Initial Project Information Document (PID) Report No: AB484. INDONESIA - Domestic Gas Sector Restructuring Region. Project Name

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Initial Project Information Document () Report No: AB484 Project Name INDONESIA - Domestic Gas Sector Restructuring Region East Asia and Pacific Region Sector Oil and gas (100%) Theme State enterprise/bank restructuring and privatization (P); Infrastructure services for private sector development (S) Project P Borrower(s) REPUBLIC OF INDONESIA Implementing Agency(ies) PGN Address: Jl. Zainul Arifin No. 20, Jakarta 11140, Indonesia Contact Person: Djoko Pramono (Finance Director) Tel: Fax: djoko_ak@pgn.co.id Environment Category A (Full Assessment) Date Prepared November 18, 2003 Auth Appr/Negs Date May 3, 2004 Bank Approval Date September 16, Country and Sector Background Key Issues. The GOI and the Bank have been discussing the key policy issues in the wider energy sector over the past few years namely the need for: (i) revising the policy and legislative frameworks of the hydrocarbon (i.e., oil and gas) and power sectors; (ii) rationalizing the prices of energy products, and gradually phasing out the substantial subsidies for petroleum products and electricity; (iii) implementing the fundamental restructuring of the key sector entities namely the State oil (and gas) company (Pertamina), the State gas transportation company (PGN), and the State power company (PLN); (iv) removing both policy and infrastructural constraints to the development of the domestic natural gas industry; and (v) improving urban air quality, by promoting the use of cleaner fuels (including natural gas). A detailed analysis of the issues, and options for addressing them, have been presented in Bank-prepared or supported studies, and those which relate to the domestic gas sector include: the Indonesia Energy Sector Assistance Strategy FY01-03; the report Indonesia Review of Electricity Supply and Demand on Java-Bali: a Framework for Prioritizing System Investments of June 2001, which examined the role of gas in power generation; and most notably, the Indonesia - Oil and Gas Sector Study (Report No IND) of June 2000 the first major review of the sector since This report was not only the culmination of an in-depth assessment of the sector with a particular focus on energy product pricing, the role and functions of Pertamina, as well as on the terms of production sharing contracts (PSCs) but it also summarized the findings of the previous two years of interactive dialogue between the Bank and the Government of Indonesia (GOI) regarding the draft new Oil and Gas Law and supporting regulations. Establish an Appropriate Legislative and Regulatory Framework. Many of the sectoral issues stemmed from, or were reinforced, by the legislative framework for the energy sector. In the hydrocarbon sector, the then prevailing laws and regulations sanctioned Pertamina s (and PGN s) sectoral dominance, and allowed the Government to interfere with the sector in ways which inhibited efficient sector operation and private sector participation. Moreover, an independent regulatory body was required. Phase Out Subsidies to the Energy Sector, and Rationalize Energy Product Prices. The most urgent post-crisis issue for Indonesia s energy sector was the need to rationalize the pricing of energy products and

2 2 to phase out the huge subsidies associated with keeping the prices of fuel and electricity at pre-crisis levels (in Rupiah terms) for instance, in 1999, total subsidies to the sector amounted to US$5.8 billion, about 6% of GDP. However, given the massive depreciation of the Rupiah, it was clear that prices had to be increased gradually, while at the same time mitigating any impacts on the poor. Furthermore, in order to sustain the effectiveness of any fuel price increase, an appropriate automatic mechanism was needed to periodically adjust the prices of fuels, in order to reflect fluctuations in foreign exchange and in the international prices of crude oil. Finally, within this context, a rational natural gas pricing structure was needed so as to facilitate together with the restructuring of the domestic gas sector the increased utilization of Indonesia s natural gas resource, given its significant economic and environmental benefits. Fundamentally Restructure the Oil and Gas Sector. Apart from energy product prices, the issue with the most profound impact on the sector was the problematic role and functions of Pertamina. The massive costs of Pertamina s inefficiencies and undue interventions in the sector stemmed mainly from the fact that: (i) Pertamina s direct operation in the exploration and production of oil and gas in its own concession areas was not efficient; (ii) Pertamina had a conflict of interest in the upstream sector by supervising the private companies with which it competed; and (iii) Pertamina enjoyed a virtual monopoly over a huge market in downstream activities. Consequently, there was a need to fundamentally reform Pertamina, by separating out and divesting many of its activities and to improve the efficiency of its remaining core operations. Moreover, the delineation of roles between Pertamina and PGN the State gas company in the transmission of natural gas were unclear, and PGN itself required restructuring in order to allow greater private sector participation in the domestic gas sector. Mobilize Investment for Essential Energy Infrastructure, Particularly Natural Gas. In addition to the above issues, since the crisis, both public and private investment in the energy sector as a whole has been significantly depressed. With respect to the domestic gas sector, while Indonesia has substantial gas reserves, the lack of an integrated gas transmission and distribution network has along with gas pricing and gas sector structural issues constrained the expanded utilization of this resource, which in turn is needed to fuel the economically and environmentally efficient development of new power generation and industrial growth. Although some reserves are on Java (the source of greatest demand growth), the best long term prospects for supporting expanded gas utilization on Java both for power generation and industrial purposes appear to be by pipeline from fields in South Sumatra and/or East Kalimantan, and LNG from West Papua. However, to deal with the challenges of implementing such major infrastructure projects and to comply with October 2001 Oil and Gas Law, which has clarified PGN s role and future structure PGN needs to restructure its operations by unbundling transmission from distribution, and to seek private sector financing and expertise. Furthermore, a key issue remains the need for a rationalized gas pricing structure, the lack of which will continue to act as a significant impediment to the expansion of the domestic natural gas industry. Key Achievements to Date in the Hydrocarbon Sector. Despite the difficult political and economic environment the country has been facing over the past several years, a number of notable steps have already been taken by the Government to address most of these sector issues. Key achievements made by the GOI on hydrocarbon sector issues over the past few years have included the following. Passage of the New Oil and Gas Law. After almost three years of drafting and redrafting following major contributions by the Bank to support the preparation of the original draft law and the accompanying regulations the new Oil and Gas Law was passed in October 2001, providing Indonesia with a new legal framework to achieve fundamental reforms in the crucial oil and gas sector, including: the introduction of a competitive market for petroleum fuels; the establishment of an independent regulatory agency; the conversion of Pertamina into a normal State-owned enterprise (Persero) by November 2003; and the clarification of the role of PGN in the gas sector. While the final

3 3 Oil and Gas Law has some shortcomings, it addresses two of the most fundamental problems with the sector, by separating Pertamina from its supervisory role over foreign contractors thus eliminating an inherent conflict of interest in Pertamina s role and function and by potentially paving the way for full liberalization of downstream petroleum product and natural gas markets. However, the issuance of implementing regulations has been substantially delayed, and the current drafts provide for a highly bureaucratic business licensing regime which could inhibit new entry. Increases in Petroleum Product Prices. The Bank s consistent message regarding subsidy removal has clearly been heard by the GOI, with respect to both fuel and electricity prices. The Government has successfully implemented a series of increases in fuel prices, with the prices of jet fuel, aviation gasoline, motor gasoline and LPG moving most rapidly toward parity with international prices. In January 2002, an automatic monthly-adjustment mechanism was introduced indexed to fluctuations in the Singapore price with most other products pegged to 75% of this level. Following a Presidential Decree in December 2002, the subsidies for all products with the exception of kerosene are on-track for being fully eliminated by 2004 (although more recently, some of the proposed increases have been put on hold for a period, in response to public demonstrations). The analysis that the Bank provided with respect to the fuel price rationalization program formed the foundation of the Government s subsequent action to gradually increase the fuel prices. In fact, a closer look at the pace and thrust of individual fuel price increases by the Government shows the extent that the Bank s analytical work has helped the Government in this regard. Agreement to Unbundle PGN and Promote Private Sector Participation in PGN s Operations. Even before the passage of the new Oil and Gas Law, PGN with the Bank s encouragement had already agreed to the unbundling of its gas distribution and transmission operations, as well as to preparing for an IPO for a reasonable share of its distribution business and to securing a strategic partner for its transmission operations. This was based on the Bank s pre-crisis TA to PGN. PGN has now requested further Bank assistance in these areas to deepen the restructuring of its organization and begin its implementation. Accordingly, associated technical assistance to develop a more detailed analytical framework for implementing corporate restructuring and increasing private sector participation is being provided as part of the Java-Bali Power Sector Restructuring and Strengthening Project (primarily for PLN), which is scheduled to go to the Board in June Partial Phase Out of Leaded Gasoline. Leaded gasoline has been successfully phased out in the Jakarta area, although this initiative has yet to be extended to other areas of the country. 2. Objectives The two main objectives of the Indonesian Domestic Gas Sector Restructuring Project are (a) to expand the supply of natural for the country's domestic market; and (b) to improve urban air quality. To achieve the first objective, the project would provide support to GOI s reform program to: (i) continue to unbundle PGN s transmission and distribution operations, and establish subsidiary corporations; (ii) create an IPO for a reasonable share of PGN's gas distribution business, when market conditions are favorable; (iii) structure the transmission operation to allow for greater private investment in gas transmission through involvement of additional strategic partner or partners; (iv) rationalize the natural gas pricing policy and thus remove gas price distortions; (v) expand the gas distribution network in West Java; and (vi) help PGN build capacity; and (vii) provide direct support to PGN during its transformation to a more market-oriented enterprise. To achieve the second objective, the country will increase the use if natural gas, both by the power and industrial sectors, thereby reducing the reliance on oil and coal.

4 4 3. Rationale for Bank's Involvement The Bank's value added to the project has several aspects. First, and most important, is to help GOI and PGN to design and implement an effective gas pricing policy and to restructure PGN through unbundling of its transmission and distribution functions to form independent corporate subsidiaries towards their partial privatization. The central issue in the gas sector is its huge investment needs, which must be largely met by private investors given the budgetary constraints and the contingent liability the public sector is facing, and given the nature of the investment which could be commercially attractive to the private investors if the appropriate policy conditions exit. The two crucial policy issues in the subsector are the gas pricing and the restructuring of PGN, which must be addressed/resolved if the private investment is to re-enter the subsector. In this context, it is doubtful that without Bank's hands-on involvement these two crucial policy issues would be addressed soon, and the country's needs to urgently meet its gas demand will be delayed. The analytical work on the energy sector carried out todate suggests that dialogue undertaken through AAA alone would not provide a level of Bank involvement sufficient to be a credible donor partner. For this reason our role must be expanded. Second, JBIC's loan of US$450 million would rely heavily, if not be contingent on Bank participation, and JBIC expects the Bank to address pricing and structural issues in the domestic gas sector to support its South Sumatra -West Java Gas Transmission Project. Third, although the Bank's financial contribution to this project is less than 7-8% of the total costs, its involvement has helped attract US$450 million from JBIC as well as US$500 million from private sector and Pertamina. Fourth, the market-sounding of international gas utilities to determine private sector interest in the downstream gas business in Indonesia has revealed a strong private sector preference for the participation of the Bank in the domestic gas sector. Finally, this value added should be assessed in the context of the importance of the energy sector to the economy, the critical issues facing the sector, and the fact that prospects for successful outcomes are likely to be significantly enhanced by the Bank's involvement in addressing them. 4. Description To take full advantage of the economic and environmental benefits that can be reaped from the removal of the pricing-related constraints on the greater utilization of domestic gas, the infrastructural constraints will also be addressed in the Project through the inclusion of an investment component for natural gas distribution on West Java of about US$80 million. PGN has divided the potential West Java distribution area into three zones, and the Bank would provide financing toward network expansion in Zones II and III. JBIC will provide related financing for the upstream gas transmission line from South Sumatra to West Java, estimated to cost US$450 million. The development and production of the South Sumatra gas field would be handled by Pertamina, which, together with the private sector (Japanese investors), would invest about US$ million to bring the gas field on stream. Although capacity building support to PGN will be able to be provided prior to the loan becoming effective under the Java-Bali Power Sector Restructuring and Strengthening Project, additional TA for capacity building and training is also likely to be warranted as part of this Project. PGN West Java Gas Distribution PGN Technical Assistance South Sumatra-West Java Gas Transmission P/L South Sumatra Gas Field Development

5 5 5. Financing Source (Total ( US$m)) BORROWER ($40.00) IBRD ($85.00) JAPAN: JAPAN BANK FOR INTERNATIONAL COOPERATION (JBIC) ($450.00) FOREIGN SOURCES (UNIDENTIFIED) ($500.00) Total Project Cost: $ Implementation Implementation Period: 5 years. Implementing Agency: PT PGN (Persero) On-lending: The Ministry of Finance will on-lend to PGN the funds associated with the Project. This will be done through Subsidiary Loan Agreements, which will pass on all costs and risks, including foreign exchange risk, incurred by the Government to PGN. Project Implementation, Monitoring and Evaluation: In January 2003, PGN through Decree No. 030.K/726/UT/2003 established a Project Implementation Unit (PIU) to implement the South Sumatra to West Java Gas Transmission Project to be financed by JBIC, and in March 2003 it was agreed that implementation arrangements for the Bank's Domestic Gas Sector Restructuring Project would be integrated into this PIU structure. 7. Sustainability The sustainability of the Project is dependent on the mitigation of the critical risks below. 8. Lessons learned from past operations in the country/sector The objectives of the Bank's previous gas distribution projects in Indonesia were to expand the physical network as well as to enhance the efficiency and the financial position of the implementing agency, PGN. While these objectives were successfully achieved, ex-post reviews of these projects made it clear that the pricing of natural gas, and the corporate structure of PGN, also needed to be addressed in order to accelerate the development of the domestic natural gas industry. The current Project addresses these sectoral issues as well, and the Government's passage of the Oil and Gas Law marks in turning point in the potential for such sectoral objectives to be achieved. 9. Environment Aspects (including any public consultation) Issues : Environmental issues are associated with the construction of gas distribution pipelines, and relate to resettlement and land acquisition, waste management, mitigation of pipeline impacts on surface water, industrial hazards, health and safety. 10. List of factual technical documents: 11. Contact Point: Task Manager Noureddine Berrah The World Bank 1818 H Street, NW Washington D.C

6 6 Telephone: (202) Fax: (202) For information on other project related documents contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C Telephone: (202) Fax: (202) Web: Note: This is information on an evolving project. Certain components may not be necessarily included in the final project.