, the ERA issued methodologies for unbundled tariffs and EPCG was functionally unbundled into separate generation, transmission, distribution and supply businesses. The transmission functional entity is responsible for the transmission system operation. In October 2005, the Government of Montenegro signed the Treaty establishing the Energy Community of South East Europe (the ECSEE Treaty). In addition, formal legal unbundling and the establishment of the transmission business unit as a separate corporate entity is planned to be complete in 2007, which will meet the ECSEE Treaty requirement for the establishment of an independent Transmission System Operator. By signing and ratifying the ECSEE Treaty and proceeding with the restructuring activities of EPCG, the Government of Montenegro has shown that it fully agrees with the goals and principles of the Athens Process and has committed itself to continued implementation of its key provisions. Annex 1 includes more details on the power sector issues and reform activities in Montenegro. 2. Rationale for Bank Involvement 7. The Bank remains heavily involved in the integration of the SEE Energy Market. First, the Bank is participating in regional efforts to promote cooperation and integration in South East Europe and inter alia supports the Stability Pact. Second, the Bank is an active participant in the Athens process, at the request of the European Commission. Third, 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 regional and country knowledge and participation in the development of the Athens process 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 Board on January 27,2005. It is a key component of the Bank s support for the Stability Pact and its working partnership with the 2

13 European Commission. Regional investment facilities for power generation and for gas, similar to the ECSEE APL for electricity, will also be considered. 8. In March 2004, the Bank published a strategy paper for energy trade in South East Europe.2 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 also describes the Bank s role in supporting policy reform and institutional development, and in lending for power generation, transmission and distribution. 9. More specifically the Bank s role is to: 0 0 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 countries 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. Complete a Regional Power Generation Investment Study, financed by the European Commission. 10. After the signing of the ECSEE treaty, the Bank published in March 2006, an update for this strategy paper. This new paper focuses on the power sector, where significant reform has been undertaken in the context of the Athens Process, and where previous Bank advice has been incorporated in the evolving legal and institutional framework. Notwithstanding the progress, the paper emphasizes that a number of significant challenges remain for a regional power market to be successfully implemented. The paper identifies these challenges and proposes ways in which these can be addressed. 11. ECSEE APL 3-Montenegro will support Montenegro in implementing its program for power market liberalization and regional power market accession. More specifically, the project will support necessary investments to help ensure the security and reliability of electricity supply to the population while the market is being liberalized and integrated to an even greater extent with the regional power market. The ECSEE APL 3-Montenegro project is consistent with the Country Assistance Strategy (CAS ) for Serbia and Montenegro. Energy sector restructuring relates to two of the three goals of the CAS - creating a more sustainable, more efficient public sector, and creating a larger, more dynamic private sector. The investment projects financed by the ECSEE APL 3-Montenegro project will improve the performance of the power sector and will assist in integrating the country electricity market into the regional market which is essential to achieve fiscal sustainability and encourage private sector-led growth. 2 World Bank Framework for Development of Regional Energy Trade in South East Europe, EMT Discussion Paper No. 12, March

14 3. Higher Level Objectives to which the Project Contributes 12. 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 the Western Balkans - the other Regional Members of ECSEE - are potential candidates for 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 legally binding energy market agreements as has now been done with Electricity. 13. ECSEE and the Athens Process are integral elements of the strategy developed by the Regional Members and the European Commission for all states in South East Europe to have access to a stable and continuous energy supply. This 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 higher level of employment as well as balanced and sustainable development. These higher level objectives are expressed in the ECSEE Treaty which is discussed above. 14. 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. It also provides a driver towards a more comprehensive economic and political integration into the European Union. 15. The Bank supports regional efforts to promote cooperation and integration in South East Europe. ECSEE is one of the most prominent of the 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. B. PROJECT DESCRIPTION 1. Lending Instrument 16. 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 Bank 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 Program if they meet specific eligibility criteria and if they need Bank support. The approved size of the APL lending facility is US$ 1,000 million. The proposed ECSEE APL 3 4

15 (Montenegro) project is in the third phase of the ECSEE APL Program3. The Credit for this Project was negotiated on April 26,2006, and was approved on May 22,2006. However, following the Montenegro referendum of May 2 1, 2006, resulting in Montenegro independence from the union of Serbia and Montenegro, and subsequently becoming a member of the Bank on January 18,2007, the Project was renegotiated on May 23, Program Objective and Phases 17. The key objectives of the ECSEE Program 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. 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. Improve the environmental situation in relation to energy in the region. 18. The Member States (Regional Members) are committing themselves under the ECSEE Treaty inter alia to: 0 Implement the EC Directives 2003/54/EC (electricity) and 2003/55/EC (gas) of the European Parliament and of the Council, dated June 26,2003, within twelve months of the entry into force of the ECSEE Treaty. 0 Implement the acquis communautaire on Environment in compliance with a timetable set out in the Treaty. 0 Endeavor to accede to the Kyoto Protocol if they have not already signed. 0 Ensure that the eligible customers within the meaning of the European Community Directives 2003/54/EC and 2003/55/EC are: o from January 1, 2008, all non-household customers; and o from January 1, 20 15, all customers. 19. The Bank supports ECSEE in a number of ways including: i) through active participation in ECSEE s implementation organization (described in Annex 1, Section 1); ii) analytical work including the March 2004 framework paper, the recently completed generation investment study and the proposed gasification study; and iii) country-level policy dialogue and project work. The ongoing regional investment and technical assistance support under the ECSEE APL is also an integral element of this comprehensive program of support. 3 To date the following are approvedhn process: APL Phase 1 (APLl) - EUR 66 million to Romania. APL Phase 2 (APL2) - EUR 50.6 million to Turkey, US$27 Million to Albania, and US$21 million to Serbia and Montenegro (Serbia project), APL Phase 3 (APL3) - US$25 million loan to Macedonia, and US$ 150 million to Turkey,, US$36 million to Bosnia and Herzegovina and US$ 9 million to Montenegro (negotiated in April 26,2006) 5

16 20. The objective of ECSEE APL is the development of a functioning regional electricity market in South East Europe and its integration into the internal 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 as well as technical assistance for institutional/systems development and project preparation and implementation. 3. Project Development Objectives and Key Indicators 2 1. Within the overall ECSEE APL objectives/context, this project (ECSEE APL3- Montenegro) would provide investment support to EPCG, the Electric Power Utility of Montenegro. Specifically, the objective of the ECSEE APL3 - Montenegro project is to improve the efficiency and reliability of the power system in Montenegro, through better supply security and closer integration into the regional markets. The key performance indicators that will be used to assess the results of the ECSEE APL3 -Montenegro project are presented in Annex The ECSEE APL program would be considered successful if the countries in the region achieve their commitments under the ECSEE Treaty and are able to: (a) develop a functioning electricity market including the agreed market liberalization targets; and (b) integrate it into the internal electricity market of the European Union. 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. 4. Project Components 23. 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). 24. The ECSEE APL3-Montenegro Project consists of the following components: Component 1 - Telecommunications System Development 25. This component includes one sub-project for the development of a modern telecommunications network for EPCG, including telecommunications links with regional utilities. The sub-project includes installation of the necessary communication equipment mainly using optical ground wires (OPGW) as the main communication links and using SDH and PDH technologies. The new developed telecommunications network and regional links will include the installation of about 620 km of OPGW in existing high voltage transmission networks. 26. The development of the modern telecommunications system is an essential project for integrating the electricity market in Montenegro with the regional markets. The system will also 6

17 be necessary to support the scheduling and execution of bilateral contracts and energy schedules of future energy imports that will be necessary to meet the growing demand in Montenegro. 27. The new telecommunications network will also enable EPCG to meet the communication requirements of dispatch, metering and high voltage network operations and provide broadband communications facilities between major EPCG offices to support improvements in EPCG financial management and administration. Significantly, the new telecommunications network and its regional links will be necessary for interconnecting the National Dispatch Center of Montenegro with the dispatch centers of neighboring countries and will enable EPCG to meet UCTE (of which it is a member) requirements that each of its members must have at least two independent point to point physical telecommunications connections with two other transmission system operators in the region. 28. EPCG has prepared a Master Plan for the development of the telecommunications system which envisages the implementation of this sub-project in the following three phases: 0 Phase I - Connection to Pozega (Serbia): This phase includes the supply of OPGW and SDH equipment for the implementation of a communication connection with the Electric Power Company of Serbia (EPS). Phase I1 - Connection to Trebinje (B&H): This phase includes the supply of OPGW and SDH equipment for the implementation of a communication link with the Electric Power Company of Bosnia & Herzegovina (B&H). Phase I11 - Completion of OPGW network. This phase should include the implementation of OPGW on 1 10 kv transmission lines to complete the two telecommunications rings connecting the National Dispatch Center in Podgorica with local transmission substations. 29. The total cost of this sub-project is estimated at Euro million, of which an equivalent of US$6 million will be financed by the ECSEE APL3 - Montenegro project. The scope of the Bank financing includes the supply of equipment and materials with supervision of installation and any other necessary incidental services for phase I and phase I1 of the project. Depending on the size of the final unallocated amount of the credit, the ECSEE APL-3 Montenegro project may finance the supply of equipment and materials for phase 3. EPCG will be responsible for partial equipment supply, design and bidding documentation, installation works and taxes. 30. EPCG will be responsible for hiring a consultant to prepare the design and technical specifications of the telecommunications system including the preparation of the bidding documents. The terms of reference of the consultant must be satisfactory to the Bank and must ensure that the design of the system is based on a least cost option which meets EPCG s telecommunications needs and the requirements for regional market integration and operation. EPCG will make all efforts to ensure that selection of the design consultant and preparation of the design and technical specifications of the telecommunications system will be implemented in a timely manner not beyond the following dates: July 1, 2007: Consultant selection and Contract Award are completed December 28,2007: Design and technical specifications are completed January 25,2008: Bidding documents for Phase I are issued. 7

18 Component 2 - Transmission Network Reinforcement 3 1. This component includes the following two transmission reinforcement sub-projects: Reinforcement of the 110 kv connection to Andrijevica 110/35 kv substation. This sub-project includes the construction of an additional 2 km 110 kv transmission line circuit to reinforce the substation s connection to the transmission network in order to comply with the N-1 transmission planning criterion and to reduce the duration and amount of energy interruptions of the load supplied by Andrijevica substation. Reinforcement of the 220 kv connection to Mojkovac 220/110/35 kv substation. This subproject includes the construction of an additional 2.5 km 220 kv transmission line circuit to reinforce the substation s connection to the transmission network in order to strengthen the transfer capacity of the transmission system in the substation local area and to eliminate energy interruptions in the area due to transmission bottlenecks caused by outages occurring during peak demand periods. 32. The total cost of Component 2 is estimated at Euro 2.66 million, about half of this cost will be financed by the ECSEE APL3 - Montenegro project. Component 3 - Improvement of Operational Reliability of Perucica HPP 33. This component includes the following two sub-projects: Replacement of the existing trash rack and trash rack cleaning machine (TRCM) installed at the bottom outlet of the Vrtac retention reservoir of Perucica HPP. The existing trash rack and cleaning machine at the Vrtac outlet which have been in continuous operations since 1960 will be replaced by a new trash rack with a screen that is designed for urban type wastes and a new cleaning machine based on modem technology. Supply of spare turbine runners for units 1 to 5 in Perucica HPP. Some of these runners have been in use for over 35 years with more than 150,000 hours of operation (assumed useful life of the runners) and have been showing symptoms of damage due to runner cavitations and general wear. 34. The total cost of Component 3 is estimated at Euro 1.66 million; about Euro 1.O million of this cost will be financed by the ECSEE APL3 - Montenegro project. A detailed description of the project is presented in Annex 4. The Regional Context. Montenegro and the Energy Community of South of South East Europe 35. Reducing the growing gap between energy supply and demand is crucial to encourage stronger economic development throughout South East Europe. Recognizing the benefits of a regional, rather than national, approach to energy issues, nations and territories in the region signed the Treaty Establishing the Energy Community of South East Europe (ECSEE) in October 2005, which will establish a regional energy market linked to the European market. The 8

19 signatories include Albania, Bulgaria, Bosnia and Herzegovina, Croatia, Greece, Kosovo (UNMIK), FYR Macedonia, Romania, Serbia,,and Montenegro. 36. At the broadest level, the regional ECSEE framework provides one potential mechanism to encourage greater interdependence among what has been a fragmented region. More specifically, regional approaches to energy issues in South East Europe offer scope to improve the utilization of existing supply and production capacities, and to optimize new generation investment across the region. An established and functioning regional electricity market will help encourage energy investment decisions to be increasingly determined on the basis of broader economic efficiency - increasing opportunities for more efficient exporters, and providing reassurance to importing countries that there is sufficient security of supply to forego less efficient domestic generation investments. 37. Electricity shortages are already developing in the region, and these will continue to increase without very significant investments. A recent World Bank supervised and EUfinanced Generation Investment Study for South East Europe, for instance, concluded that to meet even modest demand increases, investments of Euro 9.5 million (in 2005 prices) to develop new capacity and Euro 5.9 billion to rehabilitate existing plants will be required before The establishment of a well functioning regional electricity market with consistent market rules and appropriate regulatory oversight, and with market participants having fair and reliable access to the national and regional transmission networks will be critical to overcome the current fragmentation of energy supply and to encourage the new investment needed to meet these emerging demand gaps. And without a regional framework to encourage investment in least-cost generation capacity, even investments of the magnitude above are likely to leave gaps between supply and demand. 38. In addition to improving efficiency, a uniform region-wide institutional framework for electricity trading is expected to expand the region s generation mix, improve overall energy conservation and efficiency, reduce an excessively high energy intensity of production compared to international norms, and strengthen national institutions and adopt legislation and regulations to EU standards. The ECSEE Treaty has particularly provided a mechanism to eventually bring regional environmental standards as they relate to energy issues to a point consistent with the EU acquis communautaire, including the application of EU directives to new generation plants. 39. Recognizing the importance of supporting the development of the regional electricity market in South East Europe, the Board in January 2005 approved a $1 billion horizontal APL facility to support countries to better integrate into the regional energy market. So far, loans and credits totaling over $350 million have been approved for Albania, FYR Macedonia, Romania, Serbia and Montenegro (Serbia Project), Bosnia and Herzegovina, and Turkey. The investment projects eligible for Bank financing under the ECSEE APL program are: 0 Generation - plant rehabilitations in case where the priority and cost-effectiveness can be readily established; Transmission - interconnections between countries and to UCTE (Union for the Coordination of Transmission of Electricity in Europe) and transmission line and substation reinforcements within individual countries because links between countries are useful only if power can be moved across countries with reliability and upgrading of 9

20 facilities and installation of new facilities for system operations (load dispatch and communications); Distribution - metering and/or telecommunications programs which are designed to quickly enhance revenue realization and/or coordination and communication capabilities of utilities so that they can more effectively participate in the regional power market; and Technical assistance for institutional development and project preparation and implementation. 40. Within this broad framework of policy actions and regional market development needs, investments under individual APL projects will vary to some extent depending on the particular situation of countries. Due to the limited number of power supply resources (mainly two hydro power plants and one thermal power plant) in Montenegro, the country is a net energy importer. In addition, Montenegro has inadequate telecommunications links with neighboring power systems. Therefore the ECSEE investment program in Montenegro is focused on increasing the capacity and reliability of the transmission system to support an increased level of energy imports and promote the integration of the country s power system into the regional market. 41. The telecommunications system component of the ECSEE APL3 - Montenegro project will include development of a modern telecommunications network for the electric utility in Montenegro, including direct links with dispatch centers in Serbia and Bosnia. The development of such a system will be necessary for monitoring and coordinating the operations of the regional markets and for improvement of data exchanges between market participants. In addition, the development of the telecommunications system will also be necessary to support the scheduling and execution of bilateral contract and energy schedules of future energy imports that will be necessary to meet the growing demand in Montenegro. 42. The sub-projects included in the Transmission Network Reinforcement component wil increase the transmission capacity in the sub-project areas, which will be necessary to support Montenegro s energy imports required to adequately supply electricity to the northeast part of Montenegro. Improving transmission capacity will also provide the distribution company, eligible customers and competing energy producers with reliable access to the future ECSEE regional wholesale markets where they can purchase power at competitive rates. Such reliable access to the local and regional transmission systems is crucial for enabling regional wholesale energy trading. 43. The sub-projects included in the Improvement of Operational Reliability of Perucica HPP component will increase the operational reliability of Perucica hydro power plant. This 307 MW power plant is one of the two main hydro power plants in Montenegro and is a major provider of energy balancing and ancillary services necessary for the reliability of the operation of the local and regional power systems. These services provided by Perucica HPP, and similar plants, will be traded in future regional ancillary services markets to ensure the reliability of the power s ys tem. 44. Recognizing the regional dimensions of this operation, US$6 million in additional financing has been provided from the IDA 14 regional allocation on top of the US$3 million being provided by Serbia and Montenegro s country allocation. 10

21 5. Lessons Learned and Reflected in the Project Design 45. 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, 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 requires that close attention 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 therefore 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. 46. 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 ECSEE Treaty, and is backed by an exceptionally strong donor involvement. Recent reforms in the Montenegro context (power industry restructuring and regulatory reform) confirm ongoing commitment to the regional initiative. 47. ECSEE APL 3-Montenegro. EPCG has had several issues that delayed the implementation of an on-going World Bank project4. That project included new technology with complex implementation requirements (Automatic Meter Reading and Financial Management and Information System) that EPCG was unfamiliar with. Furthermore, when the project started EPCG did not have adequate capacity to carry out procurement activities according to the World Bank guidelines. These problems have been recognized by both EPCG and the World Bank team. 48. The new project should not have the same problems. EPCG has designated a small team (project management unit) comprising experienced staff that will be responsible for the project implementation and will coordinate with other corporate departments to ensure effective implementation of procurement, contracting, contract administration, disbursement, and financial management including reporting. EPCG s procurement and financial capacity have been enhanced significantly through training and through implementing the on-going project and other projects, of larger size, financed by international donors using the Bank s bidding documents. Furthermore, the investment components included in ECSEE APL3-Montenegro Project are of proven design and include technology and implementation requirements that are well known to EPCG. Also a streamlined approach emphasizing supply and supervision contracting, where appropriate, will be employed in the implementation of these components. In addition, EPCG has in the past prepared bidding documents for projects similar to the ones financed by the ECSEE APL3- Montenegro project. 4 Montenegro Emergency Stabilization of Electricity Supply Project, US$ 5 million, Closing Date: June 20,2007). 11

22 49. Consulting services will be required to assist EPCG in the preparation of the final design of the telecommunications system. EPCG and the Bank have already agreed that the cost of this consultancy services will not be financed by the ECSEE APL3-Montenegro project and in order to expedite project implementation, EPCG will complete the tendering and hiring of the design consultant to ensure that implementation of the telecommunications system will not be delayed. 6. Alternatives Considered and Reasons for Rejection 50. 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, , The components to be financed by the ECSEE-APL3 Montenegro project have been identified as priority investments following detailed project reviews based on system needs and implementation priority. C. IMPLEMENTATION 1. ECSEE Partnership Arrangements 52. 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 with both the countries and the EU signing the Treaty. Finally, ECSEE is a partnership between the SEE countries, the donors, and financial institutions 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. 2. Institutional and Implementation Arrangements 53. 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 High-level Group, Task Forces, and the Forum. This mechanism is detailed in Annex 1, Section ECSEE APL3-Montenegro. The project will be implemented by EPCG. EPCG designated a small team (Project Management Unit - PMU) for the implementation of the project 12

23 components. This team s main function will be to coordinate with other corporate departments to ensure effective implementation of procurement, contracting, contract administration, disbursement, and financial management including reporting. The Chief of PMU is the assistant director of the power transmission department of EPCG and will be responsible for overall project implementation. The PMU also includes the chief engineers of Perucica HPP, telecommunications and transmission networks and will be responsible for the implementation of the sub-projects included in the Project s three components each in their areas of responsibilities. The PMU includes employees who are in charge of the procurement and financial management of an existing World Bank project5 and therefore they are experienced with the Bank s procurement and financial management guidelines. The PMU will be responsible for submission of interim unaudited financial reports (Financial Monitoring Reports) to the Bank. 55. The legal arrangements governing the Project will be established through provisions in the Financing Agreement between the Republic of Montenegro (as the Borrower) and IDA. The Republic of Montenegro will on-lend the proceeds of the Credit to EPCG through the EPCG Sub-credit Agreement, on the same terms and conditions on which it receives the Credit from IDA. 3. Monitoring and Evaluation of OutcomedResults 56. ECSEE APL. At the regional level, the ECSEE APL program is included in the established mechanism for ECSEE coordination, the 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. 57. ECSEE APL3-Montenegro. The project implementation team will monitor progress against agreed performance indicators specified in Annex 3. EPCG 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. Reports will cover, but not be limited to the following: procurement, financial aspects of the project, environmental and land acquisition aspects. 4. Sustainability 58. ECSEE APL. The ECSEE market vision and sustainability are 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 10,2004. Montenegro Emergency Stabilization of Electricity Supply Project, US$ 5 million, Closing Date: June. 30,

24 Turkey is also expected to be interconnected with UCTE in the 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. 59. ECSEE APL3-Montenegro The project is fully sustainable. The new connecting lines to the substations and the equipment for the hydropower plant are needed under all circumstances. The telecommunications system sub-project is needed to improve EPCG operations and allow Montenegro to efficiently participate in the regional market. 5. Critical Risks and Possible Controversial Aspects 60. ECSEE APL The ECSEE APL program 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. 61. The pace of liberalization may nevertheless trigger controversy. Adjustments can however, be accommodated to some extent in the ECSEE Treaty, including derogations and subsequent modifications in accordance with the practice of the European Commission. Other potential ECSEE-related controversies 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 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 is underpinned by a legally binding international Treaty. The region should therefore develop an EU-compatible regional market and thereby represent a much larger and more attractive investment destination for prospective investors. 62. ECSEE APL 3-Montenegro. 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 ECSEE APL3-Montenegro project, where Component 2 and Component 3 sub-projects to be financed are quite conventional, small in size, and their implementation could be completed in an 18 to 24 months period. Component 1, the telecommunications system, while somewhat larger, would be equally non controversial since it involves essentially no social, environmental or land acquisition issues and i s based on proven technologies used by many power utilities. 14

25 63. Project implementation while it has been slow in the first project is expected to be much more rapid in the second project because of the increased experience of the EPCG staff and their familiarity with the technology and implementation requirements of components under the new project. Land acquisition i s minimal, just the short connector lines from the two substations to the main transmission lines. EPCG completed the detailed design of the two transmission connections by end of December, 2006, and started the process of land acquisition of necessary lots for the tower footprints. This process is expected to be completed before the project effectiveness and therefore, land acquisition is not expected to be a significant risk impacting implementation of the project. EPCG will also be required to hire the design consultant for the telecommunications component and to prepare the component design and technical specifications no later than the following dates: 0 July 1, 2007: Consultant selection and contract award are completed December 28, 2007: Design and technical specifications are completed January 25,2008: Bidding documents for Phase I are issued. 64. There is a reasonable probability that EPCG will be restructured before the project ends. This would probably involve the creation of an independent transmission systems owner and operator which would, however, remain government owned. In this case it is expected that most of the credit would be shifted to the new transmission company through a new sub-credit agreement between the Government of Montenegro and the transmission company. No new Development Financing Agreement should be required. It is expected that the implementation of the project will not be negatively impacted by the restructuring of EPCG, due to the fact that the first two components of the projects will be implemented by the transmission operation group where most of the staff of the project management unit work and because of the short implementation time for the project s third component (Improvement of Operational Reliability of Perucica HPP) which is expected to be completed by end of August Official financial forecasts for EPCG were not available at the time of the preparation of the project due to the uncertainty of future tariff reforms and restructuring activities of EPCG. The Bank team and EPCG were able, however, to develop forecasts by making certain reasonable assumptions on tariffs, EPCG operations, and pricing of energy sold to KAP according to the price envisaged in the draft KAP Power Purchase Agreement (PPA)6. These assumptions in the financial forecasts show that EPCG should reach self sufficiency in about three years and should meet the financial covenants of this project. The Bank team will continue to work with the government, EPCG and the country regulator to ensure that EPCG is compensated for its power sales to KAP according to the signed PPA and the published tariff methodology is implemented to minimize the risk of EPCG not meeting the project financial covenants. Annex 9 includes detailed description of the developed financial forecasts and associated assumptions. 66. Additional financial performance monitoring of EPCG and impact of sector reform, including EPCG restructuring, and market liberalization will be closely followed up and assessed by the Bank as part of its overall economic dialogue with the Government of Montenegro. Subsequently in September 2006, EPCG and KAP signed a Power Purchase Agreement which is significantly in line with draft PPA modeled in the financial forecast. 15

26 6. Credit Conditions and Covenants 67. 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 loandcredits 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. 68. Montenegro already fulfills the initial APL conditions and the APL3 project components comply with Bank safeguard policies. 69. EPCG would be required to meet the following financial covenants (see Annex 9 for details): (a) Self financing ratio greater than or equal to 35% starting January 1, 2008; (b) maintain collection ratio of 90% or greater starting January 1,2007 until January 1,2008, a collection ratio of 92% or greater from January 1, 2008 until January 1, 2009 and 94% or greater from January 1, In addition to the above, EPCG will be required to: 1) Carry out a mid term review by March 15,2009; and 2) implement the sub-project Environmental Management Plans and Land Acquisition Policy Framework. 71, EPCG will also maintain a financial management system acceptable to the Bank. The project financial statements and the Designated Account will be audited by independent auditors acceptable to the Bank and on terms of reference acceptable to the Bank. Entity financial statements will also be audited by independent auditors acceptable to the Bank. The annual audited statements and audit report will be provided to the Bank within six months of the end of each fiscal year. The audits will be conducted in accordance with International Standards on Auditing (ISA) as issued by the IFAC and on terms of reference acceptable to the Bank. 72. Effectiveness Conditions: The Borrower shall submit to the Bank a signed EPCG Sub-credit Agreement between the Republic of Montenegro and the EPCG. 73. Disbursement Conditions: 0 Disbursement for the supply of goods for the telecommunications sub-project will not be allowed until (i) EPCG has engaged a consultant under terms of reference and with qualifications satisfactory to the Association to prepare the final design and technical specifications for the activities under Component 1 of the project; and (ii) the final design of the telecommunications sub-project is completed by the design consultant hired by EPCG and the design of the sub-project is satisfactory to the Bank. 16

27 D. APPRAISAL SUMMARY 1. Economic and Financial Analyses 74. ECSEE APL. 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 these countries have substantial hydro power capacity, while others rely more on thermal, and two have nuclear power plants. The March 2004 framework paper discusses the country-by-county situation. This mix of hydrohhermal generation enhances the prospects for efficiency improvements 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 (i.e. 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 eastern neighbors such as UkraineRussia 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. 75. The benefits of regional power trade in general and trade benefits in the SEE region specifically are studied in the Generation Study for South East Europe, This study estimates that full regional integration would lead to a total system cost reduction of the order 10% over the period Savings are due largely to export from countries with low cost (lignite) fuel resources, 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. 76. ECSEE APL3-Montenegro. A detailed economic analysis of the project is presented in Annex. This analysis takes into account the two major benefits which will result from the transmission and hydropower plant investments to be undertaken as well as their costs. These benefits are explained below. 77. Reduction in Enerw Interruptions. Electricity interruptions occur when a transmission line or substation is unable to reliably supply the required electricity. Good examples of this are the Andrijevica substation which has only one line connecting it to the grid and the Mojkovac substation with the weak capacity of the local transmission system to which it is connected. When forced outages occur in the substation s local transmission systems, the customers drawing power from the substation have unserved energy. This unserved energy i s valued at 38.5 Euro centdkwh which is the value used in the regional Generation Investment Study performed for the SEE region. 7 This is a joint study of the Bank and the European Commission. It is posted on the ECA pages of the Bank s website. 17

28 78. Additional Generation. The additional equipment for the Perucica hydropower plant will allow additional generation to occur. Currently parts of the plant would be temporarily stopped and in some cases water is spilled if the trash rack, trash cleaning machine or some of the runners are not working. With a new trash system and back up runners the plant can produce more electricity than it would otherwise. This additional electricity is valued at the 2005 cost of imported electricity of about 4.5 Euro centslkwh. 79. Telecommunications The benefits of the modern telecommunications system are substantial, as described in Annex 9, and include the integration of the Montenegro electricity market into the regional market and providing EPCG with increased control and monitoring capability of the local power system. 80. The real Economic Rate of Return for the transmission and generation components (Components 2 and 3) is estimated to be about 18%. Significant economic benefits will be achieved by the development of the regional markets in South East Europe as explained in Annex 9. The implementation of the telecommunications system (Component 1) will be necessary to integrate the Montenegrin electricity market into the regional markets and to realize the economic benefits of accessing regional supply resources to meet its growing demand. These benefits are significant for Montenegro in terms of cost and security of electricity supply; however it would be hard to quantify these benefits which are directly attributed to the telecommunications system. Therefore, no Economic Rate of Return was calculated for this subproject Financial forecasts for EPCG were prepared on the basis of 2004 financial statements (2005 statements were not available during appraisal) combined with estimates of the tariffs which are likely to be set by the Energy Regulatory Agency (ERA), the regulatory body for Montenegro. Based on the 2003 Energy Law the tariffs that ERA establishes should cover costs and not provide cross subsidies. The forecasts in Annex 9 show that EPCG should be financially viable and able to meet its commitments, including the proposed loan covenants assuming that tariffs are raised in accordance with the methodology agreed with the regulator, ERA, and the company is compensated in some form for its below market price sales to KAP. The Bank will continue to work with ERA to ensure that the published methodology is implemented and with the Government of Montenegro to ensure that the EPCG is compensated for its below market price sales to KAP. 2. Technical 82. 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 10,2004. Additional interconnections, within the region and with the European Union, will be required to accommodate the projected increasing power flows. The APL program will support some of these additional projects, and other donors participating in the Athens process will support others - active donor coordination is aimed at ensuring that the 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 18

29 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. 83. ECSEE APL3-Montenegro. The power system assets in Montenegro are old with many of the system components having exceeded their useful life. The performance of the network is poor by international standards. Often constraints in the internal transmission network occur during peak demand periods which forces equipment outages and cause interruptions of energy to the consumers. Upgrades and expansion of the local transmission and distribution networks are required in order to fulfill the N- 1 network security criteria and to reliably supply power to existing and future electricity consumers. In addition, substantial investments are needed to improve the operational reliability of the existing generation plants in Montenegro. 84. EPCG has developed a short list of urgent projects selected for financing by the IDA Credit, justified by their high impact on the reliability of the power system operation and their short implementation timeframe. The selected projects will be focused on strengthening the capacity of the transmission network, improving the operational reliability of one of the country s two main hydro power plants, (Perucica HPP, which is a major producer of ancillary services needed for the reliability of the transmission system) and assisting the integration of the Montenegrin electricity market into the regional market. EPCG has provided the Bank with detailed justifications and conceptual designs of the final investment projects. 3. Fiduciary 85. 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 APL3-Montenegro 86. Procurement. A procurement capacity assessment carried out by the Bank found that EPCG staff has experience in the Bank s procurement rules. EPCG staff have worked on procurement in previous Bank projects, and are preparing bidding documents in advance of the finalization of the current credit. Annex 8 includes the main results of the procurement capacity assessment and the procurement plan of the project. 87. A Bank review of EPCG s financial management arrangements has also been undertaken and they were found to be generally satisfactory. The financial management arrangements of the project are therefore acceptable to the Bank. The annual audited project and entity financial 19

30 statements will be provided to the Bank within six months of the end of each fiscal year, and project financial statements will be provided also at the closing of the project. Financial statements will be audited by a private auditor acceptable to the Bank. 88. EPCG will produce a full set of interim unaudited financial reports or Financial Monitoring Reports (FMRs) for each calendar quarter throughout the life of the project. The reporting is based on EPCG s own reporting systems. The project will use transaction based disbursements. The staff in charge of proj ect coordination and implementation has prior experience in working on World Bank projects. Satisfactory internal control procedures for the project are in place. 89. The designated account (Special Account) for administering the project funds will be opened in a commercial bank acceptable to the Bank. 4. Social 90. ECSEE APL. ECSEE s overall social impact is positive. The common objective of the parties adhering to the Athens Process and the ECSEE Treaty 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 de-facto 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. 91. 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 lowincome 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. 92. ECSEE APL3-Montenegro has very limited social impacts. There is very limited land acquisition required for project components relating to new power transmission lines. EPCG has also prepared a Land Acquisition Policy Framework (LAPF). The LAPF documents the legal basis for expropriation, if any, the treatment of affected persons, the process to be followed, and EPCG s reporting requirements to the Bank as regards land acquisition. 93. Affordability of power is likely to become an issue in the Montenegrin context as power tariffs increase over time to cover operating and investment costs. To resolve this dilemma, the Government of Montenegro could evaluate a range of alternatives to mitigate the effect of price 20

31 increases on poor and vulnerable households. These measures include the identification of poor and vulnerable consumers and design of a tariff scheme to finance a safety net program in the energy sector. 5. Environment 94. 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. 95. 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. 96. ECSEE APL3-Montenegro. The project is rated a category B project. EPCG has prepared the necessary Environmental Management Plans (EMPs) to mitigate any environmental impacts of the sub-projects included in Component 2 and Component The EMPs for the Transmission Network Reinforcement sub-projects were translated into the local language. Consultation and disclosure of the EMPs are completed. The sub-projects of the Transmission Network Reinforcement Component involve a modest amount of construction activity and will have minimal environmental impacts which have already been mitigated by the sub-project EMPs. The route of the transmission connections will almost certainly follow existing right-of-way. If new right-of-ways will be required for the construction of the new connections, the right-of-ways will not cross any officially designated forest areas or officially designated or known natural habitats. 98. The trash rack sub-project primarily involves the purchase of a new piece of equipment and disposal of the older obsolete system. The work involved in this sub-project will not have any impacts on existing dams or their safety. The plant follows regular inspection and maintenance procedures, required by country regulations, to ensure the integrity of the dam structures. The plant operation procedures include operation safety procedures and an emergency response plan. An EMP for the sub-project was prepared by EPCG based upon and in accordance with recommendations of the World Bank dam safety specialist. Consultation and disclosure of the EMP for the trash rack sub-project will not be needed because the pieces of equipment to be installed are on existing company property and there are no affected groups anywhere near the project site. No EMP will be prepared for the supply of the spare turbine runners, as the new runners will be used as spare parts installed when needed and EPCG staff are well trained and have performed this activity many times during the plant operation. World Bank Draft Note on Poverty and Environmental Impact of Electricity Price Reform in Montenegro, February

32 99. No EMPs are necessary for the upgrading of the telecommunications system which will involve installing optical ground wires (OPGW) in existing transmission lines and more telecommunications equipment in certain larger substations. 6. Safeguard policies Safeguard Policies Triggered by the Project Yes No Environmental Assessment (OP/BP/GP 4.01) [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 4.11) [ ] [XI 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 (OPBP 4.37) [I [XI Projects in Disputed Areas (OP/BP/GP 7.60) [I [XI Projects on International Waterways (OP/BP/GP 7.50) [I [XI 100. The sub-projects included in the Transmission Network Reinforcement component will require land acquisition for the tower footprints and may require the removal of some structures to clear the right of way under the transmission lines. EPCG has prepared a Land Acquisition Policy Framework acceptable to the Bank that will guide land acquisition during project implementation. 7. Policy Exceptions and Readiness 101. No policy exceptions are being sought. The project is ready for financing. 22

33 Annex 1::ECSEE Program and Montenegrin Power Sector Background Energy Community of South East Europe APL 3 - Montenegro Project 1. The Energy Community of South East Europe (ECSEE) In 2002, to pave the way for an efficient regional response to the emerging supply constraints in South Eastern Europe (SEE) and the supply security concerns, the governments of SEE and the European Commission (EC) signed in Athens, Greece, a Memorandum of Understanding on the Regional Electricity Market in South East Europe and its Integration into the European Union Internal Electricity Market. This document is referred to as the Athens Memorandum With the inclusion of natural gas, a more detailed version of the memorandum was signed, which is referred to as the Athens Memorandum 2003, and supersedes the 2002 document. The signatories expressed their intent in formalizing their commitments therein. The regional market development process is referred to as the Athens Process. ECSEE Objectives The key objectives of the Energy Community of South East Europe (ECSEE) are to: 0 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; Establish an integrated regional market 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 energy security of supply of South East Europe and the European Union by providing incentives to connect the Balkans to Caspian, Middle Eastern and North African gas reserves and to exploit indigenous reserves of fossil fuels; 0 Improve the environmental situation in relation to energy in the region. Parties involved in the Athens Process include: 23

34 The European Community. Adhering Parties are Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia, Romania, Serbia, Montenegro, and Turkey. The United Nations Interim Administration in KOSOVO, pursuant to the United Nations Security Council Resolution The Adhering Parties and the United Nations Interim Administration in Kosovo 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. Neighboring non-eu Member States can request to participate as observers. Currently, Moldova is participating as an observer. The Treaty establishing the Energy Community (the Treaty) The Council of the European Union authorized the European Commission in June 2004 to open negotiations on behalf of the European Union, with SEE countries. ECSEE s Ministerial Council concluded on December 13,2004 that there was broad agreement on the substance of the Treaty and directed their negotiators to conclude remaining details as soon as possible. The Treaty was consequently signed on October 23,2005 by all of ECSEE s Regional Members (with the exception of Turkey) and by the European Community. 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). ECSEE Implementation Mechanism A comprehensive coordination and implementation mechanism has been established that 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 meeting takes place biannually with the participation of the Ministers in charge of Energy of the participating 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 Ministries in charge of Energy of the countries and the European Community. The group meets, when necessary, on the initiative of the Commission and the Presidency in Office, in order to prepare the agenda for 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: (1) the SEE Energy Regulators Task Force, which works closely 24

35 with the Council of European Energy Regulators (CEER); and (2) the SEE Transmission System Operators Task Force (SETSO), which interacts with the European Transmission System Operators Group (ETSO) and the Regional Group for Coordination of Electricity Transmission in the Southeast European Interconnected System (SUDEL). The ECSEE Electricity Forum meets at least twice yearly. The Forum comprises representatives of the governments, regulators and transmission system operators of the countries, CEER, SETSO, ETSO, SUDEL, producing companies, consumers, the European Commission, the Stability Pact, and donors including the Bank. Donors are members of the ECSEE Electricity 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 politicamechnica1 goals and organizing donors. The Commission was funding an Athens Process secretariat, based in Athens, to support the process, inter alia, benchmarking and monitoring it. The Ministerial Council, the Permanent High Level Group and the Forum have been in existence since 2003 and are formally recognized in the ECSEE Treaty. The Treaty establishes a Regulatory Board and a Secretariat: The Regulatory Board would be an advisory body that monitors the implementation of all statutory, technical and regulatory rules. The Regulatory Board would be composed of one representative of the energy regulators of the Regional Members. The European Commission would represent the European Union. The Secretariat would monitor ECSEE s development and review the implementation and functioning of the energy market. The Secretariat would assist the Council, the Permanent 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 regional electricity market can be briefly outlined as follows: ECSEE Participants: 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, 25

36 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 SETS0 and in the framework of the UCTE. Integration of ECSEE into the European Union Internal Energy Market: Except for Turkey all countries of the SEE operate synchronously as a part of the main European power system administered by UCTE 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 countries of the region secure access to major trading partners and important import sources to meet possible electricity shortfalls and requirements for emergency support. This highlights the electricity/economy dimension in ECSEE s integration into the European Union internal energy market. 2. The World Bank ECSEE APL Program The Use of Adaptable Program Lending (APL) for ECSEE. The key policy and institutional elements for an APL program have been defined and established. ECSEE is a regional program, with strong country commitment and with wellestablished coordination mechanisms at the highest political level, also at the level of regulators and transmission companies in the region, as well as among donors supporting the program, plus the ECSEE Electricity 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 would 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 to be 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 the Vice President, Europe and 26

37 Central Asia Region. 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. The 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 FY07-08 This phasing provides for a four-year program (FY05-FY08). Each APL installment would have an implementation period of 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. In addition to project triggers (which determine when an individual investment is eligible to receive Bank funds), policy triggers determine the eligibility of an individual country to receive Bank assistance under the APL program. Policy Triggers A fundamental eligibility criterion for a country to qualify for Bank support is the signing of 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 for 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. 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. For a countryhorrower to be or remain eligible for Bank support under the APL program, the Bank also needs to be satisfied that the countryhorrower 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 Treaty commitments but not have implemented or launched credible programs or other critical measures that are needed for market participation. The Treaty calls for the opening of the electricity market to all non-household customers by January 1, The target dates that are being applied as triggers under the ECSEE APL program will be those incorporated in the Treaty including derogations and subsequent 27

38 modifications agreed by the European Commission and ECSEE Regional Members. Triggers will not be applied to loanskredits already approved Environmental Considerations The Bank s standard environmental requirements would apply to projects supported under the APL program. An environmental management plan or plans 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 US$ 1.0 Billion ECSEE APL Lending Program The US$1 billion size of the ECSEE APL facility approved by the Bank represents a significant commitment to ECSEE by the Bank. Even though the size may appear to be large, the financial requirements of power development in the region are also very large, and the Bank s US$ 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 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, cannot 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 for prospective investors. A tentative country breakdown of the utilization of the APL program financing is given in the table 1.1 below. To date the following are approvedhn process: APL Phase 1 (APLI) - EUR 66 million to Romania. APL Phase 2 (APL2) - EUR 50.6 million to Turkey and US$27 Million to Albania and US$21 million to Serbia and Montenegro (Serbia project) APL Phase 3 (APW) - US$25 million loan to Macedonia, and US$ 150 million to Turkey (approved in March 2006), US$36 million to Bosnia and Herzegovina (in process ) and US$ 9 million to Montenegro (in process) 28

39 Kosovo Macedonia Romania Serbia Montenegro Turkey Unallocated TOTAL I 84 I114 I255 I 246 I ,000 The above APL financing plan includes a proposed unallocated portion of US$93 million (about 9%, 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. 3. Montenegro Sector Issues Overview of the Power Sector The power sector in Montenegro i s owned and operated by a state owned entity ElectroPriveda Crna Gora (EPCG). EPCG has an effective monopoly of generation, transmission, distribution and retail sales. During 2005, EPCG was functionally unbundled into separate generation, transmission, distribution and supply businesses. The Montenegrin electricity system is a small one, serving about 250,000 customers. Total electricity demand in Montenegro in 2004 was about 3,800 GWh. Households account for 1,400 GWh, with the majority of households using electricity for heating. The country industry includes an aluminum plant (KOMBINAT ALUMINIJUMA - KAP) whose demand consists of almost 50% of the country total electricity demand. Other large customers include steel and railway companies. Montenegro is unable to satisfy all this demand from its own generation capacity, and has to import 33% of its total needs. EPCG imported about 540 GWh in 2004, and KAP and the steel company imported a further 710 GWh on their own account. These imports come from various neighboring countries and are arranged on an annual contract basis as well as on shorter term basis. The total installed generation capacity in Montenegro is about 849 M W and consists essentially of one thermal (lignite) unit (Pljevlja with a net available capacity of 191 MW) and two hydro plants (Piva with 342 M W and Perucica with 307 MW). Serbia and Montenegro have a longterm power exchange agreement in place for the Piva power output whereby Montenegro makes available the Piva power output (mostly peak energy) and receives a greater amount of base load power from EPS (the Serbian utility) in return. In addition to these three major power plants, Montenegro has seven small hydro power stations with a total capacity of 9 MW. In 2003, EPCG had a total net generation of 2,607 GWh. Hydropower accounted for 1,533 GWH (59%), while Pljevlja lignite power plant generated 1074 GWh (41%). 29

40 The transmission system in Montenegro consists of 1562 km of 400 kv transmission lines, km of 220 kv transmission lines, 6465 km of 110 kv transmission lines and about km of low voltage distribution lines. The transmission system is interconnected with Serbia by 400 kv and 220 kv lines, with Albania by 220 kv lines and with Bosnia and Herzegovina by lines of the three voltage levels (400 kv, 220 kv and 110 kv). Total losses in the Montenegrin system are high compared to European standards. Distribution losses have remained at around 19% over the past ten years, estimated as being evenly divided between technical losses and electricity theft. Collections over the past year have improved considerably from 80% in 1997 to 90% in Reform Direction-Energy Law and the EU Market Integration Process The Government embarked upon a comprehensive reform and restructuring program of the electricity sector in order to create a liberalized, efficient and economic sector. This is being carried out under the Energy Law of The principles and goals of the reform program defined by this Law are substantially in line with EC Directives (1 996/92/EC and 2003/54/EC) concerning rules for the internal market for electricity. Montenegro is also a signatory of the Athens Memoranda of 2002 and 2003 and the ECSEE Treaty of Reform Implementation Functional and Corporate Restructuring of the Sector Unbundling Pursuant to the law and consistent with the Athens Treaty, ECPG has been functionally unbundled into separate generation, transmission, distribution and supply businesses. Formal legal unbundling and the establishment of the transmission business unit as a separate corporate entity is planned for 2007, which will pave the way for the establishment of the independent Transmission System Operator. Independent Regulatory Framework - Montenegro has set up an independent regulator, the Energy Regulatory Agency (ERA), with jurisdiction over electricity licensing, tariff setting and customer service issues. Under the terms of the Energy Law, ERA is required to reform electricity tariffs so that they are cost reflective and to eliminate the cross-subsidies between different customer categories. Status of Tariffs. In December 2005 EPCG filed a consolidated business plan (revenue requirement) for 2005 with ERA. The regulator has yet to reach an agreement with EPCG on the allowable costs or a decision on the appropriate tariff based on this plan. However, the ERA tariff order is expected in April 2007 and it is anticipated that it will provide a phased path to achieve cost reflective tariffs over a period of about three years. Competitive Market Structure - ERA is responsible for the timing of market opening. Taking into account Montenegro s commitments under the ECSEE Treaty, the objective is to start to open the market for non-household consumers by January 1, This, however, allows only a limited period of time to complete the restructuring of the sector and the preparation of the market design and rules. The ERA is also responsible for establishing the market design and rules for the electricity market in Montenegro. ERA has already hired a consultant, financed by 30

41 the European Agency for reconstruction (EAR), to assist the agency in developing the market rules, resolving tariff issues and preparing for market liberalization to meet the ECSEE Treaty requirements. Montenegro s Regional Interconnections - Montenegro is integrated into the Balkans Electricity Market. It has transmission lines connecting it to Serbia and Albania and electricity imports to Albania transit Montenegro. In addition, Montenegro imports base load power from Serbia and exports peaking power to Serbia. In October 2004, the resynchronization of the second UCTE (Union for the Coordination of Transmission of Electricity in Europe) zone was successfully completed and today Montenegro s transmission system is part of UCTE which coordinates the operation and development of the transmission networks of its member. Key Medium-Term Sector Issues (a) Ensuring supply - Electricity demand has been growing at about 2 percent per annum over the last 7 years and is expected to continue to increase as a result of rising household and commercial use of electricity. The main proposal for additional domestic generation is to add a second unit at the existing thermal power station. However, this would require a new mine in the longer term to supply the proposed new unit and the new mine (Maoce) would be even higher cost than the current Potrlica mine. (b) The other alternative is to reduce electricity consumption by increasing tariffs and increasing efficiency. However, the main consumer of electricity in the country, the Aluminum works (KAP), is very sensitive to electricity prices and was built in Montenegro primarily because it offered cheap electricity prices. As part of KAP s privatization, it will be guaranteed low although rising prices until About one third of domestic electricity usage is now imported and most likely that will increase in line with the growth in demand. Other parts of the Balkans have lower cost sources of electricity generation. (c) EPCG Financial Situation - EPCG makes a substantial loss as a result of moderate to low tariffs combined with the high costs of the thermal power plant, high costs of imports largely for sales to KAP at below cost and significant system losses especially in distribution. The Government needs to implement a plan to resolve this situation. This plan should include measures to reduce distribution losses, subsidies to EPCG to compensate for the below cost sales to KAP as well as moderate price increases. (d) Privatization - Montenegro needs to decide on a privatization strategy including what parts of EPCG it would propose to privatize. The establishment of this privatization strategy would have an impact on the outcome of EPCG restructuring and whether future EPCG legally unbundled entities would be completely separate entities or will be under an EPCG holding company. The Government of Montenegro was expected to complete the privatization strategy by the end of Nevertheless, the sale activities for the privatization of the Pljevlja thermal power plant and its mine are already underway. Furthermore, EPCG plans to complete the legal unbundling of the EPCG transmission business unit in

42 The European Agency for Reconstruction is financing a technical assistance to assist the Government of Montenegro and EPCG in addressing many of the above issues. The objectives of this technical assistance are: 0 Assist the Government of Montenegro to develop and implement an energy policy and strategy that is in accordance with the ECSEE Treaty. 0 Support EPCG in restructuring activities. 0 Investigate the options of the attraction of private sector capital in the energy sector to assist the Government of Montenegro to prepare the privatization strategy. Assist in improving the financial viability of the electricity sector. In addition, the Bank Second Structural Adjustment Credit (SAC 2) built on and consolidated reforms in a number of areas, including in the energy sector. In the energy sector, the SAC 2 supported the implementation of a restructuring plan for EPCG, and the signing of a multi-year power purchase agreement between the Podgorica Aluminum Plant (KAP) and EPCG, which provides for a phased tariff increase in the medium term. The restructuring and functional unbundling of the generation, transmission, distribution and supply businesses of EPCG have moved forward. To date. the multi-year power purchase price agreement contained in the Privatization Strategy for KAP, was signed in September Even with the implementation of this agreement, the agreed floor price still falls below the cost recovery level of EPCG, therefore impacting EPCG financial position. 32

43 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies Energy Community of South East Europe APL 3 - Montenegro Project 1. Support for the ECSEE Program 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 and the Electric Power Emergency Reconstruction Project in Serbia were instrumental for the resynchronization of the second UCTE zone (Eastern part of Bosnia, plus Albania, Bulgaria, Greece, Macedonia, Romania, Serbia and Montenegro) with the Western 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 program, in large part co-financed with EIB 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 internal 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. 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. The Spanish Government has provided support through a trust fund to help the Bank review ECSEE investment projects and to help fund an electricity market expert panel for Turkey. CIDA of Canada is providing regional technical assistance (the SEETEC project) for the development of the regional electricity market in South East Europe. USAID is providing technical assistance on legal and regulatory aspects of power reforms and restructuring, including institution-building 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 (footnote 2) contains a comprehensive listing of technical assistance in the ECSEE context. The Italian 33

44 Government may provide technical assistance for ECSEE preparatory work to ECSEE Regional Members. All of these agenciedcountries except Spain are members of the ECSEE Forum. In addition, the Pre-accession Programs sponsored by the Government of Netherlands is providing assistance to the public sectors of the EU candidate member states (Bulgaria, Croatia, Romania and Turkey) for the implementation of the acquis communautaire. 2. Support for the Montenegro Electricity Sector A large number of the institutions mentioned above as well as other institutions and governments have provided support for the Montenegro Electricity Sector. Donors and Lenders Support The World Bank Group is funding an existing project with EPCG (Emergency Stabilization of Electricity Supply Project). This is an IDA credit of US$ 5 Million equivalent (3.8 Million SDR). The Credit is planned to close by end of June 2007 and it includes the following two components : Power Distribution Pilot including the installation of AMR meters. Financial Management System. The EU has donated funds for feasibility study for a transmission interconnection project between Montenegro and Albania. European Agency for Reconstruction has donated funds for rehabilitation and expansion of existing substations. The European Investment Bank has provided a Euro 11 million loan for replacement parts for the Perucica and Piva hydropower plants and replacement parts transmission facilities. These replacement parts consist of turbine wheels, regulators, switches, disconnectors, transformers and meters. USAID donated funds to assist Montenegro in paying for electricity imports The Government of Switzerland has also donated funds for a substation expansion. The Government of the Netherlands has donated funds for a wind turbine pilot project. The Government of Spain has donated funds for a management training program of staff from the electricity energy sector. The Government of Norway has made extensive donations for transformers (both distribution and transmission), software, meters, communications systems and technical studies. The Government of France has provided a loan of Million Euro for rehabilitation of six existing transmission sub-stations and the equipment for about 60 new distribution sub-stations. 34

45 The Government of Germany, primarily acting through KFW, has provided 8.6 Million Euro of grants and loans for the rehabilitation of the Perucica hydropower plant. German funding of a 400 KV transmission line from Podgorica to Tirana in Albania is at an advanced stage with the Germans expected to provide over 40 Million Euros in grant and loan facilities for this line. 35

46 Results Framework Annex 3: Results Framework and Monitoring Energy Community of South East Europe APL 3-Montenegro Project 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 institutionalhystems 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 APL3-Montenegro, the objective of the project is to improve the efficiency and reliability of the power system in Montenegro, through better supply security and closer integration into the regional markets. Intermediate Results One per Component 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. The substations have fewer blackouts, the hydropower plant generates more electricity at lower operation and maintenance cost and the company operates more efficiently with UCTE and the regional markets as a result of the improved telecommunications system. Use of Outcome Information An increasing number of electricity consumers are free to choose their electricity supplier. The Montenegrin power network operates more reliably with greater supply security and its integration into the regional markets is improved. 36

47 Component 1 : The integration of the Montenegrin power sector into the regional markets is improved. Component 2: Transmission Network in the subproject areas is reinforced Component 3: Operational Reliability of Perucica HPP is improved i) Satisfactory completion of the first two phases of the component s subproject and Phase 3 if financed by ECSEE APL3- Montenegro. (ii) Communication links with two neighboring dispatch centers are operational. (i) Satisfactory completion of the component s subprojects. (ii) Unserved Energy due to forced outages in the subproject s local areas reduced by 50%. (i) Satisfactory completion of the component s subprojects. (ii) Operation and Maintenance cost of the trash rack system is reduced by 75%. (iii) Maintenance cost of the turbine runners is reduced bv 20%. System communications and communications with other regional systems are improved resulting in lower costs and efficient operations. Widespread forced outages in the areas of the two substations are reduced. System operation and maintenance costs are reduced and reliability is improved. 37

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51 Annex 4: Detailed Project Description Energy Community of South East Europe APL 3-Montenegro Project Power Sector Investment Needs The power system assets in Montenegro are old with many of the system components having exceeded their useful life. The performance of the network is poor by international standards. Many often constraints in the internal transmission network occur during peak demand periods during which forced equipment outages cause interruptions of energy to the consumers. Upgrades and expansion of the local transmission and distribution networks are required in order to fulfill the n-1 network security criteria and to reliably supply power to existing and future electricity consumers. In addition, substantial investments are needed to improve the operational reliability of the existing generation plants in Montenegro. Based on feasibility studies and historical performance of the power system, EPCG prepared an initial list of investment projects proposed for financing by the new ECSEE APL3-Montenegro project. The proposed investment projects include projects (shown in Table 4-1) required for the rehabilitation and expansion of the transmission, distribution and generation systems in Montenegro. Ta Project Number WB-T-2 WB-T-3 WB-E-T- 1 WB-E-T- 2 WB-E-T- 3 Project Cost (million of Euro without VAT and duties) Transmission Projects to the transmission network 1.21 EntryBxit connection of 220/110/35 kv Mojkovac substation to the transmission network 9.11 Telecommunications system 2.00 Rehabilitation of substations It Project Needs Project Name WB-T-1 I 1.03 I Entry/Exit connection of 110/35 kv Andrijevica substation Construction of the 400/100 kv Ribarevine substation Construction of 110/35/10 kv Kotor substation with a 110 kv transmission line connecting Tivat - Kotor substation WB-G-4.7 Production and delivery of spare turbine runners to units Perucica HPP 41

52 WB-E-D-1 WB-E-D-2 WB-E-D-3 WB-E-D-5 WB-E-D OO WB-E-D-4 I 0.70 Sources: EPCG Grounding of neutral points in the distribution networks Rehabilitation of the 35/10 kv Bistrica substation Rehabilitation of 10 kv switchgear at Podgorica 3 110/10 kv substation Construction of 110/10 kv NikSiC substation Construction of 35 kv lines (Virpazar - Podgor and Podgor - Cetinje) with rehabilitation of 35/6 kv Podgor substation I Rehabilitation of 35/10 kv Humci substation Project Components The initial list of EPCG investment projects exceeds the amount of the ECSEE APL 3 - Montenegro IDA Credit. EPCG has thus developed a short list of urgent projects selected for financing by the IDA Credit justified by their high impact on the reliability of the power system operation and their short implementation timeframe. The selected projects will be focused on integrating the energy market in Montenegro with the regional markets, strengthening the capacity of the transmission network and improve the operational reliability of one of the country s two main hydro power plants, Perucica HPP, which is a major producer of ancillary services needed for the reliability of the transmission system. EPCG has also provided the Bank with detailed justifications and conceptual design of the final investment projects. The ECSEE APL3 - Montenegro project will have the following three investment components: Component 1: Telecommunications System Development This component includes one sub-project for the upgrading of the telecommunications network for EPCG, including telecommunications links with regional utilities. The subproject includes installation of the necessary communication equipment predominantly using optical ground wires (OPGW) as the main communication links and using SDH and PDH technologies. The upgraded telecommunications network and regional links will include the installation of about 620 km of OPGW in existing high voltage transmission networks. 42

53 The upgraded telecommunications network will enable EPCG to meet the communication requirements of dispatch, metering and high voltage network operations and is necessary for the regional market integration and operation. It will also provide broadband communications facilities between major EPCG offices to support improvements in EPCG financial management and administration. The upgraded telecommunications network and its regional links will be necessary for interconnecting the National Dispatch Center of Montenegro with dispatch centers of neighboring countries in accordance with the recommendations of the South East Europe Cooperative Initiatives (SECI) project Telecommunications System and Ancillary Services Market Development in South East Europe. The development of the regional telecommunications links will enable EPCG to meet UCTE (of which it is a member) requirements that each of its member must have at least two independent point to point physical telecommunications connection with two other transmission system operators in the region. EPCG has prepared a Master Plan for the development of the telecommunications system which envisages the implementation of this sub-project in the following three phases: 0 Phase I - Connection to Pozega (Serbia): This phase includes the supply of OPGW and SDH equipment for implementation of the communication connection with the Electric Power Company of Serbia (EPS). OPGW will replace the existing ground wire on the 400 kv HVL Podgorica 2 - Ribarevine and Ribarevine - SS Pljevlja 2 lines with a total length of about 150 km. The estimated cost of this phase is Euro 2.64 million. 0 0 Phase I1 - Connection to Trebinje (B&H): This phase includes the supply of OPGW and SDH equipment for the implementation of communications with the Electric Power Company of Bosnia&Herzegovina (B&H). OPGW will replace the existing ground wire on 400 kv, 220 kv and 110 kv transmission lines of total length of about 230 km. The estimated cost of this phase is about Euro 3.70 million. Phase I11 - Completion of OPGW network. This phase should include the implementation of OPGW on 1 10 kv transmission lines to complete the two telecommunications rings connecting the National Dispatch Center in Podgorica with local transmission substations. The total length of the planned OPGW to be implemented in this phase is about 245 km at estimated cost of Euro 4.48 million. The total cost of this project is estimated at Euro million, of which an equivalent of US$6 million will be financed by the ECSEE APL3 - Montenegro project. The scope of the Bank financing includes supply of equipment and materials with supervision of installation for phase I and phase I1 of the project. Depending on the size of the final unallocated amount of the credit, The ECSEE APL-3 Montenegro project may finance the supply of equipment and materials for phase 3. EPCG will be responsible for partial equipment supply, design and bidding documentation, installation works and taxes. Consulting services will be required to assist EPCG in the preparation of the design of the telecommunications system. EPCG and the Bank agreed that the cost of these 43

54 consultancy services will not be financed by the project and to expedite the project implementation. EPCG will be responsible for partial equipment supply, design and bidding documentation, installation works and taxes. EPCG will be responsible for hiring a consultant to prepare the final design and technical specifications of the telecommunications system. The terms of reference of the consultant must be satisfactory to the Bank and must ensure that the final design of the system is based on a least cost option that meets EPCG telecommunications needs and the requirements for the regional market integration and operation. Component 2: Transmission Network Reinforcement This component includes the following two transmission reinforcement sub-projects: Reinforcement of the 110 kv Connection of Andrijevica 110/35 kv Substation Sub-project Andrijevica 110/35 kv substation is located in the northeastern part of Montenegro and is connected to the SS Bearne - EVP Trebjesica 110 kv transmission line by a single transmission circuit (T connection). During peak demand periods, the substation supplies a total load of about 10 MVA. Andrijevica s single connection to the transmission network has suffered from a large number of forced outages as a result of its outdated and run down condition. Due to the substation single connection to the transmission grid, these forced outages have caused interruptions of the energy supplied by the substation. Table 4-2 shows the number, duration and amount of energy interruptions to the substation load that have occurred in 2004 and Total number of supply interruptions Total duration of supply interruptions Duration of the longest interruption Duration of the shortest interruption Assessment of total energy not being delivered, based on the average power of 6 MW Year 2004 Year hours 17 minutes 61 hours 59 minutes 27 hours 9 minutes 18 hours 18 minutes 3 minutes 3 minutes 314 MWh 372 MWh This sub-project includes the construction of an additional 2 km 1 10 kv transmission line circuit to reinforce the substation connection the to the transmission network to comply with the N- 1 transmission planning criterion. The construction of the additional circuit will result in significant reduction in the duration and amount of energy interruptions of the load connected to Andrijevica substation. In addition, this sub-project will improve the voltage performance of Andrijevica substation and will enable the maintenance of the substation connection and transformer without any interruption in the supply. 44

55 The total cost of this sub-project is about Euro 1.22 million. The ECSEE APL 3- Montenegro project will finance the supply of the project equipment and materials with supervision of installation at an estimated cost of Euro 0.67 million. The remaining cost of the sub-project will be financed by EPCG including partial equipment supply, preparation of the design and bidding documents, civil and installation works, land acquisition and local taxes. 0 Reinforcement of the 110 kv Connection of Mojkovac 220/110/35 kv Substation Sub-project Mojkovac substation is located in the northeast part of Montenegro and i s connected to Podgorical- Pljevlja kv transmission line by a single transmission circuit (T connection). The substation is also connected to the 1 10 kv local transmission network by a 150 MVA transformer. The substation s two connections are part of a 110 kv dominantly transmission loop that represents a second transmission path in the northeastern part of Montenegro and which with the 400 kv transmission lines transport a large portion of the energy from Piva HPP, Pljevlja TPP and imports from Serbia to main load centers in Montenegro. The 220 kv connection of Mojkovac substation represents the section with the weakest capacity in this 1 10 kv transmission loop. Historical performance of the local transmission network has shown that forced outages of this substation s connection had required partial shedding of load supplied by the 110 kv transmission loop, as illustrated in Table 4-3. Table Sources: EPCG This sub-project includes the construction of an additional 2.5 km 220 kv transmission line circuit to reinforce the substation s connection the to the transmission network. The construction of the additional circuit will be necessary to strengthen the transfer capacity of the 1 10 kv transmission loop and will almost eliminate energy interruptions of the local load supplied by this loop caused by forced outages of local transmission facilities. The total cost of this sub-project is about Euro 1.44 million. The ECSEE APL 3 - Montenegro project will finance the supply of the project equipment and materials with supervision of installation at estimated cost of Euro 0.65 million. The remaining cost of the sub-project will be financed by EPCG including partial equipment supply, preparation 45

56 of the design and bidding document, civil and installation works, land acquisition and local taxes. Component 3: HPP Perucica Operation Reliability Improvement Perucica hydro Power Plant is the second largest hydro power plant in Montenegro. It consists of seven generating units, each with two turbine runners, fed by three water penstocks'o. The plant has been a major source of energy supply and producer of ancilary services necessary for the reliable operation of the Montnegrin and regional transmission systems. Due to this exceptional value and importance, EPCG propsoed the following two sub-projects to be financed by the ECSEE APL3 - Montenegro project: Replacement of a Trash Rack and Trash Rack Cleaning Machine (TRCM) Subproject The exiting trash rack and cleaning machine at the plant's Vrtac retention reservoir have been in continuous operations since 1960 when the power plant was put in operation. The cleaning machine was designed based on outdated technology that does not meet current water cleaning needs and has passed its operational useful life. The cleaning machine capacity is inadequate for the type and quantity of debris that is deposited on the trash rack (screen) and which over the years has changed in type from large organic wastes materials into classic urban wastes. Such inadequate operation has resulted in clogging of the trash rack causing decreased water flow to the hydro power plant. The increased clogging of the trash rack had required on two occasions, in 2004 and 2005, manual cleaning of the trash rack. Since the trash rack is constantly submerged by water during the plant operation, the manual cleaning of the trash rack is only possible when the whole Perucica HPP is shut down during which the plant's intake, channels, tunnel and penstocks are empty of water. Therefore, during the operation of Perucica HPP, especially in the periods of significant water inflow (around 180 days in the year), two to fifteen EPCG workers with appropriate equipment are used for protection against total clogging of the trash rack. The workers perform the following activities that could be performed, or minimized, by modern cleaning machine: Trash removal from the channel preceding the trash rack Trash removal from Vrtac retention Trash removal from the cleaning machine plateau Repair of the existing cleaning machine This sub-project includes dismantling and replacing the existing trash rack and cleaning machine by a new trash rack with a screen that is designed for urban type wastes and a new cleaning machine based on modern technology. EPCG has gained knowledge and experience in preparing the design and installation of such sub-project. In 2005, EPCG 'O Penstock No. 1 feeding Unit 1 and Unit 2. Penstock No. 2 feeding Unit 3, Unit 4 and Unit 5. Penstock No. 3 feeding Unit 6 and Unit 7. Units 1 to 5 are 40 MW each. Units 6 and 7 are 65 MW each. 46

57 completed the replacement of the trash rack and cleaning machine located at another water outlet at Perucica HPP. The project was financed by EIB. The implementation of this sub-project will improve the function and reliability of the water cleaning system at Perucica and improve the water flows into the hydro power plant and hence will increase its efficiency and power production. The total cost of the sub-project i s about Euro 0.83 million. The APL 3 (Montenegro) Credit will finance the supply of the project equipment with supervision of installation at estimated cost of Euro 0.5 million. EPCG will be responsible for financing the cost of preparation of the system design and bidding documents, partial equipment supply, civil and installation works. 0 Supply of Spare Turbine Runners for Units 1 to 5 in the Perucica HPP Subproject Some of the existing runners in the plant have been in use for over 35 years with more than 150,000 hours (assumed useful life of the runners) of operations. These runners have been showing symptoms of damages due to cavitations and their run down and outdated conditions. Table 4-4 shows the number of working hours for turbine runners in Pericuca HPP. Table 4-4: HPP Turbine Runners Unit - Runner Number of Working Hours 1- A B A A B A (OLD) I 6- A hew) I B I A B The table shows that the six turbine runners installed at units 1 to 5 have exceeded their assumed life cycle. Currently the plant has a few old, exploited, overhauled runners that have been used as back up runners to replace runners damaged during operation. The run 47

58 down condition of the operating and back up runners has required more regular inspection, maintenance and runner replacement if repair is required. Regular inspection of one runner takes two days, on average and the replacement of one turbine runner takes between six and eight days. Two runners were replaced and repaired in 2004 and another two runners in In the same period eight periodic checks of runners were undertaken. Runner inspections and replacements require drainage of the penstocks feeding water to the units'' whose runner is being replaced, or inspected. In such situation, all other units fed by the same penstock are put out of service. This sub-project consists of the supply of new spare turbine runners for units 1 to 5 in Perucica HPP to improve the operation reliability of the plant and prevent any long shutdown of units in the plant due to shortage of spare turbine runners. The total cost of the supply of the spare runners is Euro 0.83 million of which the APL 3 (Montenegro) Credit will finance Euro 0.5 million. EPCG will be responsible for the preparation of the technical specification and bidding documents of the spare runners, partial equipment supply and installation. I' See footnote 7 48

59 ~~ Annex 5: Project Costs Energy Community of South East Europe APL 3-Montenegro Project I Project Cost by Component Foreign Million Euro VAT & Local VAT Total Duties Million Million Million Million Euro Euro Euro Euro Phase I Phase I1 Phase so I ComDonent 2: Transmission Network Reinforcement Reinforcement Andrijevica 110/35 kv Connection Reinforcement Mojkovac 220/110/35 kv Connection Component 3: : HPP Perucica Operation Reliabilitv ImDrovement Replacement of the trash rack and cleaning machine Supply of spare turbine runners I Note: (1) Assumed Exchange rate = 1 Euro = US$ (2) The scope of the Bank financing includes supply of equipment and materials with supervision of installation. Depending on the size of the final unallocated amount of the credit, the ECSEE APL-3 Montenegro project may finance the supply of equipment and materials for phase 111. (3) The final cost estimates and number of phases for the telecommunications system development project will be determined four months after the Design Consultant is hired and may be different from the envisaged three phases listed in the above table. In such case, the Credit funds available to the telecommunications system development project will be allocated to the project phases determined by the Design Consultant. 49

60 Annex 6: Implementation Arrangements Energy Community of South East Europe APL 3-Montenegro Project 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 High-level Group, Task Forces, and the Forum. This mechanism is detailed in Annex 1, Section 1. ECSEE APL3-Montnegro The project will be implemented by EPCG. EPCG designated a small team of staff (Project Management Unit - PMU) for the implementation of the project components. The structure of the PMU consists of: 0 Chief of the PMU 0 Chief Engineer of telecommunications system development component 0 Deputy PMU and Chief Engineer of transmission network reinforcement component 0 Chief Engineer of Perucica HPP operation reliability improvement component 0 Procurement Specialist 0 Financial Specialist 0 Project Administrator This team s main function will be to coordinate with other corporate departments to ensure effective implementation of procurement, contracting, contract administration, disbursement, and financial management including reporting. The chief of the PMU is the assistant director of the power transmission department of EPCG, who will be responsible for overall project implementation. The PMU includes employees who are in charge of the procurement and financial management of an existing World Bank projecti2 and therefore they are experienced in the Bank procurement and financial management guidelines. The PMU will be responsible for submission of interim un-audited financial reports (Financial Monitoring Reports) to the Bank. The ECSEE APL 3 - Montenegro project will finance the supply of equipment and materials, including supervision of installation and any necessary incidental services of the sub-projects included in the project s three components. The procurement of the project components is expected to be through international competitive bidding. The remaining costs of the sub-projects will be financed by EPCG including partial equipment supply, preparation of the design and bidding document, civil and installation works, land acquisition and local taxes. For the telecommunications sub-project, consulting services will be required to assist EPCG in the preparation of the final design Montenegro Emergency Stabilization of Electricity Supply Project, US$ 5 million, Closing Date: June. 30,

61 of the telecommunications system. EPCG and the Bank agreed that the cost of this consultancy services will not be financed by the project and to expedite the project implementation, EPCG will complete the hiring and the design and technical specifications of the telecommunications system no later than: 0 July 1, 2007: Consultant selection and Contract Award are completed. December 28,2007: Final design and technical specifications are completed. January 25,2008: Bidding documents for Phase I are issued. The following EPCG department will be responsible for project implementation: Transmission Network Reinforcement sub-projects and the telecommunications system development sub-project will be the responsibility of the transmission functional entity. HPP Perucica Operation Reliability Improvement sub-projects will be the responsibility of the generation functional entity. A procurement plan has been prepared (see Annex 8). 51

62 Annex 7: Financial Management and Disbursement Arrangements Energy Community of South East Europe APL 3-Montenegro Project Country Issues The latest CFAA report was prepared in 2002 and related to Serbia and Montenegro as a whole. CFAA noted that there are a number of risks on the management of public funds in Serbia and Montenegro. 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, (f) poor implementation capacity in line ministries, and (g) the lack of recent Bank implementation experiences within Serbia and Montenegro. Since rejoining the membership of the World Bank, Serbia and Montenegro 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, both the number of commercial banks and firms assessed as acceptable to audit Bank-financed projects has increased, indicating an improvement in the fiduciary environment. Experience in implementing Bankfinanced projects is 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 ECSEE APL3-Montenegro Project will be implemented by EPCG. EPCG designated a small team of staff (project management unit) for the implementation of the proposed Project to work under the Executive director of the EPCG who will be responsible for overall project implementation. This unit will be staffed either with employees in charge of an ongoing project13 being implemented by EPCG or other employees trained by them. This team will be responsible for submission of interim un-audited financial reports (Financial Monitoring Reports) to the Bank. Strengths of the ECSEE APL3-Montenegro project implementation arrangements focus on the fact that EPCG has prior experience of working on Bank s financed projects. Performance of the ongoing project, from a financial management point of view, is satisfactory. In addition, EPCG audit report for 2004 was unqualified. Complexity of the ECSEE APL3-Montenegro project scope is low, with the project having only three components and rather straight forward flow of funds. There are no particular fiduciary weaknesses to the project. However, attention should be paid to EPCG being in the process of unbundling. If the unbundling results in creation of separate legal entities a potentially more complex situation would be created. Questions l3 See footnote 10 52

63 that could arise in this case would be how to organize the capacity to manage e.g. flow of funds; how this shift will be managed in terms of reporting and information systems; and how accounting software would be inherited from the previous entity. Further development of the unbundling process will be closely monitored. Funds Flow The following legal agreements will define the flow of funds and the respective parties roles and responsibilities: 0 The Financing Agreement, between IDA and Republic of Montenegro; and The Sub-credit Agreement, between Republic of Montenegro and EPCG on the same terms and conditions on which the republic of Montenegro receives the Credit from IDA. Project funds will flow from: the Bank - either by direct payment on the basis of direct payment withdrawal applications or as an advance, via a Designated Account (previously referred to as Special Account) to be opened in a commercial bank acceptable to the Bank, which will be replenished under transaction based disbursement method, and managed as described below in the section on disbursement arrangements. Staffing of the Accounting/Finance Function EPCG staff is adequately qualified and possesses previous experience of working on the World Bank s financed projects, as well as working with other international financiers. Performance of ongoing project in terms of financial management is satisfactory. No particular issues were encountered during implementation. Accounting Policies and Procedures EPCG 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 IFRS but is by no means fully compliant. The project accounts will be maintained using the cash basis of accounting. EPCG has instituted a set of appropriate accounting procedures and internal controls including authorization and segregation of duties, and the project will generally be implemented in accordance with EPCG s standard operating procedures. Financial management and internal control policies and procedures instituted during implementation of ongoing project will continue to be applied for the new project as well. They will serve as guidance for staff and minimize the risk of errors and omissions, as well as delays in recording and reporting. These standards also clarify responsibilities, including level of authority, clear control over assets, cash, and bank accounts, and it ensures timely and accurate financial reporting. 53

64 Internal Audit There i s an internal audit department in EPCG, counting three employees which hold local qualifications in accounting and auditing. The Internal audit department reports to the Board of Directors, and it is independent in its work and presentation of its findings. However, with internal audit being introduced in Montenegrin companies only in recent years, with no specific qualifications in internal audit, and the path to obtaining qualifications in accounting and auditing not being assessed, as well as considering the lack of training in internal audit practices and standards in the country, no reliance is placed on internal audit function in EPCG. External Audit Separate project and entity financial statements will be audited in accordance with terms of reference acceptable to the Bank by a private sector auditing company acceptable to the Bank. The auditor will be appointed by EPCG who will be responsible for delivering to the Bank, within six months of the closing of each fiscal year, the audited financial statements. The annual cost of the project and entity audit will be covered by EPCG s own resources. Reporting and Monitoring Reporting for the project will be based on the locally developed accounting system currently used in EPCG extracting data for payments made to a spreadsheet. This system has also been used for the on going project. There is no need to develop specific software for the project. Project management-oriented interim un-audited financial statements (previously called Financial Monitoring Reports (FMRs) will be used for project monitoring and supervision. The format of the FMRs will be acceptable to the Bank. EPCG will produce a full set of the reports for each calendar quarter throughout the life of the project. They will be due 45 days after each quarter end. The accounting for the project is on a cash basis; while the entity s annual audited financial statements are prepared in accordance with provisions of the Law on accounting and auditing in force in Montenegro, or any law succeeding it. Information Systems Information systems and software used in EPCG are not fully integrated. Employees are not networked and they do not have direct access to needed information. Information is shared manually instead. This poses certain problems in flow of information and in efficiency of assignments performed. It also increases risk of error, and aggravates 54

65 knowledge sharing. However, it is expected that these problematic issues will be resolved with the installation of a new Financial Management Information System which is being financed by the World Bank in an on-going project and is expected to be completed by the end of FMRs will be generated using spreadsheets based on the information from EPCG s accounting system and the exchange of additional information between the project management team and headquarters staff in charge of administering the Designated Account. Disbursement Arrangements The disbursement methods will be direct payments to suppliers and, if needed, advance to a Designated Account, Withdrawal applications will be documented for each transaction according to the requirements stipulated in the disbursement letter. Once the Project becomes effective a Designated Account may be opened in a commercial bank acceptable to the World Bank, to which the advance funds will be transferred. The Designated Account will be managed and operated by EPCG. The Authorized Allocation for this Designated Account would be Euro 250,000. Applications for replenishment of the Designated Account will be submitted quarterly. Documentation requirements for replenishment would follow standard Bank procedures as described in the Disbursement Handbook. Bank statements of the Designated Account, which have been reconciled, would accompany all replenishment requests. Counterpart-funding will be executed from EPCG s normal bank accounts. Allocation of Credit Proceeds Category Credit Allocated Expressed in SDR Expenditures to be Financed (1) Goods 4.0 million (telecommunications sub-project) (2) Goods 2.0 Million (Substation connections And Perucica HPP sub-proj ects) 80% 80% Supervision Plan During project implementation, the Bank will supervise the project s financial management arrangements in two main ways: (i) review the project s interim unaudited financial reports (financial management reports) as well as the project s and entity s annual audited financial statements and auditor s management letter; and (ii) perform on- 55

66 site supervisions, review the project's financial management and disbursement arrangements to ensure compliance with the Bank's minimum requirements. Supervisions will be performed by the Bank accredited Financial Management Specialist. 56

67 Annex 8: Procurement Arrangements Energy Community of South East Europe APL 3-Montenegro Project A. General Procurement for the proposed project would be carried out in accordance with the World Bank s Guidelines: Procurement under IBRD Loans and IDA Credits dated May 2004 and the provisions stipulated in the Legal Agreement. The general description of various items under different expenditure categories is described below. For each contract to be financed by the Credit, the different procurement methods estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank project team in the Procurement Plan. The Procurement Plan will be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. Procurement of Works: NIA Procurement of Goods. Goods and services (other than consultants services) procured under this project would include: turbine runners, trash rack and trash rack cleaning machine, equipment and materials for substations transmission connections and equipment and materials for the telecommunications system. The procurement will be done using Bank s standard bidding documents (SBD s) for all International Competitive Biddings. Selection of Consultants: N/A Operating Costs: N/A B. Assessment of the agency s capacity to imdement procurement The Bank team and Government of Montenegro have agreed that EPCG will be the implementing agency of the projects financed by proposed IDA Credit. An assessment of the capacity of the EPCG to implement the procurement actions under the project was initiated by Plamen Kirov (ECSPS) in January 2006 and completed after the EPCG s designation of Project Management Unit in March The assessment reviewed the organizational structure and capacity of EPCG. EPCG is currently implementing a Bank-financed investment project (Montenegro Emergency Stabilization of Electricity Supply Project (MESESP), US$ 5 Million, Closing date: June 30,2007). The staff dealing with implementation of this project has gained good experience in the Bank s procurement, reporting and disbursement. Additional experience has been gained in the implementation of some other projects financed by some other donors (EAR; EU, Governments of Switzerland, Netherlands, Spain, Norway, and USAID). The PMU, designated by the EPCG, comprises of seven people: Chief of the PIU; Procurement Specialist; Financial Specialist; Project Administrator; and, three 57

68 Chief Engineers. The procurement specialist dealing with the procurement management under MESESP will be involved in the implementation of the new project. The procurement of the sub-projects will be carried out through several ICB Goods contracts. The staff that will be dealing with the procurement has experience with the Bank s ICB Goods procurement procedures. The PIU will be responsible for the day-to-day project management including procurement, financial management, progress and financial reporting and project monitoring and evaluation. The CPAR (June 2002) has assessed the risks (legal framework, regulatory functions, enforcement regime, public sector institutions, corruption, etc.) that may negatively affect the ability of the implementing agencies to carry out procurement process and has rated it a high risk. Therefore the prior review thresholds are those applicable to a high risk country. The corrective measures which have been agreed are that the Bank procurement specialist will: (i) provide additional training to the PMU procurement staff on the application of the current procurement guidelines and the respective ICB Goods documents; (ii) provide training to the PMU staff on the preparation of the technical parts of the bidding documents (technical specifications) (iii) conduct a comprehensive procurement training for all project related staff as part of the project launch workshop; (iv) the Bank s Standard Bidding Documents will be used. The Bank will monitor procurement activities. The Bank s procurement specialist will conduct prior review and will provide guidance on all procurement related activities. C. Procurement Plan The Borrower, at appraisal, developed a Procurement Plan for project implementation which provides the basis for the procurement methods. This plan has been agreed between the Borrower and the Project Team on March 27,2006 and which was updated on May 23,2007, and is available at the PMU at the EPCG. 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. D. Frequency of Procurement Supervision In addition to the prior review supervisions to be carried out from Bank offices, the capacity assessment of the PMU has recommended one supervision mission per six months to visit the field. The PMU procurement staff will properly collect and maintain the procurement documentation. Details of the Procurement Arrangement Involving International Competition. e Goods and non consulting services. (a) List of contract Packages which will be procured following ICB. 58

69

70 (b) All ICB Goods contracts will be subject to prior review by the Bank. 0 Consulting Services N/A 60

71 Economic Analysis Annex 9: Economic and Financial Analysis Energy Community of South East Europe APL 3-Montenegro Project Benefits for the telecommunications component (Component 1) The development of a modern telecommunications system linking the power system in a region is part of the investment needs necessary to enable a regional electricity markets to work. In South East Europe, the Generation Investment Study concluded that to meet even modest demand increases, investments of Euro 9.5 billion (in 2005 prices) of new generation capacity and Euro 9.5 billion to rehabilitate existing plants will be required before This amount of investment is assumed to be planned and implemented on a regional basis and could save up to Euro 6.7 billion compared to new generation capacity that is planned and implemented by individual countries to meet their own demand increases. Therefore, the economic benefits of establishing the regional market are significant. Given that Montenegro is a net energy importer, the development of regional energy markets with lower generation costs will benefit Montenegro and will reduce the cost of energy supply to its consumer. The development of a well functioning regional market will require establishing design and rules of the regional markets, investments in transmission and information technology infrastructure including modern telecommunications systems necessary for the coordination and operation of the regional markets using efficient means of system monitoring and data exchanges between system dispatch centers. Therefore, the development of a modem telecommunications system (Component 1) will be necessary to integrate the Montenegrin electricity markets into the regional markets. In addition to the benefit of enabling the establishment of the regional market, the benefits of the telecommunications system component include: Replace slow analog equipment with faster digital equipment. Increase reliability of the telecommunications system since the current system is old and spare parts are hard to obtain. Cost savings of around 250,000 Euros per year from reduced use of telecommunications capacity leased from fixed line and mobile suppliers. Increased telecommunications capacity. Increased ability to coordinate with UCTE and to interact with the regional market. Improved quality of telecommunications. Benefits for transmission and generation components (Components 2 and 3) This project will also invest in two specific transmission investments and in replacement of equipment in the Perucica hydropower plant. It is possible to estimate an Economic Rate of Return (ERR) for specific investments in transmission lines and to a lesser extent in the 61

72 replacement investments in the Perucica Power Plant. The ERRS for these project components are based on the following categories of benefits: Reduction in Energy Supply Interruptions: Outages have been a problem at the Andrijevica and Mojkovac substations. Andrijevica is connected by only a single circuit to the main transmission lines and Mojkovac s connection has limited transfer capacity. During outage conditions of the substation s connections, interruptions of the energy supply to the two substations occurs which in turn often leads to outages for the customers using these substations. In estimating the benefit of reducing outages, we used the economic value of unserved energy provided by the Bank Consultants that did the GIS study for the Balkans,, 385 Euro per MWh, minus the cost of importing the energy. Increased generation: In the case of the replacement equipment for the Perucica hydro power plant, the additional benefit from having this equipment would be the additional generation. This is valued at the cost of imports estimated to average around 4.5 Euro cent/kwh. (Under the terms of the import contracts for 2006 they s will average 4.2 Euro cents/kwh. Import prices are anticipated to increase further in 2007 and 4.5 Euro Cents is a quite conservative real estimate for the next 20 years). There are other potential benefits but these were even harder to quantify. These benefits include: 1) meeting rising load at the substations, which would, however, require additional investment besides the new lines; and 2) reduction in operating and maintenance costs at the Perucica Hydropower plant which is very dependent on what would happen with the labor savings. Costs and Returns from Transmission and Generation Components All of the cost numbers mentioned below exclude VAT and duties and are in constant Euro terms. All of the calculations were done in constant 2006 Euros with no adjustment of costs or benefits for inflation. Andriievica Substation. The main benefit from this investment of about Euro 1.03 Million in a new connection line from this substation to the main transmission line is the reduction in unserved energy. Unserved energy was 372 MWh in 2005 and has been rising rapidly- about 20% per year.. Taking the value of unserved energy at 38.5 Euro cents/kwh and assuming unserved energy in the future rises at 5% per year (a conservative assumption compared to 20% actual increase) due both to the continuing deterioration of the existing line and rising demand, the ERR is 16% real. Mojkovac Substation. The main benefit from this investment of about Euro 1.2 Million in a connector line from this substation to the main transmission line is also the reduction in unserved energy. This was 295 Mwh in 2005 and again rising rapidly. Using the same value of unserved energy as discussed above and conservatively assuming that the amount of unserved energy would rise 5% per year, as also assumed above, the ERR is 11%. Perucica Hydropower plant. These equipment replacements and spare parts are essential to ensure the safety of, and to insure against catastrophic failure of, the Perucica hydropower plant. Their economic value lies in allowing the power plant to continue to operate. 62

73 If the trash rack which is planned to be replaced were to fail, the plant would be left with substantially reduced production for six months while a new trash rack was fabricated and installed. If it is assumed that only 10% of production would be permanently lost because water would need to be spilled while the plant is suffering from reduced capacity and this lost production is worth 4.5 Euro cents/kwh-(the cost of imports), the trash rack would have a three month pay back period. If only 1/2% would be lost the ERR would be 44%. The economic value of the spare runners is also hard to estimate. This is partially a safety issue and partially an issue of reduced production and the two issues are related. The failure of one of the existing aged runners would certainly take that unit out of service pending a replacement, but such a failure while in use can also damage other parts of the unit and may pose a risk to the safety of the workers. Some units use a common intake e.g. units 1 and 2 use the same penstock and intake. It is not currently possible to isolate one unit for maintenance - it is necessary to stop all the units using that intake. (Stop valves exist to isolate individual units but these are now very old and thus considered not fully reliable - these valves will be replaced in the ongoing refurbishment of the plant). It is assumed that with the new runners 2.7 Gwh of additional production would be possible (compared to total production 957 Gwh in 2004). This would be due to fewer breakdowns in the operating units with less spillage of water. If this is the case and the additional production is worth 4.5 Euro centslkwh then the spare runners have an ERR of 13%. The ERR for the transmission and generation components, is 18% real including the Perucica Power Plant Replacement parts. If the ERR is calculated only for the transmission lines to the substations it is 13% real. The net present value of the project is $2.07 Million at a 10% discount rate and assuming a 20 year life for the components. This analysis does not include the significant safety and environment benefits which were not quantified. The cost of the new telecommunications system would be about 9.1 Million Euro excluding VAT of which the Bank would fund about 6 Million Euro. The remainder would be funded by EPCG from their own sources. The benefits of this sub-project resulting from assisting its integration into the regional markets are significant for Montenegro in terms of cost and security of electricity supply, however it would be hard to quantify these benefits which are directly attributed to the telecommunications system. Therefore, no Economic Rate of Return was calculated for this sub-project. Costs and Economic Rates of Return by Component Component cost (Mil Euro.) Economic Rate of Return Andrijevica Substation line Mojkovac Substation Line Trash Rack Spare Runners Telecommunications System % % % % 9.11 N.A. 63

74 Financial Analysis EPCG is a vertically integrated electricity company and prepares consolidated accounts for the electricity sector. However it is in the process of unbundling. Functional unbundling has already been completed and legal unbundling is expected to follow, starting with the transmission aspects of the company and continuing with the other functions depending, in part, on the Government s plans for private participation in the sector. Average tariffs are currently some 6.78 Euro cents per kwh for distribution consumers in However the direct sales to HT consumers are so large (>50% of demand) and at the comparatively low rate of 2.54 Euro Cents /kwh that the average realization comes down to some 3.66 Euro Cents/kWh which is below the cost of supply. A new tariff order from the regulator based on unbundled tariffs is needed. However, the regulator has not reached agreement with EPCG yet on its costs or rate of return on assets and until this is done the regulator cannot provide a tariff. Billing Realisation of Electricity and Average Prices for the Period January to November 2005 No. CATEGORY OF Amounts CONSUMPTION kwh Billing Surcharge TOTAL AVERAGE PRICE Billing realisation For Billing Plus as per realisatio Surchar tariff Electricity ns/kwh ge/kwh ineur ineur categories Imports cents cents Collection efficiency has improved over the past few years, but was a challenge during the conflict years and shows a dip in each year of currency conversion Le. first to the DM in 1999 and then to the Euro in The collection efficiency for 2005 was around 90% and gradual improvements in this are expected to continue. The Bank has agreed with EPCG that by end of 2008 the collection efficiency will have improved to 94% or above. 64

75 EPCG Collection Efficiency 100% 80% 60% 40% 20% 0% z for any region D Lowest achieved for any region +Average collectioi Efficiency In 2004 total sales of EPCG are recorded at 1 63 million. At this level of sales, EPCG makes an operating profit and is able to cover its debt service - but after depreciation it makes a net loss (6% in 2004) and is not investing in its assets as fast as they are depre~iating ~ so the overall asset base is declining (after adjusting for the impact of asset revaluation in 2004). The following historic accounts,below, have been derived from audited financial reports of EPCG through The accounts for 2005 were not available at the time of appraisal. While many of the challenges faced by EPCG are similar to those faced by other power utilities in the region, there is one issue which presents unique difficulties for the power company:- that of the power supply to the major aluminum business, U P. KAP accounts for almost half EPCG s electricity sales. Traditionally, KAP has paid EPCG a rate for power which is below the cost of supply since the Government considered KAP a strategic industry. The company s ability to correct this anomaly is constrained by social and political factors. KAP has now been privatized and under the agreed power purchase contract between KAP and EPCG a significant increase ( about 50%) in the price that EPCG charges KAP is expected in However, the price charged KAP would still remain below the cost of supply to EPCG or the cost of electricity imports, which at the margin are imported to supply KAP. The regulator will also determine a tariff for this supply and will expect the Government to make good any difference between the regulated price and the price stated in the KAP privatization agreement. It remains to be seen how this subsidy will be forthcoming. A second issue is the power supply from Pljevlja thermal power station (TPP). This plant is also planned for privatization along with its associated coal mine. The cost of coal production is expensive - rendering the power from the thermal power station barely competitive with regional imports. The cost of coal production will need to be reduced and the efficiency of the thermal l4 Depreciation in 2004 was 37million compared to investments in plant and machinery of some 9 million. l5 IPA report on Privatization strategy for EPCG and Pljevlja coal mine - May quotes cost of electricity generated as 3.78 cents from Pljevlja TPP which is slightly below the cost of imports. 65

76 power plant to be increased if this plant is to have a long term future. The Electricity law effectively gives Pljevlja five years (from passage of the law in June 2003) to adjust to trading in the regional market. A Government subsidy will be required if EPCG is to be obliged to purchase power from this above the market price after the five year period is up. The other factor having a major bearing on EPCG s financial resources and requirements is the burden of mainly pre-war debt, which amounts to some 96 million. London club debt has not been serviced by EPCG for a number of years and it expected to be largely written off. The Paris Club group of creditors has agreed to a write-down some of the outstanding balance with the Republic of Montenegro and EPCG assumes that this reduction will be passed on to them, but as yet there is no formal agreement on this. Historical Financial Performance Balance Sheet Long term assets Property plant and machinery Long term Investments Long term receivables Total Current assets Cash and Bank Short term investments Accounts receivable Stock Total Intangible assets Net Assets 2004 eo00 1,026,292 3,509 18,110 1,047, ,067 9,594 70,584-1,118, PO00 870,978 2, , , ,688 73,159 9,833 85,300 5, , eo00 916,089 1,773 28, , ,390 63,532 10,541 75,619 3,759 1,025, eo00 959, , ,009 2, ,625 14,005 80,457 3,335 1,052,801 Capital and reserves Stock - Government Stock - Other Non operating assets Accumulated profit/loss Total Long term liabilities Long term Debt Current liabilities Accounts payable Short term loans Other Total Net Liabilities Net liabilities and reserves 613, , , , ,307 42,202 4,199 1,665 48, ,373 1,118, , ,336 - ( 1 0 8, 73 7) 798, , ,845 8,677 1,886 62, , , , ,746 13,590 (79,09 8) 827, ,498 55,769 8,837 1,789 66, ,893 1,025, , ,746 13,590 (45,498) 861, , ,353 7, , ,263 1,052,801 66

77 Income and Expenditure Revenue Energy sales Elec services Other operating revenue Extraordinary Revenue Total Expenditure Cost of Thermal power Coal for thermal plants Cost for Hydro Perucica Cost for Hydro Piva Other imports Imports from EPS Transmission costs Distribution costs Services Administration Depreciation Extraordinary Costs Total Net operating income/loss 2004 loo0 138,865 2,526 17,913 3, ,697 6,433 23,632 5,591 6,230 27,698 (2,876) 5,829 30,48 1 2,479 10,523 37,109 20, ,466 (10,769) 2003 loo0 156,997 1,523 13,631 5, ,860 7,131 24,382 5,368 4,286 45,934 3,916 4,792 29,324 2,230 9,897 52,151 13, ,954 (25,094) 2002 loo0 140,664 2,550 19,373 4, ,719 7,250 32,778 5,022 3,412 49,757 1,647 4,088 28,495 2, ,301 52, ,469 (31,750) 2001 loo0 113,329-23,622 4, ,196 6,129 13,396 3,828 3,584 39,528-5,729 26,132-12,790 46, ,505 (1 6,309) Other Income and expenditure Interest on loans Foreign exchange gains and losses Total (3,469) 3, (5,454) 909 (4,545) (5,037) 3,189 (1,848) (2739 1) (690 19) (8,410) Net Income/loss (10,313) (29,639) (33,598) (24,719) Financial forecast With the present level of uncertainty due to the timing of unbundling, the future tariffs, market liberalization in 2008 and possible privatization; EPCG is not confident of preparing realistic financial projections. Once the expected tariff order is announced it is expected that financial projections will be prepared to accompany the next regulatory filing. However, a financial model was prepared for the analysis of privatization options'' for the sector and gives some indication of the future financial health of EPCG - although clearly very dependent on the assumptions made as to the price paid for power from Pljevlja TPP and the price charged to KAP. This financial model was modified by the Bank team and then further modified by EPCG l6 IPA report on Privatisation strategy for EPCG and Pljevlja coal mine - May under technical assistance from European Agency for Reconstruction 67

78 so as to provide the most realistic projections although these projections come with a very high degree of uncertainty. Nevertheless, these financial projections show that it is possible for the sector to become profitable, 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 increases; and development of an affordable investment program based on priority investments needed to maintain and increase current production and improve quality of supply. Revenue and costs for the Electricity sectors I 250 Staff and operations LLILY Transrnssion Costs l e I 0 m8n Rrucica & Small Hydro mm Fljevlja Thermal m Fijevba Coal -Revenue I 1 68

79 n Ln 0 g 9 ;

80

81

82

83 Environment Annex 10: Safeguard Policy Issues Energy Community of South East Europe APL 3-Montenegro Project The ECSEE APL3 Montenegro project is rated a category B project. EPCG have prepared necessary Environmental Management Plans (EMPs) to mitigate any environmental impacts of the sub-projects included in Component 2 and Component 3. The EMPs for the Transmission Network Reinforcement sub-projects were translated to the local language. Consultation and disclosure of the EMPs were completed on March 3 1, The sub-projects of the Transmission Network Reinforcement involve a modest amount of construction activity for construction of a transformer bay and the suspension of high voltage electrical lines. There are no unique or unusual environmental issues. During construction, the impacts are standard (dust, noise, solids disposal-primarily at Moj kovac substation-land clearance etc.) and can be mitigated with good engineering practice. During operation, the chief concerns are with electric and magnetic fields, neither of which is problematic at the voltages involved. The overhead transmission lines, towers and substations will be designed to provide electric and magnetic field strengths to meet international standards at ground level (transmissioddistribution lines) or at the fence-line (substations). All these issues have been reflected in the EMPs. The route of the transmission connections will highly likely follow existing right-of-way. If new right-of-ways will be required for the construction of the new connections, the right-of-ways will not cross any officially designated forest areas or officially designated or known natural habitats. The trash rack sub-project primarily involves the purchase of a new piece of equipment and disposal of the older obsolete system. The work involved in this sub-project will not have any impacts on existing dams or their safety. The plant follows regular inspection and maintenance procedures, required by country regulations, to ensure the integrity of the dam structures. The plant operation procedures include operation safety procedures and an emergency response plan. An EMP for the sub-project was prepared by EPCG based upon and in accordance with recommendations of the World Bank dam safety specialist. Consultation and disclosure of the EMP for the trash rack sub-project will not be needed because the pieces of equipment to be installed are on existing company property and there are no affected groups anywhere near the project site. No EMP will be prepared for the supply of the spare turbine runners, as the new runners will be used as spare parts installed when needed and EPCG staff are well trained and have performed this activity many times during the plant operation. The telecommunications system development sub- project entails the installation of optical ground wires in existing high voltage transmission lines located in different parts of the country and,therefore, will have no environmental impact and no EMP will be developed for this project. 73

84 Social The sub-projects included in the Transmission Network Reinforcement component will require land acquisition for the tower footprints and may require the removal of some structures to clear the right of way under the transmission lines. EPCG has prepared a Land Acquisition Policy Framework acceptable to the Bank that will guide land acquisition during project implementation A copy of the LAPF is contained in Annex

85 Background Annex 11: Land Acquisition/ Expropriation Policy Framework Energy Community of South East Europe APL 3-Montenegro Project The overall APL objective is "the development of a functioning regional electricity market in South East Europe and its integration into the internal 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, and technical assistance for institutionalhystems development and project preparation and implementation. The Montenegro Energy Project will contribute to meeting the ECSEE objective through investments in electricity transmission and distribution, replacing a trash rack on a critical hydro plant and, depending on the availability of funds, purchasing spare turbine wheels and upgrading energy-related telecommunications within Montenegro and with its neighbors. Two project investments will require land acquisition: EntryExit connections to the transmission network at the Andrijevica Substation (1 10/35 kv) and Mojkovac Substation (220/110/35 kv). Another component has been proposed that would improve transmission lines serving consumers in the distribution system in the communities of Zeta and Tuzi, located south of Podgorica, which are rapidly becoming suburbs of the city. This component would also require land acquisition, but the remaining components will not. The alignments for the entry/exit connection and distribution transmission lines have been determined and entered into the land use plans in the respective areas, but precise land acquisition requirements will not be known until the final technical designs are completed. EPCG has prepared and disclosed this Land Acquisition Policy Framework to cover all land acquisition in the project in compliance with the World Bank's Operational Policy 4.12, Involuntary Resettlement (OP 4.12). Legal Basis for Land Acquisition As a public utility, EPCG is empowered to acquire private land for specific purposes that are determined to be in the public interest. The rights and obligations of EPCG relating to the use and protection of facilities for public interest are spelled out in the Article 1, Clause 3, in the Electricity Law, published in the Official Gazette of the Republic of Montenegro No. 39/03. The legal basis for private ownership of land and the acquisition and expropriation of private land by the State or its agencies is defined in the Constitution of the Republic of Montenegro (Article 45 of the Constitution of the Republic of Montenegro - Official Gazette of the Republic of Montenegro No. 48/92) and elaborated in the Expropriation Law, No. 55/2000, which was modified subsequently to comply with a decision of the Supreme Court of the Republic of Montenegro, No. 14/2001, published in February, The Supreme Court decision clarified the constitutional basis for expropriation, limits of expropriation and the objective of compensation: 75

86 The Constitution, therefore, guarantees the property right and only exceptionally allows the possibility of depriving or limiting the property right in case when that is imposed by the public interest and established by the Law or based on the Law. The owner of the property on which the property right is abolished or limited, must receive a compensation that cannot be lower than its market value. Therefore, the Constitution, along with determining the reasons for abolishment or limitation of property rights, defines also the lowest limit for the determination of a compensation for the abolished or limited property right as an equivalent. The upper limit of the compensation is not defined in the Constitution. The intention is, therefore, that the previous owner is not put into a less favorable position - through application of measures of coercion - as compared with the position he used to have before the application of such measures. Therefore, the abolishment of someone s property right or its limitation is intricately connected with the determination and payment of the belonging compensation or equivalent, the value of which cannot be lower than the market price of a real estate that is being expropriated or a real estate over which the property right is being limited. In accordance with that, as estimated by the Constitutional Court, the determination and payment of compensation must precede the transfer of property right or, at least, be simultaneous with it. The most salient elements of the Expropriation Law are as follows: e e e e e e e 0 e e Expropriation can only be undertaken for public interest, which must be documented in the proposal for an expropriation decision. The Government agency responsible for property and legal affairs confirms public interest, based on a proposal by the investor. The agency that authorizes public interest can permit the investor to conduct preliminary studies on the lands to be expropriated after consultation with the owner(s). The investor submits an expropriation proposal to the local organ in charge of property and legal rights in the municipality in which the land is located; the proposal is based on a preliminary design and includes documentation confirming the investment in spatial plans and establishing public interest; identification of the location and ownership of affected plots, with cadastre extract; estimated cost of expropriation, based on standard evaluation principles; proof that the estimated cost is deposited in an expropriation account. Plot owners are consulted before the expropriation decision is adopted. Compensation is based on the market value of the land and assets (or market rental value, if expropriation is temporary), transition expenses and damages. Compensation can be in cash or in kind-including substituting land or structures and replacing or moving structures. After public interest has been established, the investor can negotiate the amounts and condition of purchase with owners without resorting to expropriation; negotiations are recorded in minutes. After the expropriation decision is adopted, owners are notified in writing of the decision, their right to request expropriation of a whole plot, proposed compensation methods and amounts and the timetable for processing; and are invited to negotiate. If negotiations are not successful, the local property and legal affairs office forwards documentation to the local court to determine compensation; the owner can also appeal to the court for a decision on compensation and the amount of land to be expropriated. 76

87 Land Acquisition Requirements and Project Affected Persons Project investments will entail minimal land acquisition, although the exact amount is yet to be determined. The two entry/exit connection lines between the Andrijevica and Moj kovac Substations and the main transmission lines, respectively, will follow the alignment of existing entry connection lines. The terrain is typical mountain foothill terrain with forests and pastures; little of the land is used actively. Depending on the final technical design, the new lines will either run parallel to existing lines or a double line will replace the existing line. In either case, land will be acquired either for the tower footprints on the new line or the expansion of relocation of tower footprints, if the existing line is replaced with two. The size of a tower footprint varies from 20m2 to 1 30m2. The Andrijevica connection line is approximately 1.6 km and the Mojkovac connection line is approximately 2.5 km. New line bays will be constructed on each substation, as well. The Andrijevica sub-station site i s adequate for the new bay; the Mojkovac site will acquire additional land from the defunct state mining enterprise located next to the site. If the line replacement option is selected for the two sets of lines, additional land requirements will be miniscule, but construction may interrupt service. The double line option will require more land to be acquired (less than 0.5 ha in total), but construction can proceed without affecting existing service. EPCG purchases the land for footprints and compensates owners for temporary use of land used for construction, as well as damages to property values and assets resulting from use restrictions in the right-of-way under the transmission lines. As the additional transmission lines follow existing alignments, the investment is not expected to affect property values significantly and no structures are likely to be affected. Consequently, the cost of land acquisition is expected to be reasonable and relatively easy to negotiate. Three categories of people will be affected by the investment in connector lines: landowners who own land that EPCG will purchase either to place new tower footprints or to expand existing footprints; landowners whose land will be used temporarily during construction; and landowners who own land under the right-of-way of new transmission lines that must be cleared for safety purposes. The proposed component to improve transmission lines that serve the Tuzi and Zeta distribution areas south of Podgorica will also require land to be acquired for tower footprints and other above-ground facilities. One of the three lines being considered will follow the existing alignment, but may require towers to be relocated. The other transmission lines will follow new alignments, one of which is already included in the Podgorica urban plan. These investments will be implemented according to standard land acquisition procedures and practices, but will be somewhat more complicated, as the rights of way may go through inhabited areas. The alignments of the transmission lines will be designed to minimize land acquisition and avoid above ground assets. Nonetheless, clearing the right-of-way under the lines may require the demolition or relocation of structures, some of which are thought to be illegal or informal. Compensation for informal structures will be consistent with payments for legal structures. It is not possible to estimate the amount of land to be acquired or other compensation that will be required for this component, but land acquisition and expropriation procedures, and compensation, will follow the Expropriation Law and EPCG s standard practices. Two categories of people may be affected by investment in the distribution transmission lines in addition to the three categories identified above: owners of informal or illegal structures located 77

88 in the right-of-way of the reserved alignment or new alignment; and the municipality, which will cede or rent land for footprints or rights-of-way for the new transmission lines in some places. EPCG Land Acquisition Procedures and Experience EPCG has a land acquisition office in the Transmission and Distribution functional entities of EPCG that manages expropriation and land acquisition process for new investments. The unit follows land acquisition procedures and compensation standards that are fully consistent with the Expropriation Law and the Electricity Law. During the 1990~~ EPCG had few resources for new investment. Maintenance and rehabilitation were undertaken on an as-needed basis. Consequently, there was virtually no involvement in land acquisition or expropriation. More recently, however, EPCG constructed a major transmission line from Podgorica to Cetinje, which provided valuable experience in land acquisition according to old and new laws. The 110 kv PodgoricdCedtinje transmission line was constructed to provide safe and quality electric energy to the Montenegro coast. This transmission line via Cetinje (which had been connected to the coast) provided a third 1 10 kv line to complement two existing lines that connected Budva and Bar with the main electric point in Podgorica. Construction of the PodgoricdCetinje transmission line started in 1998 and the process of expropriation was undertaken at the same time. Due to legal, property and financial problems of EPCG, as well as the unexpectedly long time required for land expropriation, construction was interrupted very often. In 2000, construction was completely suspended. Work started again in the middle of 2004 and was completed by the end of the year. The alignment of the transmission line mainly goes across sparsely populated mountain-village areas, except where it exits Podgorica, across agricultural and urban land. The km transmission line consists of 1 15 steel-latticed poles. To complete construction of the line, more than 200 different agreements were made with land owners to compensate for expropriation costs and damages. Although compensation was paid, works were finished and the transmission line is functioning, some compensation amounts are still being challenged in court. Current EPCG staff managed the process, successfully accomplishing their objectives. The process took considerably more time than anticipated, however, largely due to apparent loopholes in expropriation legislation, through which a few landowners (approximately 5 out of 200) sought to receive high prices for their land and to increase the amount of land to be acquired. In addition, the process was undertaken in a general atmosphere of public distrust and uncertainty, given the negative expropriation experiences that characterized the previous administration. Ultimately, EPCG was able to gain access to the land, but some cases are still pending in court. The PodgoricdCetinje line was a totally new transmission line that traversed the area from Podgorica to Cetinje, from an urban area to more scenic areas close to the coastal tourist area. By comparison, the entry/exit transmission lines to be funded in the project follow existing 78

89 alignments in areas that have much less economic and scenic value. Consequently, the land acquisition process is expected to be much simpler and expedient for the connector lines. If the Zeta and Tuzi component is included in the project, however, it will be more challenging, as the component will include both new and modified transmission lines. The lines will primarily follow the periphery of the two consumption areas, avoiding densely populated sections, and every effort will be made to avoid residences and business facilities. Nonetheless, it is possible that the placement of tower footprints or the rights-of-way will require the demolition of legal or informal structures, and it is also possible that the local residents will object to the alignment of new transmission lines, reflecting the common NIMBY ( not in my backyard ) phenomenon. To ensure that the process goes smoothly in each case, EPCG will apply lessons learned from the PodgoricdCetinje experience. Three lessons will be applied: Disseminate information proactivelv. As early as possible, and as thoroughly as possible, EPCG will launch a public information campaign to inform residents about nature and benefits of the investments, as well as design, land acquisition and construction procedures. Hold public consultations to both present and obtain information. Although public consultations are not required by law, EPCG staff learned that public meetings held along the alignments paid big dividends in establishing credibility, answering questions and listening to concerns, and offering information that directly addresses public and private concerns. In turn, the consultations yielded information that helped designers make reasonable choices. Minimize land acquisition and disruption. Small changes in alignments can often reduce the impact of land acquisition on individual households and, therefore, reduce opposition and exaggerated expectations. The land acquisition team will thus work closely with the design team to help avoid problems that might otherwise occur. Implementation Responsibility and Financing The land acquisition team in the Transmission and Distribution Functional Entity of EPCG, respectively, will be responsible for carrying out the land acquisition and expropriation. They will work closely with the local property and legal affairs offices as well as project designers. EPCG will finance land acquisition and, according to the law, will deposit funds to cover the estimated cost of land acquisition in an expropriation account before requesting an expropriation decision. In addition, EPCG is responsible for all transaction costs. Payments for costs of court appeals shall be assigned in compliance with applicable laws. Grievance Procedures Affected persons are consulted at the time the expropriation decision is being made. Once the decision is made, affected persons can appeal to the court at any time if they are dissatisfied with negotiation process. Payments for costs of court appeals shall be assigned in compliance with applicable laws. 79