Report No. PIC3688

Project Name Russia-Krasnodar Power Generation Project (@i

Region Europe and Central Asia

Sector Electric Power & Other Energy

Project ID RUPA40162 Public Disclosure Authorized Borrower Russian Federation

Implementing Agency Kuban GRES, c/o V. I. Gorin, Chief, Department of Foreign Economic Relations RAO EES Rossii, 103074, Moscow, Kitaigorodsky Proezd, 7 Telephone: (095) 220-67-36 Fax: (095) 9-76-01

Date This PID Prepared March 28, 1996 Public Disclosure Authorized Date Initial PID Prepared January 6, 1995

Projected Appraisal Date May 6, 1996

Projected Board Date June 19, 1997

Country and Sector Background

1. The Russian power supply system comprises approximately 200 GW of generating capacity, a transmission network, divided into regional grids, which encompasses 2.5 million km of high-voltage lines, and 72 regional generation/distribution enterprises charged with providing Public Disclosure Authorized electricity and heat to local customers. Generation is predominantly thermal (68 percent), with hydro (22 percent) and nuclear (10 percent) stations comprising the balance. Regionally, however, over 50 percent of the hydro capacity is located in Siberia and the Far East, while over 80 percent of the nuclear capacity is located in the Northwest and Center regions. Generation in 1994 totaled 880 TWh, 22 percent below the 1990 output figure. Preliminary estimates for 1995 indicate that the decline in electricity sales has decelerated to about 2%.

2. Because of limited transfer capability between regions, some regional supply systems are unable to meet demand. This has been a particular problem in the North Caucasus Region. The need for new capacity was identified over 10 years ago, and construction was started on a nuclear plant at Rostov. While two 1,000 MW units were partially completed, the plant was not commissioned, due to public opposition. Public Disclosure Authorized The drop in consumption since 1990 has provided some respite. Nevertheless, a deficit of about 2,000 MW is projected by 2000, assuming that most of the existing capacity could be kept in operation. However, much of the existing capacity is operating beyond its design life and is due for decommissioning. Within the North Caucasus Region, the Krasnodar system is already in deficit, relying for 60 percent of its electricity consumption on imports from neighboring utilities. Reliability of supply has also eroded because of the aging of the asset base as most of the generating units are over 30 years old. While a number of alternatives have been studied to alleviate the capacity shortfall in the Krasnodar region, the near-impossibility of obtaining financing has proved to be a major barrier.

Objectives

3. The Government has broadly defined its objectives within the power sector to include: (i) reducing load shedding; (ii) improving efficiency of production, transmission and consumption of power; (iii) encouraging competition and entrepreneurship within the sector; and, (iv) stimulating the flow of debt and equity capital to support required capital investment. This project would help address the reduction of load shedding in the North Caucasus by installing equipment that can be operational quickly. The goal of the project would be to eliminate blackouts due to generation constraints by 2000. The power plant would also help reduce operating costs as its efficiency is estimated to be about 50t greater than the current plant average. The project would also support the initial steps toward establishing competition among generating plants, as the project would be independent, and privately owned.

Project Description

4. The proposed project would involve construction of a new power generating station in Krasnodar Krai, at a site near Mostovskoy, to meet current and projected electricity supply requirements of the region. The new plant is proposed to consist of two 450 MW blocks of combined cycle generating capacity that would be fueled by natural gas. Each block would consist of two 150 MW gas turbines, two heat recovery steam generators (HRSGs) and one 150 MW turbo-generator set. The project would also include construction of a 60 km gas pipeline to supply the plant, ancillary control systems, and switchyard and transmission facilities to connect the plant to the grid. The power plant component is estimated to cost approximately US$808 million, while the related transmission costs and gas pipeline are estimated to cost $95 million and $75 million, respectively. The foreign cost component of the power plant is estimated to be about US$345 million, while local costs are approximately US$463 million. Taxes and duties are estimated to be about $130 million, of which about $87 million would be VAT. The project is attractive because of its flexible nature. It could be constructed and operated in stages starting from as small as the first 150 MW simple cycle unit which could be operational within two years of contract award. It is also proposed to include $10 million to finance studies that would support the Government's efforts to induce increased private sector participation in the sector by improving the power sector structure, and the legal and regulatory framework.

Financing

5. The Bank loan of $510 million would finance most of the foreign exchange costs of the power plant and the proposed technical assistance. The remaining $308 million for the power plant would be financed from equity contributions by the shareholders. The founding shareholders and

- 2- their (tentative) equity stakes would be: RAO EES Rossii (30%), Gazprom (209), Kubanenergo (15%), Integrated Power Complex (8%) and Power Machine Building Complex (7%). The remaining equity participation is expected to be financed through foreign investment. The related gas pipeline would be financed by Gazprom and the transmission line by RAO EES Rossii.

Implementation

6. The project would be implemented by Kuban GRES, a newly formed corporate entity whose sole responsibility would be the construction and operation of this project. A team of key personnel covering engineering, procurement, commercial, environmental and personnel matters would be established early on. Consultants with experience in procurement and construction and operation of a combined cycle plant of this size would be engaged to assist Kuban GRES staff. Training of Kuban GRES staff would take place abroad, in similar facilities, and a training component would be included within each equipment procurement package. It has also been recommended that the manufacturer supply staff to supervise the operation of the equipment during its first year of operation. It is also proposed that experts of international repute, with experience in establishing corporate entities, be engaged to assist Kuban GRES management and staff in establishing corporate and operating procedures.

Sustainability

7. The primary natural resource that would be utilized by the project is natural gas as a fuel. Russia has a reserve to production ratio of about 80 years, based on its current proven reserves. Current prices enable the financial viability of the sector, thus ensuring that the plant can be adequately maintained.

Lessons Learned from Past Operations in the Country/Sector

8. Based on lessons learned from prior lending, four key principles are meant to be followed to serve as a basis for future power sector projects: (i) the establishment of transparent regulation that is independent of power suppliers and that avoids government interference in day-to-day power company operations; (ii) the commercialization and corporatization of, and private sector participation in, the power sector; (iii) the use of Bank funds to support programs that will facilitate the involvement of the private sector; and, (iv) the provision of assistance to finance importation of services which will improve efficiency. The Government has indicated its strong support for the role of the private sector in power as the regional utilities have been privatized and the Government has reduced its holdings in RAO EES Rossii from 97% to about 60%. The proposed project would continue support for private sector participation, as private ownership of Kuban GRES would represent about two-thirds of the total. A regulatory environment was established by decree for the power sector in 1992 with the Federal Energy Commission (FEC) responsible for the wholesale market and Regional Electricity Commissions responsible for retail markets. This initiative was formalized under the Law on Natural Monopolies (as well as including the regulation of other natural monopolies), but the

-3 - mandate for the previously formed FEC had lapsed. The new regulatory body has not been established, and staff not selected, but is expected to be established shortly.

9. Initial lending projects in Russia have also provided a number of lessons which should be reflected in carrying out new projects. Among those most relevant to the proposed project are: (i) the importance of identifying and selecting appropriate project executing agencies; (ii) the need to address implementation and procurement issues at an early stage; (iii) the advantages of involving local counterparts and consultants in the project preparation process; (iv) the need for a clear identification of policy objectives and early attention to policy- related issues; and (v) the need to provide technical support to the project implementation teams. These aspects have been fully taken into account in project design.

Environmental Aspects

10. The proposed project technology represents one of the most efficient technologies available to convert fossil fuels to electrical energy. Compared with other conventional thermal technologies, it will minimize greenhouse gas (GHG) and particulate emissions associated with increased electricity production. Incorporating modern pollution control technology into the design of the project would further reduce atmospheric emissions. Furthermore, the site for the proposed plant is well removed from major urban areas, which will help to minimize any adverse impacts typically associated with a project of this size. Air quality monitoring equipment will be funded under the project and installed at key sites. The Environmental Assessment has been publicly reviewed in Krasnodar and has been accepted. The Russian Government has approved the Environmental Assessment as it meets both the regulations of the Russian Government and the World Bank.

Program Objective Categories

11. The program objectives that will be addressed under this project include: privatization/commercialization, through the establishment of an independent, privately owned joint stock company; and, environmental, by implementing an environmentally friendly technology.

Project Benefits

12. Benefits accruing as a result of the project include reduced load shedding, lower operating costs owing to the high thermal efficiency of the plant, increased reliability of supply, and reduced atmospheric emissions. Load shedding in the region needs to be addressed as quickly as possible to avoid the benefits forgone due to lost production from power curtaients. With planned increased throughput at the port in Novorossiysk, oil refinery development, agricultural processing, and tourist development in Sochi, the prospects for development in Krasnodar appear favorable. The project would support these efforts by financing the infrastructure needed for the success of these developments.

Project Risks

-4- 13. Risks are commensurate with those attached to any large power project and include, among others: uncertainties regarding the future market; technical risks associated with introducing a new technology in the Russian power sector; risks of physical calamities; financial risks both in terms of internal cash flow generation to meet local costs of construction and long term pricing policies which protect the financial viability of the owner; uncertainties relating to capital and operating costs; and risks associated with fuel availability and cost. Most of these risks will be adequately dealt with in a timely manner, through the establishment of power purchase, fuel purchase and implementation agreements. Retail prices increased adequately during 1995 to meet the financial needs of the sector. However, the accounts receivable issue will need to be continually addressed during project implementation. Market risk has been dealt with through the structuring sales as a two-part tariff in the power purchase agreement and through plant design. The plant design is modular and can be implemented in 150 MW stages, each stage being capable of delivering useful output. Hence the market risk can be mitigated by staging project implementation.

Contact Point: Gary Stuggins, Task Manager, EC3IV Public Information Center The World Bank 1818 H Street N.W. Washington D.C. 20433 (202) 473-2607 (tel) (202) 477-3285 (fax)

Note: This is information on an evolving project. Certain components may not necessarily be included in the final project.

Processed by the Public Information Center week ending March 21, 1997

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