The World Bank Modernizing Ukrainian Railways (P173448)

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Public Disclosure Authorized

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Project Information Document (PID)

Concept Stage | Date Prepared/Updated: 01-Dec-2020 | Report No: PIDC29815

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Public Disclosure Authorized

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The World Bank Modernizing Ukrainian Railways (P173448)

BASIC INFORMATION

A. Basic Project Data OPS TABLE

Country Project ID Parent Project ID (if any) Project Name Ukraine P173448 Modernizing Ukrainian Railways (P173448) Region Estimated Appraisal Date Estimated Board Date Practice Area (Lead) EUROPE AND CENTRAL ASIA Jun 28, 2021 Sep 07, 2021 Transport

Financing Instrument Borrower(s) Implementing Agency Investment Project Financing Ministry of Infrastructure Ukrainian Railways

Proposed Development Objective(s)

The Project development objective is to increase the efficiency and financial sustainability of Ukrainian Railways.

PROJECT FINANCING DATA (US$, Millions)

SUMMARY-NewFin1

Total Project Cost 250.00

Total Financing 250.00

of which IBRD/IDA 250.00

Financing Gap 0.00

DETAILS-NewFinEnh1 World Bank Group Financing

International Bank for Reconstruction and Development (IBRD) 250.00

Environmental and Social Risk Classification Concept Review Decision High Track II-The review did authorize the preparation to continue

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The World Bank Modernizing Ukrainian Railways (P173448)

Other Decision (as needed)

B. Introduction and Context

Country Context

1. Ukraine’s economic growth has been uneven since the country’s independence in 1991 due to high levels of vulnerability to external shocks and significant structural challenges in the domestic economy. During the 2000- 2007 period, Ukraine sustained high annual growth rates of 7 percent on average. Capital inflows surged, and credit growth boomed, fueled by the external borrowing of commercial banks. This enabled an expansionary fiscal policy that resulted in the accumulation of a structural deficit. Growth was almost entirely driven by favorable external conditions but was not supported by structural reforms. With the onset of the global financial crisis, the Ukrainian economy suffered a sharp contraction of 15 percent in 2009. The subsequent recovery was cut short by the Maidan Revolution of 2013/2014, which together with the events in Crimea in March 2014, and the armed conflict in the east of the country beginning in 2014, resulted in a prolonged severe recession. Between 2013- 2015, the economy contracted by a cumulative 15.6 percent, while poverty and economic vulnerability increased. The Government of Ukraine (GoU) subsequently undertook a series of macroeconomic, institutional and business environment-related reforms that helped stabilize the economy, with gross domestic product (GDP) growth resuming in 2016. However, the pace of economic recovery has been modest, with growth averaging just 2.8 percent annually between 2016-2019 reaching 3.2 percent in 2019.

2. Economic activity has been further affected by the global COVID-19 pandemic shock. The economy is projected to contract by 5.5 percent in 2020, reflecting the severe impact on both external and domestic demand. Going forward, the economic outlook depends on the duration of the health crisis as well as progress on reforms to address sectoral bottlenecks, the ability to mobilize adequate financing to meet major repayment needs and continued adherence to prudent macroeconomic policies. The recent rapid increase in the number of daily cases of infections adds pressure to the health situation and increases the probability of limiting economic activities again.

3. While poverty declined significantly in recent years, this trend is likely to be reversed as a result of the economic contraction resulting from the COVID-19 pandemic. Moderate poverty (according to the World Bank’s national methodology for Ukraine) declined from a peak of 27 percent during the crisis in 2015 to 20 percent in 2018 and an estimated 18 percent in 2019. Despite the decline, it remains slightly above the pre-crisis level of 14 percent in 2013, with the prospect of increases due to COVID-19. With labor incomes, employment, and remittances impacted sharply by the COVID-19 crisis, poverty is projected to increase sharply in 2020. Moderate poverty remains higher in rural areas (28.5 percent versus 15.5 percent in urban areas in 2018), where local communities face challenges such as poor living conditions, outdated infrastructure, and limited public services provision. The socioeconomic impact of the COVID-19 pandemic will also vary across the country and will require public health interventions and social assistance for vulnerable households. Decreasing poverty rates and promoting shared prosperity remain significant development challenges that require Ukraine to capitalize on the drivers of growth through structural, policy, and investment reforms and the development of human capital.

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The World Bank Modernizing Ukrainian Railways (P173448)

4. There are over 3,500 state-owned enterprises in Ukraine whose average returns to assets is only a fraction of that of private companies. Ukraine has embarked on a large program for the privatization of state-owned enterprises with the exception of some 300 enterprises working in national security, energy, national monopolies which will not be privatized. The assets of the 100 largest state enterprises comprise about 90 percent of all state enterprise assets, and the three biggest, Naftogaz, Ukrainian railways, and Energoatom, hold two-thirds of all these assets. While these are not envisioned to be privatized, increasing efficiency and transparency and focusing on core business for these state-enterprises is essential.

5. The transport sector was negatively impacted by COVID-19 due to limitations on the use of public transport, closure of non-essential services, stoppage of passenger rail services and closure of borders to passenger flights. While essential supply chains continued to operate, they were still hampered by delays at border crossing points and internal regional restrictions on transportation movements. Disruption in transport services not only negatively impacted the livelihood of many transport operators, public and private transport companies but also access which is essential for reducing poverty and enhancing sustainable economic growth.

6. Although Ukraine’s Human Capital Index (HCI) is higher than the average for lower middle-income countries, it is lower than the average for Europe and Central Asia. A child born in Ukraine will be 63 percent as productive when she grows up as she could be if she enjoyed complete education and full health. Affordable safe transport access is an important contributor to improving human capital directly through better access to education and health facilities as well indirectly through higher income levels that would allow Ukrainians to spend more on health and education.

7. While Ukraine’s level of Greenhouse Gas (GHG) emissions are currently only about 60 percent of its 2030 Nationally Determined Contribution (NDC) targets, the targets are deemed low1 and are expected to be revised upwards during the ongoing update by the government, highlighting the need for adopting and scaling up environmentally sustainable growth policies. While transport currently contributes about 11 percent of GHG emissions in Ukraine, emissions from transport have been growing 2-3 times faster than Ukraine’s nominal GDP since 2015. This requires interventions that target longer term structural change in the sector and shifts toward environmentally friendly transport modes.

Sectoral and Institutional Context

8. Railways are critically important for the Ukrainian economy, where the gross domestic product relies on significantly more transport movements than in other countries in Europe.2 The high transport intensity of Ukraine is due in large part to the important role of grain production, and heavy industries in the economy, as well as on Ukraine’s large size which requires long-distance movements. These attributes endow the railways with a strong comparative advantage in freight transport with a modal share of over 60 percent, down from 70 a few years ago. Ukrainian railways, (Ukrzaliznytsia; UZ), handles a little less than half of the country’s exports and generates about 4 percent of its GDP. UZ is one of Ukraine’s largest SOEs and its largest employer with a staff of over 260,000.

1 Climate action tracker (July 30, 2020 update): https://climateactiontracker.org/countries/ukraine/ 2 About 2-2.5 tonne-km (tkm) are associated with the generation of one Euro of GDP in Ukraine, compared to 0.8 tkm and 0.14 tkm in Poland and Germany respectively (data for Poland and Germany are based on Eurostat statistics).

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The World Bank Modernizing Ukrainian Railways (P173448)

9. Ukraine’s railway network size and traffic rank among the top in the world. Ukraine has a very dense railway network with a total length of track of about 20,000 km, making it one of the largest in Europe and the world. About a third of the network is double or triple tracked; and a little less than half is electrified. UZ’s freight transport task is a little less than 200 billion ton-km and its passenger transport task is about 28 billion passenger- km. In terms of cargo traffic, Ukraine's railway is the fourth on the Eurasian continent after the Chinese, Russian and Indian railways. UZ’s freight intensity (annual tonnage per track-km) is 3-5 times higher than in European countries. UZ is also the world's sixth largest rail passenger transporter in Europe.

10. As important as the railways are today for Ukraine’s inclusive and sustainable growth, their significance is expected to further increase in the future. Three demand factors and one supply factor are expected to lead to this outcome. On the demand side, first, the historic opening of the land market in Ukraine in July of next year is expected to contribute to significant increases in land yields and agricultural exports. This is predicated on the fact that land productivity in Ukraine, which has some of the world’s richest soil, is only a fraction of the productivity in countries such as Germany and France. Second, the government’s rolling out of weigh-in-motion systems to control truck overloading on roads and the passage of a law last year increasing the fines for overloading, will result in a shift to railways. Third, about 71 percent of transport sector GHG emissions in Ukraine come from road-based modes. The increasing focus of the government on reducing GHGs in line with the expected higher NDCs targets will likely to encourage a further shift to green modes such as railways and inland waterways. Finally, on the supply side, the planned opening of the market for locomotives for cargo traffic3 will introduce competition, improve quality and encourage investment in logistics terminals increasing the efficiency of operations.

11. The importance of the railways in Ukraine notwithstanding, the sector is facing serious difficulties that are negatively impacting its efficiency, quality of services and financial sustainability. Overall, Ukraine ranked 119th among 160 countries on the quality of trade and transport infrastructure in the World Bank’s Logistics Performance Index (LPI) for 2018. More specifically, the railway sector has problems with its: legal and regulatory framework; institutional framework and corporate governance; UZ’s financing sustainability and unbalanced capital structure; assets in high need of rehabilitation or replacement; inadequate commercial policies; and operational inefficiency and excess labor. These issues are discussed below.

12. The draft railway law and implementing regulations need to be enacted. The draft law was initially prepared during the period 2014-2015 but was not enacted at the time. Since then the law has been significantly amended to better align with the requirements relating to railways contained in the EU-Ukraine Association Agreement (AA) and has benefited from comments from the Bank team. The draft law, which is expected to be passed by Parliament in the next few months, sets out broad aims, roles and responsibilities of the key governance agencies and broad criteria for executing those functions. The ‘market opening’ provisions of the new Railway Law include arrangements allowing properly licensed cargo train operating companies, whether public or private, to provide transport services on Ukraine’s rail network on a fair and equal (competitively neutral) basis. Additionally, the law provides the framework for the institutional and financial separation between infrastructure management and transport operations, as well as introduction of the compensation for public service obligations (PSOs). It is estimated that 56 by-laws will need to be adopted for the implementation of all necessary provisions of the draft law: especially for the reorganization of UZ, market opening, tariff setting, licensing, safety, and organization of socially important passenger services, among others.

3 The 2014 Ukraine- European Union Association Agreement sets the year 2022 as the year for market opening.

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The World Bank Modernizing Ukrainian Railways (P173448)

13. The corporate governance of UZ needs to be strengthened. In 2014 and as part of a reform to the railway sector in Ukraine, UZ was transformed into a joint stock company (JSC) with the State, represented by the Cabinet of Ministers, as the sole shareholder. The 6 regional units of the railways (that made up UZ prior to the transformation) were merged into one legal entity along with 80 support enterprises including medical, educational and other support units. Thereafter, UZ was reorganized into 34 branches, including 6 regional, 28 functional and 2 representative offices. A critical part of the reorganization, which is yet to take place is the managerial and financial separation between infrastructure and operations which require the establishment of track access charge (TAC) and a PSO regime. This is essential to enable the cargo company once established to compete in the market to the benefit of all consumers. The corporatization of UZ and the establishment of a supervisory board were an important first step. However, UZ cannot yet be said to be managerially independent because, among other constraints, there is quite heavy regulation of commodity tariffs and UZ management is required to internally cross-subsidize many activities. Recent perceived interference by the government into the roles of supervisory boards in state banks and state-owned enterprises, coupled with compensation ceilings and delays in their payment by the government has led to resignation of supervisory board members including in UZ.

14. Ukrzaliznytsia’s financial situation is tenuous. Between 2013 and 2016, UZ had a negative financial bottom line. Cumulative losses between 2014 and 2016 were about US$ 2.4 billion.4 While indeed UZ showed a net profit of US$1.4 million in 2017 increasing to about US$ 105 million in 2019 as a result of several actions it took (most importantly increasing freight charges), the current situation is not sustainable particularly when one considers the significant underinvestment in the railway sector (see para 17), the unbalanced capital structure of the company and the company’s difficulty in refinancing (see para Error! Reference source not found.), the operational inefficiencies and the lack of clear government financial support to the railway sector for infrastructure and passenger services as defined under the EU acquis.

15. The COVID-19 outbreak has had a major disruptive impact on domestic and international transport and mobility. The entire transport sector has faced a huge drop in the mobility demand due to many transport customers having been forced to temporarily suspend their activities with international borders being closed. Suspension of international and some domestic passenger traffic by UZ following the decision by the Cabinet of Ministers of Ukraine and a drop in freight movements, have not only negatively impacted users but UZ projects a loss of about US$ 37 million this year due to the restrictions. The financial implications notwithstanding, UZ stands ready to deliver the necessary freight and passenger transport services, while safeguarding the health and safety of the rail workforce and their customers. MoI has requested a delay in the payment of UZ’s dividends to the government to help UZ cope with the financial difficulties

16. Distortionary commercial policies: There is heavy regulation of commodity tariffs and passenger fares and UZ management is required to internally cross-subsidize many activities. Rail freight services cover their operating costs and create a surplus. However, passenger services generate large losses. In 2019 the UZ profit generated from freight traffic amounted UAH 19.5 billion (US$ 720 million), it was used to cover the losses generated by the passenger services of UAH 12.8 billion. About 60 percent of the passenger losses were from suburban (regional) passenger services. The practice of cross subsidizing passenger services is becoming exceedingly difficult after the drop in freight throughput following the conflict with Russia. Moreover, this practice taxes shippers and reduces business competitiveness and is not permitted under the EU acquis. The need to adopt a formal PSO framework

4 The losses for 2014, 2015 and 2016 were respectively Ukrainian hryvnia (UAH) 16.8 billion, UAH 15.4 billion and UAH 7.3 billion (based on the audited consolidated financial statements).

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will crystalize for government the real costs of operating passenger services previously concealed by cross- subsidies from freight, and the costs of operating non-commercial lines, currently supported by traffic on the core network. Such transparency will help underpin a more critical scrutiny of how to improve social value for money in the rail sector policymaking. In addition, the current tariff arrangements create distortions in the market because any price increase from year to year via indexation is equally applied across all traffics. Although relativities are maintained, the industries being served are subject to other forces such as world trade and supply and demand and applying the same price index is unresponsive to those other forces.

17. About half of the current rolling stock was purchased in the 1980s and urgently needs replacement; and about a quarter of the track is overdue for a major overhaul; the useful life of about 80 percent of the machinery has expired; and most of the locomotives and wagons are over 90 percent worn. As of mid-2020, out of a total of 20 thousand km of operated main railway tracks, 6 thousand km require repairs, while another 3 thousand km require urgent rehabilitation. An additional of 2 thousand km of station and special tracks require repairs. UZ estimates the need for renewal/repair of about 1,400-1,800 km per year but has been unable to keep up with its desired level of track maintenance resorting to speed restrictions on many routes. Services are greatly hampered by the current severe regime of continuous speed restrictions across the network. The average speed is low at 43.3 km/h, and the network has 1,113 km of speed-restricted tracks. The Covid-19 pandemic made the situation worse in 2020, with UZ repairing only 5.8 km of main tracks in first six months of the year compared to 33 km in the first six months of 2019. UZ has correctly prioritized the acquisition of locomotives and is in the process for acquiring about 250 new ones, and overhauling over 1,000 ones but the limited financial resources are making the implementation of these plans difficult.

18. Labor rightsizing is essential to enable the railways, especially the cargo company once established, to operate efficiently and compete with other train operators. Modern railway enterprises, whether state-owned or private, are by their nature less labor intensive than their former structures. Within these enterprises, there are many technical functions which become redundant and for which labor requirements have declined substantially over the last few decades as a result of comprehensive labor reform programs that aim to increase the productivity levels of the railway companies. Two principal areas for restructuring have centered around adapting the railway companies’ labor force structure to market changes that require a shift toward modern and state of the art skills, such as in the areas of information technology, finance and engineering, and, secondly, to reduce labor force expenditures to increase the companies’ efficiency and competitiveness in the context of limited availability of public funds for the railway sector. As a result, a modern efficient railway operation needs far fewer staff numbers that were needed in the past to handle a given level of traffic and railways across the word have hence witnessed major reductions in labor levels. For example, in the World Bank’s Eastern Europe and Central Asia region alone, railway employment reduced by more than 2 million over the last thirty years. Today, labor costs typically account for about 25 percent to 35 percent of operating costs in well run railway companies. In Ukraine these are currently around 50 percent of operating costs.

19. To consolidate its railway reform work and develop a sustainable base for the future, the Government of Ukraine has requested the World Bank’s support for continuation of institutional, physical, and operational modernization of the sector in an integrated manner. The proposed Project will support institutional reforms essential for the efficient operation of the sector as well as labor restructuring in UZ and critical physical investments. Support to labor restructuring aims to have an ‘assured effect’ that it will be addressed within UZ’s

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HR strategy on the basis of transparent and socially responsible retrenchment approaches, governance and grievance redress procedures. The Project’s proposed activities align with UZ’s development strategy.

Relationship to CPF

20. The proposed Project is consistent with the 2017-2021 WBG Country Partnership Framework (CPF) for Ukraine. It supports two objectives under Focus Area 1 (making markets work): (i). improving the quality of infrastructure services; and (ii) creating a level playing field for the private sector. The proposed Project will improve the quality of infrastructure services through a combination of high-priority investments, operational efficiency activities and institutional reforms. It will help level the playing field in the rail freight sector by supporting reforms to enable market opening in line with the EU acquis to allow private operators open access to the railway infrastructure. IFC is considering support to private sector operators once the market opens. The proposed project will also support the cross-cutting focus area of the CPF: better governance, anticorruption and citizen engagement. The planned governance reforms and support to international transparency initiatives, such as the Construction Transparency Initiative (CoST), under the Project will increase transparency in the use of public resources and strengthen citizen engagement. By supporting a green mode of transportation, the Project will contribute to the reduction of GHGs as envisioned by the CPF.

21. The Bank’s program of assistance to Ukraine since the outbreak of the pandemic has been adjusted in line with the WBG COVID-19 Crisis Response Approach Paper, Saving Lives, Scaling-up Impact and Getting Back on Track to support the country in the three phases of its response to the crisis: Relief, Restructuring, and Resilient Recovery. The current CPF is being adjusted in two ways: first, to support the country in managing the ongoing health, social and economic crisis; and second, to strengthen the institutional foundations for an inclusive and sustainable longer-term recovery. More specifically, the adjustments are being addressed through interventions to: (i) save lives, (ii) protect the poor and vulnerable, (iii) ensure sustainable business growth and job creation; and (iv) strengthen policies, institutions, and investment for rebuilding better.

22. The proposed project covers all four areas. It will strengthen the emerging policies for sector COVID response and improve sector readiness to respond to natural disasters and pandemics and reduce contagion risk. While the impact on saving lives during this stage of the pandemic may bel limited, this would put the railways in a favorable position to manage pandemics and natural disasters in the future. The current fiscal situation of the government and UZ is increasing the pressure on restructuring and modernizing the railways while significantly reducing the workforce. The Project will ensure that retrenchment is managed and implemented according to fair, transparent and accountable procedures with a view to minimizing the socioeconomic impact of job losses on the poor and vulnerable in particular. The Project will help strengthen measures to protect and mitigate risks for workers, in particular through alternative livelihood and employment assistance support using existing national mechanisms.

23. One of the priorities of this proposed Project is to continue to strengthen the policies and institutions in the Ukrainian rail sector. This operation will support institutional and operational efficiency reforms to enable UZ and the railway sector to offer higher quality, competitive and sustainable services. By strengthening the railway policy and institutional frameworks, the project will support sustainable business growth and job creation. In addition,

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the Project’s investment in critical infrastructure is expected to create many jobs not only in construction but in services and manufacturing.5

C. Proposed Development Objective(s)

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The DO is to increase the efficiency and financial sustainability of Ukrainian Railways (UZ).

Key Results (From PCN)

D. Concept Description

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Legal Operational Policies Triggered? Projects on International Waterways OP 7.50 No Projects in Disputed Areas OP 7.60 No

Summary of Screening of Environmental and Social Risks and Impacts .

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5 International evidence shows that a US$100 million in well-conceived railway investment could create 13,000 to 22,000 jobs as per: (i) Center on Globalization, Governance & Competitiveness, Duke University, 2014, Infrastructure Investment Creates American Jobs, Washington, DC, Alliance for American Manufacturing. (ii) Community of European Railway and Infrastructure Companies, 2014, The Economic Footprint of Railway, Brussels: Ecorys. (iii) National Roads Authority, 2013, The Employment Benefits of Investment Projects, Dublin, Ireland, The AECOM Consortium. (iv) European Commission Directorate General for Mobility and Transport, 2015, Study on the Cost and Contribution of the Rail Sector, Brussels, Prepared by Steer Davies Gleave.

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Note: To view the Environmental and Social Risks and Impacts, please refer to the Concept Stage ESRS Document. Please delete this note when finalizing the document.

. CONTACT POINT

World Bank Moustafa Baher El-Hefnawy, Daniel P. Owen, Elena Lungu Program Leader

Borrower/Client/Recipient

Ministry of Infrastructure

Implementing Agencies

Ukrainian Railways Volodimyr Zhmak CEO [email protected]

FOR MORE INFORMATION CONTACT The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 473-1000 Web: http://www.worldbank.org/projects

APPROVAL

Task Team Leader(s): Moustafa Baher El-Hefnawy, Daniel P. Owen, Elena Lungu

Approved By APPROVALTBL Country Director: Arup Banerji 16-Feb-2021

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