Report No. PID11579

Project Name ALBANIA-ALBANIA POWER SECTOR GENERATION & ... RESTRUCTURING PROJECT

Region Europe and Central Asia Region

Sector Power (100%)

Public Disclosure Authorized Project ID P077526

Borrower(s) ALBANIA

Implementing Agency Address KESH Address: Blloku Vasil Shanto, Tirana Albania Contact Person: Mr. Genci Dango, Head of PMU Tel: 355 42 34501 Fax: 355 42 34501 Email: [email protected]

Environment Category A

Public Disclosure Authorized Date PID Prepared January 2, 2003

Auth Appr/Negs Date July 14, 2003

Bank Approval Date December 16, 2003

1. Country and Sector Background

Background. Albania has been facing a major electricity crisis since the summer of 2000. The crisis was initially the result of excessive demand resulting from a failure to curb illegal use of electricity and non-payment of bills. Significant progress is continuing to be made since the beginning of 2001 in addressing these issues as a result of the implementation of an Action Plan agreed by the Government with the Public Disclosure Authorized donors. Electricity losses have been reduced, tariffs increased and collections improved; demand growth has slowed significantly. However, the crisis has been aggravated by the impact of adverse hydrology on Albania's predominantly hydropower-based system, as a consequence of which domestic generation has fallen significantly (from over 5,000 GWh in 1998 and 1999 to 3,000 GWh in 2002). From being a net exporter of electricity until 1997, Albania has had to import increasing quantities of electricity (from 300 GWh in 1998 to 2,300 GWh in 2002). Given the uncertainties regarding the future availability of large quantities of electricity imports at competitive prices, the Government and the donors believe that it is prudent to add domestic thermal generation capacity to reduce the dependance on imports and to diversify domestic generation so as to reduce vulnerability to hydrological variations. The addition of domestic thermal generation capacity would also allow more efficient utilization of the hydropower capacity to meet domestic peak demand, and would have a Public Disclosure Authorized positive regional impact by facilitating the favorable exchange of peak hydropower energy with non-peak energy from neighboring systems.

Macroeconomic Setting. Since the civil unrest in early 1997 triggered by the collapse of several pyramid schemes, Albania has made substantial economic progress. Real GDP growth exceeded 7% for the years 1999 and 2000, before falling to 6.5% in 2001, and an expected 4.5% to 5% in 2002. The fall was due to poor rainfall that caused a slowdown in growth in agriculture (which accounts for about half of GDP) and a big fall in hydroelectricity production. Inflation was generally limited to under 4% per year, the exchange rate was stable, and external reserves were adequate at 4 to 5 months of imports. Foreign financing was provided mainly through high levels of external assistance and workers' remittances (equal to 10 to 12% of GDP).

Less favorable aspects of Albania's economic performance include a large budget deficit of 8.5% of GDP in 2001, large current account deficits of 6.3% of GDP in 2001 and an estimated 8.75% in 2002, substantial emigration of the most educated Albanians, limited financial intermediation, a narrow export base, weak governance and administrative capacity, and a relatively poor investment climate. From 1992 to 1999, net foreign direct investment in Albania was among the lowest in the region. Inflows increased in 2000 and 2001 to US$ 143 million and US$ 204 million respectively as a result of large scale privatizations.

Poverty in Albania. In 2001, Albania's GNI per capita was US$ 1,230 (World Bank Development Report 2003, Atlas method) compared to an average of US$ 2,010 for the Europe and Central Asia region. However, almost one in three Albanians is poor, with over 500,000 Albanians (out of a total population of 3.1 million) living on less than US$ 1 a day. Four out of five poor live in rural areas. Income poverty is compounded by weak, deteriorating or absent infrastructure and services. Forty percent of households lack access to two or more necessities such as basic education, water, sanitation and heating.

The GPRS has five main goals for the next three years: (i) achieve real GDP growth of 18 to 21 percent; (ii) reduce the number of persons with income less than US$ 2 per head from 47% to 38%; (iii) improve infrastructure and related services, such as electric power, potable water supply and sewerage, increasing the poor's access to these services; (iv) reduce the infant mortality rate by 15%, the maternal mortality rate by 25%, and the incidence of infectious diseases; and (v) increase the elementary school enrollment rate by 4%, the secondary enrollment rate by 25%, and the average schooling period by 5%.

Regional Setting. The 1999 Kosovo crisis led to coordinated international efforts to improve ties within Southeastern Europe through the Stability Pact and with the European Union through Stabilization and Association Agreements (SAAs) between the EU and countries in the region. In October 2000, the European Commission invited Albania to start negotiations on a SAA. This process gives Albania a significant incentive to reform its institutions, including those in the power sector, in line with requirements in the EU.

Energy Resources and Production. Albania's most important energy resource is hydroelectricity. The total potential hydropower capacity is about 3,000 MW, with an annual generation potential of about 10 TWh. Current installed capacity is 1,450 MW, and the average annual generation from 1992 to 2001 was 4,344 GWh. Hydropower generation normally provides more than 95% of Albania's total electricity production. Oil reserves are estimated at 440 million tons, of which about 43 million tons have been produced. The remaining recoverable reserves are estimated to be 32

- 2 - million tons (by conventional recovery methods), but the use of enhanced oil recovery techniques could increase the recoverable amount considerably. The largest oil field (Patos Marinza) is being redeveloped with the involvement of Premier Oil, UK, using enhanced oil recovery techniques. The Government has granted licenses to a number of foreign companies for both onshore and offshore exploration. Production is mainly of heavy oil with API gravity from 5 to 30 degrees, and sulphur content ranging up to 9%-. Production fell from about 1.1 million tons per year at the beginning of the 1990s to 0.3 million tons in 2001. The oil is processed in two refineries, the Fier refinery built in the 1960s with Russian technology and having a capacity of 0.5 million tons per year, and the Ballsh refinery built in 1978 with Chinese technology and having a capacity of 1 million tons per year. These refineries supply only about 30%- of national petroleum demand, with the rest being met by imports. The remaining recoverable reserves of natural gas are estimated to be approximately 1.5 billion cubic meters. Gas production fell from a maximum of 0.95 billion cubic meters in 1982 to 0.01 billion cubic meters in 2000. Future production of domestic natural gas is not expected to be significant. Albania has proven coal reserves of about 700 million metric tons, with recoverable reserves of 280 million tons. The coal is predominantly low-grade lignite with a heat value of 3000 kcal/kg and a sulphur content of 6 to 8 percent. Coal production and consumption diminished during the 1990s to insignificant levels because of the poor quality of the fuel and the high cost of production and transport.

Power Sector Physical Infrastructure. The Drin River cascade, with a total installed capacity of 1,350 MW (Fierze - 500 MW, Komani - 600 MW, and Vau i Dejes - 250 MW), provides about 90%- of the country's electricity generation. The remaining 100 MW of hydropower capacity is accounted for by small plants on other rivers. Albania's small amount of thermal electricity is produced at the Fier thermal power station, consisting of two Chinese built units of 12 MW and 25 MW respectively and a 60 MW Czech built unit. The plant operates on heavy fuel oil produced by the Fier refinery. The units are in a bad state of repair and operate at well below capacity. The Chinese units were constructed in the 1960s, and are scheduled to be decommissioned at the end of 2005. The Czech unit was commissioned in 1980 and is being considered for rehabilitation.

At the end of 2001, the transmission system consisted of 120 km of 400 kV lines, 1,100 km of 220 kV, 50 km of 150 kV, 1,198 km of 110 kV and 1,242 km of 35 kV. There was a 400 kV interconnection to Greece (Elbasan - Kardia), a 220 kV interconnection to Montenegro (Vau i Dejes - Podgorica) and a 220 kV interconnection to Kosovo (Fierze - Prizren). There was also a 150 kV interconnection with Greece (Bistrice 1 - Igumenice). The distribution system consisted of 140 km of 20 kV lines, 5,620 km of 10 kV lines, 2,860 km of 6 kV lines, and 13,600 km of 0.4 kV lines.

Power Sector Background. At the beginning of Albania's economic transition in the early 1990's, the country was virtually 100%- electrified and was a net electricity exporter, with exports of around 20%- of domestic generation in 1991 and 1992. However, while the three hydropower plants of the Drin River Cascade were in reasonably good condition, the Fier thermal power plant and the transmission and distribution systems were badly run down because of previous neglect of maintenance, and there were frequent power outages due to overloading of facilities, which frequently

-3 - caused explosions in transformers. Demand within Albania fell initially to 79t of the 1989 level by 1992 because of declines in industrial production. Thereafter it rose by 10.4 9 per year to 6,160 GWh in 2000. This increase was due mainly to a sustained surge in consumption, much of which was illegal, by households and small commercial establishments. The quality of electricity supply was improved temporarily by emergency repairs financed by donors, including IDA, but most of the required rehabilitation and expansion of facilities has yet to be made, financing for only a part of which has so far been committed.

By 1998, Albania had become a net electricity importer and, by the second half of 2000, a serious electricity shortage had set in, partly as a result of a fall in hydropower production caused by reduced river flows. This shortage has involved frequent and prolonged load shedding (i.e., deliberate partial cut-off of electricity because of insufficient supply). The demand estimate of 6,160 GWh in 2000 includes 450 GWh of load shedding. In 2001, demand grew by only 1.6w to 6,200, but net imports jumped by 75W to reach 1,750 GWh and load shedding increased to around 800 GWh. In 2002, domestic generation is expected to meet less than 50t of demand and imports are expected to reach about 2,300 GWh at a cost of about US$ 75 million equivalent. The country has been unable to get all the imported electricity it needs because of transmission constraints (which, however, have been eased as a result of donor investments) and financial constraints.

The Albanian Power Corporation (KESH) is unable to pay for the imports needed out of its own resources because of financial difficulties caused by widespread illegal use of electricity, poor collection of electricity bills, and retail electricity prices which are below the cost of imported electricity. Faced with these difficulties, the Government has been providing a subsidy, but its high level (about US$ 24 million equivalent in 2002) is diverting funds from other critical needs. Government budgetary considerations require a gradual reduction in the subsidy for imports, and load shedding is expected to continue for several years.

The electricity crisis is having multiple adverse impacts on the poor. There is the direct impact in that frequent and prolonged load shedding deprives them of light, space heating and cooking fuel, thereby adversely affecting their quality of life and their health, as well as restricting their access to education. Secondly, by diverting budgetary resources to electricity imports, it diverts funds from poverty reduction efforts. Thirdly, it adversely affects economic growth, which is recognized to be the main instrument to reduce poverty in Albania.

The crisis affects economic performance in a number of ways. The fall in hydropower production causes directly a fall in national output. The electricity imports contributed to a widening of Albania's trade deficit in 2001 and 2002. The load shedding has led to cuts in industrial production, and it has also caused smaller industrial and commercial enterprises to install costly back-up diesel-fuelled power generators. These generators now produce an amount of electricity equal to about 15t of what they receive from the grid. Electricity shortages are also listed among the factors which representatives of business mention as reasons for slow expansion in production of tradables.

- 4- The failure to adequately address the power sector's failings led to the suspension in 1997 of donor support for the Drin River Cascade Rehabilitation Project (cofinanced by EBRD, Austria, Italy, Japan and Switzerland) and the suspension in 1998 by IDA and other donors of disbursements for the Power Transmission and Distribution Project (cofinanced by IDA through Credit No. 2826-ALB, EBRD, Italy, Japan and Switzerland). These were the two main donor-financed operations in the power sector in Albania at the time apart from Italian support for distribution system rehabilitation in Tirana. Donor activities related to the Drin River Cascade Rehabilitation Project were restarted in 2000 following the signing of a contract with ENEL (Italy) to provide management assistance to KESH.

Activities related to the Power Transmission and Distribution Project were restarted in 2001 following the development of an acceptable Action Plan to tackle the critical issues of the sector and its successful initial implementation by the Government and KESH. Part of the remaining amount of the IDA credit was reallocated to provide financing for household meters and an Energy Sector Study. The study, to be completed in January 2003, includes preparation of: (i) electricity demand projections to 2015, (ii) a least-cost power generation investment program covering the same period, (iii) a power transmission master plan, (iv) a plan for reduction in technical and non-technical power losses, (v) a power dispatch plan, (vi) a power distribution master plan, (vii) an evaluation of the potential for district heating, (viii) an evaluation of the technical and economic feasibility of imported natural gas, (ix) a petroleum strategy, (x) an overall investment plan and financing options, (xi) electricity tariff reform taking into account long run marginal cost estimates, and (xii) recommendations for energy sector restructuring.

The successful initial implementation of the Action Plan also made possible the preparation and approval by the Association's Executive Directors of the Power Sector Rehabilitation and Restructuring Project (Credit No. 3671) on June 20, 2002.

The Government made an initial attempt at sector reforms in late 1995 by passing legislation providing for the establishment of an electricity regulatory agency, unbundling and corporatization of the power sector, and the beginning of privatization. However, progress in implementing the reforms was slow and the process was suspended in 1997 following large-scale civil disturbances triggered by the collapse of several pyramid schemes (see "Power Sector Reform" below). The sector reform process is now starting up again, based on a Power Sector Policy Statement adopted by the Government in April 2002. The Power Sector Rehabilitation and Restructuring Project provides support for this reform process. The proposed project would provide further support.

Sector Issues

There are five main sector issues: (i) a serious and growing electricity shortage; (ii) unbilled consumption of electricity and non-payment of bills; (iii) willingness/ability of consumers to pay for electricity; (iv) power company financial difficulties and associated Government subsidies; and (v) power sector reform. Significant progress has been made in addressing some of these issues and in improving overall sector

- 5 - performance since the beginning of 2001. However, much still remains to be done and the proposed project is intended to support a continuation and strengthening of these efforts.

A Serious and Growing Electricity Shortage. Although Albania was until a few years ago a net exporter of electricity, conditions in the power sector have deteriorated, and Albania has been facing a severe electricity shortage since the summer of 2000. The crisis was initially the result of excessive demand caused largely by a failure to curb illegal use of electricity and non-payment of bills. Although these aspects are now being addressed, the shortage has been aggravated by the impact of less favorable hydrology on the predominantly hydropower-based system. This has obliged KESH to resort to import of electricity (limited by transmission and financial constraints) and load shedding.

Domestic generation by KESH in the year 2001 was 3,650 GWh. This is much lower than the 4,600 to 5,300 GWh generated between 1998 and 2000. KESH imported 1,750 GWh, and load shedding amounted to around 800 GWh bringing total demand to about 6,200 GWh. The situation remained difficult in 2002 as the unfavorable hydrological conditions experienced in 2001 have continued, and domestic generation was only around 3,000 GWh in 2002 with imports of about 2,300 GWh and load shedding of over 900 GWh.

The need for electricity imports will continue to grow unless supply is increased. Supply under average hydrological conditions is about 4,200 GWh. The Energy Sector Study carried out under the Power Transmission and Distribution Project projects electricity demand to grow from an unconstrained estimate of demand of 6,550 GWh in 2002 (slightly higher than KESH's estimate as the result of the use of a different method of calculation) by 2.9w to 6t per year over the period 2015, depending on the rate of economic growth. These demand projections take into account the demand-reducing effect of success in reducing illegal use and non-payment of bills and in encouraging the use of other forms of energy, such as LPG, particularly for space heating. Therefore, the gap between demand and supply would have been 2,350 GWh in 2002 if it had been an average hydrological year, and this gap would grow steadily larger over time. By 2015, the gap would exceed 6,000 GWh in a normal year with a medium growth scenario.

Imports are currently less expensive than new domestic power generation, but this situation is not likely to continue for long. A recent Bank-financed review of electricity supply and demand in South-East Europe (2002-2012) concluded that a shortage of generating capacity could appear in the region by as early as 2005 in the absence of new generating capacity. Thus prices of electricity imports to deficit countries in the region are expected to soon rise to the level of the full cost of power from new plants, if not higher. Therefore, it would be prudent to consider the addition of domestic generation capacity for Albania to reduce the dependence on imports, especially since it will take a significant time to bring additional capacity into production.

Supply could be increased modestly by rehabilitating the 159 MW Fier thermal power station, which has been operating at very low levels. However, the Energy Sector Study recommends against rehabilitation of this plant on technical and economic grounds. The only remaining option is new

- 6 - power generation. The proposed project would be the first new generating plant since the Komani hydropower station entered service in 1987. It would reduce the import gap by up to 700 GWh per year (assuming 100 MW installed capacity and availability of about 80%). At the earliest likely year of commissioning of this project (2007), it would provide less than 20% of the supply deficit in a normal hydrological year.

Unbilled Consumption of Electricity and Non-Payment of Bills. Unbilled consumption of electricity (due to faulty meters, meter tampering or bypassing, or consumption by un-metered customers in excess of billed levels) and non-payment of electricity bills grew rapidly during the 1990s through the year 2000. During 2000, KESH's power transmission and distribution losses were 43.4% of electricity supplied to the grid, of which about 20 percentage points are estimated to have been "non-technical losses," and collections were 61.5% of billings. During 2001, which was the first year of implementation of the Action Plan (see "Government Strategy" below), KESH's power transmission and distribution losses fell to 38% of electricity supplied to the grid, of which about 14 percentage points were "non-technical losses." In the same year, bill collection improved to 84.5%, including payments of arrears relating to previous years' bills. During the first nine months of 2002, losses were 41.6t for KESH plus the pilot companies compared to the target of 41.7%. During this period, KESH had also met the nine-month collection targets for both private and domestic customers. However, overall collections were 87.1% compared to the target of 88.9% as a result of the Government's failure, due to budget constraints, to provide sufficient funding to fully cover the current electricity bills of budgetary and non-budgetary entities and the agreed amount of arrears on behalf of these entities. Adequate provisions have been made in the 2003 Government budget to allow the Government to fully meet these obligations for 2003, and similar provisions will be made in subsequent years.

Willingness/Ability to Pay for Electricity. Albanian households consume high amounts of electricity for their relatively low incomes, largely due to widespread switching to electricity for space heating, water heating and cooking from other forms of energy such as wood and kerosene, and to the acquisition of many new appliances, mostly inefficient in their use of energy. To the extent that bill collection is improved, non-technical losses are reduced and electricity prices are raised to cost-covering levels, household consumers will have to pay an increased amount for electricity. As a result, there will likely be some reduction in household electricity consumption as consumers switch to cheaper alternatives or find ways of conserving energy. The household survey carried out as part of the Energy Sector Study found that the "core poor" (10-15% of the customers in urban areas and 20% in rural areas) would have electricity bills of more than 20% of their income and the "vulnerable poor" (30% of customers in Tirana and rural areas and 15% in other urban areas) would have electricity bills of about 10% of their income. Some of these consumers may find it difficult to pay for their electricity consumption. The Energy Sector Study will make recommendations on the most appropriate subsidy mechanism for low-income consumers.

Public sector consumers also have difficulty paying their electricity bills. As of October 31, 2002, the total debt of public sector consumers to KESH was Lek 5.0 billion (US$ 35 million) compared to the debt to KESH

- 7 - of household consumers of Lek 13.0 billion (US$ 92 million). The water supply companies pay for very little of their electricity consumption, since water prices do not cover costs and these companies have poor collection rates. Several large state-owned industrial companies also have difficulties paying KESH because of their own poor commercial performance. Pending a strengthening of the financial performance of the delinquent public sector enterprises, it will be necessary for the Government itself to pay KESH on their behalf, for current bills as well as arrears in some cases, as foreseen in the Action Plan (see "Government Strategy" below).

Power Sector Financial Difficulties and Associated Government Subsidies. Until 1997, KESH's operating costs were low since nearly all its electricity production came from hydropower plants, and it had hardly any debt service obligations. Since then KESH's costs have increased steeply as a result of the need to import rapidly increasing amounts of electricity. In 2000 and 2001, KESH earned after-tax profits, but only because it received subsidies of US$ 25 million equivalent and US$ 29 million equivalent respectively from the Government as part of the cost of imported electricity. During 2002, the significant increase in imports, coupled with a reduction in the Government subsidy to US$ 24 million equivalent, is expected to result in KESH incurring a slight loss. The Action Plan forecasts for 2003, based on domestic generation of 3,100 GWh and continuing tariff increases, project a modest profit. The Plan also anticipates that the need for Government subsidies for electricity imports can be phased out by the end of 2004.

The Power Corporations of Elbasan, Shkoder and Vlore (see the next paragraph) have experienced financial difficulties since their creation as "voucher privatized" entities in 1995 as a result of their inability to reduce non-technical losses and improve bill collection. Elbasan's performance has been the best of the three and comparable to that of KESH. Shkoder and Vlore were severely affected by the civil disturbances which followed the collapse of the pyramid schemes in 1997. In 2001, Elbasan paid 81% of the amount billed to it by KESH, Shkoder only 2% and Vlore 259. This situation is expected to improve with the taking over by KESH in early 2003 of the distribution functions of these companies.

Power Sector Reform. During preparation of the Power Transmission and Distribution Project in 1995, the Albanian Government, with assistance from the Bank, began the process of reforming the power sector. A comprehensive Regulatory Law was enacted in 1995, and in mid-1996 the Electricity Regulatory Entity (ERE) was established. In August 1995, Parliament approved an Electricity Law providing for unbundling and possible privatization of the power sector and involvement of independent power producers, and a Law on Privatization of the Electrical Power Department providing for privatization of the power sector beginning with distribution. In October 1995, the municipal power distribution enterprises of Elbasan, Shkoder and Vlore were separated from KESH and converted to joint stock companies in accordance with the Law on the Transformation of State Enterprises into Joint-Stock Companies (effective May 15, 1995). The objective was to privatize these companies quickly as a pilot experiment and then to privatize the rest of distribution. KESH itself was also converted to a joint-stock company. In October 1995, Parliament approved a law requiring that at least 30% of the shares of a

- 8 - privatized power sector entity be sold through the mass privatization program and at least 30% of the shares be reserved for a strategic investor. From November 15 to December 20, 1995, 30% of the shares of Elbasan, Shkoder and Vlore were auctioned in exchange for vouchers. However, these shares were dispersed among many purchasers, so that no shareholder apart from the Government was able to exercise much influence on the management of these corporations.

There was a delay of about half a year by the Government in finalizing the contract with the consultants selected to assist in privatization of the three pilot companies and the rest of the distribution enterprises. By the time this contract was signed in early 1997, widespread civil unrest had started as a result of the collapse of several pyramid schemes. Progress on reform was then suspended. The Government (and IDA) judged that interest by foreigners in buying into the power sector would be low until the political situation stabilized. The privatization consultants then commenced work on preparing the bidding documents for a foreign power utility to take over temporary management of KESH and the three "pilot" companies through a management contract. However, this initiative did not gain the support of all the donors. Eventually it was agreed to have a more limited management assistance contract under which a team from a foreign utility would provide advice to senior KESH management on a day to day basis. This contract was awarded to ENEL, who commenced work in September 2000. The contract is being extended to the end of August 2003, and KESH has agreed under the Power Sector Rehabilitation and Restructuring Project to have an international utility provide it with management assistance up to June 30, 2004. ENEL has made contributions in many areas, such as reorganization of KESH, establishment of computerized billing, tariff reform, and preparation of the Action Plan and its annual updates.

In 2000, ownership of the Government's shares in the Power Corporations of Elbasan, Shkoder and Vlore was transferred to KESH as the first step towards reabsorbing the pilots into KESH. The distribution functions of these corporations will be taken over by KESH in 2003 in accordance with the Action Plan.

The ERE still exists, but until recently had inadequate staff and other resources and was not allowed to exercise the full powers envisaged for it under the law. However, its situation is beginning to improve. The ERE is now financing its operations from fees paid by the licensees, has been increasing its staff, and is gradually playing a more significant regulatory role. An Electricity Law is expected to be passed before preappraisal that will contain provisions strengthening the ERE.

Government Strategy. Recognizing the magnitude of the power sector crisis and its serious implications, the Government developed in late 2000 an Action Plan to tackle the critical issues. The plan includes measures to reduce electricity losses, improve collections and reduce demand, as well as other wide-ranging measures to urgently improve the performance of the sector. Implementation so far has been largely successful. KESH's collected revenue has increased from Lek 8.1 billion (US$ 58 million) in 2000 to Lek 17.3 billion (US$ 124 million) in 2002.

The Government has also prepared and adopted a longer-term sector

-9- strategy. In late 2000, the Minister of Public Economy and Privatization appointed a special task force with members from the Ministry, the National Agency of Energy, the Albania-EU Energy Efficiency Center and KESH, to prepare a strategic action plan to reform the power sector. With the assistance of consultants financed by USAID, the task force presented its report on February 28, 2001. The report provided a list of recommendations to strengthen the ERE, unbundle KESH, establish rules for a new commercial energy market, and eventually privatize the power sector, beginning with distribution, next with generation, and finally with partial privatization of transmission. The same consultants assisted in the preparation of a Power Sector Policy Statement (see Sections B3 and C2) and have helped to prepare new draft electricity legislation. The Government adopted the Policy Statement in April 2002.

In parallel, the Government and KESH have been making efforts to find financing for new power plants. China has offered to provide loan financing for the 80 MW Bushati hydropower station on the Drin River, with average annual production of 350 GWh and an estimated cost of US$ 159 million. The Government has given priority to thermal power capacity over Bushati because of the need to diversify Albania's predominantly hydropower system based almost entirely on the Drin River. Bushati is not currently being implemented and the Energy Sector Study will determine whether it is within the least-cost generation investment plan. The Government has asked the Bank to assist in arranging donor financing for a new 100 MW thermal power plant. This would be financed under the proposed project.

2. Objectives

The development objective of the project is to achieve significant improvement in power system outcomes (balance in the supply and demand of electricity, efficiency in its supply and use, financial viability of the power sector, and institutional effectiveness within the sector) through priority investments and other measures to: (i) increase thermal generation for meeting part of the domestic base load demand, thereby allowing more efficient utilization of hydropower for meeting domestic peak demand and for exchanges with base load energy from other power systems of the region, and (ii) enforcement of a strengthened policy regime.

3. Rationale for Bank's Involvement

The power sector is in the midst of an electricity shortage that puts at risk Albania's recently favorable macroeconomic performance and its economic growth and poverty alleviation prospects. This provides the principal rationale for a new initiative in the power sector at the present time. The value that the Bank could add through the proposed project would come from: (i) its experience with three other projects in the power sector in Albania since 1992; (ii) its experience with similar power sector issues in other countries; (iii) its focus on sector policy issues; (iv) the technical advice it could provide in areas such as investment planning, project management, procurement, financial management, environmental improvements; and (v) continuation of its leadership role among the other donors and its contribution towards securing financial support for the project from other donors. As noted in

- 10 - Section D.3, a coordinated donor approach has been very helpful in focusing the Government's attention on addressing the power sector issues. The Government and donors, including the IMF, have consistently sought the Bank's advice not only on project-related matters but on other sector issues as well, and since 2000 have almost always acted on this advice.

4. Description

The project would consist of a combined-cycle power station fueled by distillate oil at a six-hectare greenfield site about six km north of Vlore adjacent to an offshore oil tanker terminal. The plant would be designed to allow conversion to natural gas if and when imported gas is brought to Albania. The plant size would be 80 MW - 120 MW depending on the bids and subject to the amount of total available financing, which would be specified in the bidding documents. The total amount of financing is currently expected to be US$ 85 million (IDA - US$ 20 million, EBRD - US$ 30 million, EIB - US$ 30 million, KESH - US$ 5 million) but this estimate could change during project preparation. The site is expected to permit the construction of additional thermal units in the future, if these are needed. The project cost includes US$ 3 million for the needed refurbishment of the existing oil tanker terminal.

5. Financing Total ( US$m) BORROWER $0.00 IBRD IDA $20.00 BORROWING AGENCY $5.00 EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT $30.00 EC: EUROPEAN INVESTMENT BANK $30.00 Total Project Cost $85.00

6. Implementation

Financing Plan

Of the total project cost of US$ 85 million, IDA would provide a credit in the amount of US$ 20 million, EBRD and EIB would each provide US$ 30 million and KESH would provide US$ 5 million to cover local costs.

Lending Arrangements

The IDA credit would be lent to the Republic of Albania for 40 years with a 10-year grace period and at the standard IDA service charge. The credit would be relent to KESH for 20 years with a 5-year grace period and an interest rate equal to the six- month US dollar Libor rate plus 0.75%.

Implementation

MWH Consulting (USA) have prepared a detailed siting and feasibility study of the proposed Vlore power plant with financing from USTDA. They will assist KESH in preparing the environmental assessment and will also prepare the detailed technical specifications for inclusion in the tender documents. The proposed project would be completed between April 1, 2004 and September 30, 2007. The Government would be responsible for the policy actions designated as its responsibility in the Action Plan and the Power Sector Policy Statement. Management of the implementation of the project would be carried out by KESH, with the Project Management Unit (PMU) responsible for implementation of the Power Sector Rehabilitation and Restructuring Project continuing for the proposed project. A Procurement Capacity Assessment was carried out during preparation of the Power Sector Rehabilitation and Restructuring Project, and the findings will be updated during project preparation.

Subsequent Institutional Arrangements

Once the Vlore power station is commissioned, it would be established as a separate corporatized enterprise, with all of its shares held by KESH. In order to provide for satisfactory financial performance (at least in the initial years), consideration would be given to providing the plant with a power purchase agreement for a limited period. This issue will be decided during project preparation.

Financial Management and Disbursement

During preparation of the Power Sector Rehabilitation and Restructuring Project, in accordance with the Bank's financial management requirement, a Bank accredited financial management specialist reviewed the financial management system for the project to:

- assess the project's capacity and readiness for implementation; and

- review whether the necessary elements are present for a sound project financial management system such as adequate internal controls, project accounting, project staffing and audit arrangements.

The findings would be updated during project preparation. It is anticipated that the same financial management arrangements would be made for the proposed project.

Supervision and Monitoring

As this is a complex project with a major reform component, a significant supervision effort by IDA staff would be required. IDA would also carry out a mid-term review by September 30, 2005. In addition to the topics covered under the Financial Monitoring Reports (FMRs), the mid-term review would include a review of the overall institutional and financial performance of KESH. This review would identify any additional measures to be taken to ensure the efficient completion of the project and achievement of the project objectives.

7. Sustainability

The sustainability of the project and program depends on continuing improvements in reducing power losses and improving bill collection. Efforts prior to 2001 failed to bring about continuing improvements in these areas. However, the prospects of sustained success are greater this time for the following reasons:

- 12 - - The extent of the problem has reached crisis proportions and is having major macroeconomic implications. The Government realizes that failure to address and resolve the root causes of this crisis would have unacceptable economic, social and political repercussions.

- There is widespread public awareness about the extent of the crisis, its causes and its implications, partly as a result of an extensive media campaign. This has resulted in a greater acceptance of the need for the tough measures that have been initiated by the Government and KESH, and this in turn has made the task of implementing these measures somewhat easier.

- The extent and range of measures taken recently is unprecedented.

- Processing of the project is dependent on specified loss reduction and collection improvement targets being achieved. The Action Plan targets have generally been met since implementation began in January 2001.

- There is a coordinated donor approach to the sector, and the donors have repeatedly stated that future donor assistance would be jeopardized if there are slippages in meeting the agreed performance targets.

Sustained reductions in losses and improved collections would improve KESH's financial performance, making it easier for the company to make the necessary expenditures to reduce, and eventually, overcome the electricity shortage. Improved financial performance would also enhance the attractiveness of the power sector to foreign investors and improve the prospects for successful sector restructuring and privatization.

8. Lessons learned from past operations in the country/sector

Experience since lending to the Albanian power sector began in 1992 shows that: (i) implementation of the investments has been satisfactory; and (ii) the Government has been prompt to pass the legislation necessary for major reforms; but (iii) follow-up actions were ineffective; and (iv) until recently KESH, partly because of inadequate government support, had not been able to achieve a sustained reduction in power losses and increase in bill collection, nor had KESH and the Government made much progress towards implementing previously approved sector reform and privatization. The failure in reducing losses and improving bill collection has been the main cause of the poor sector performance and resulted in the electricity crisis that the country has been experiencing since summer 2000. Experience has also shown that a coordinated donor approach to sector issues, including willingness to suspend disbursements, has been important in focusing the Government's attention on addressing these issues.

This experience was reflected in the design of the Power Sector Rehabilitation and Restructuring Project in the following ways: (i) major emphasis was given to reduction in both technical and non-technical losses and improvement in bill collection, with specified targets to be achieved by critical dates during preparation and implementation of the project; (ii) the Government's two-year Action Plan designed to meet these targets was endorsed by the donors and initial implementation has been quite successful; (iii) the sector reform program was defined in a thorough and

- 13 - comprehensive way with substantial technical assistance and was endorsed by the Council of Ministers and the donors prior to Board presentation; (iv) substantial attention was given to institutional strengthening, particularly of KESH through continued management assistance, and of the ERE; and (v) a realistic time schedule was set for implementation of the program, with the objective of largely solving the power loss and bill collection problems, improving KESH's financial performance and strengthening the ERE. Bank staff is keeping other donors informed about progress in achieving the project's objectives, and will propose further periodic donor meetings in order to ensure continuation of the current coordinated approach to dealing with the sector's problems.

The design of the proposed project gives equally large emphasis to reduction in non-technical power losses, improvement in bill collection, institutional strengthening and sector reform. As the proposed project is expected to be cofinanced by EBRD and EIB, this will also contribute to effective donor coordination.

9. Environment Aspects (including any public consultation) Issues

The potential environmental issues have been identified in the feasibility study and are as follows:

Construction Phase

Emissions to air. Fugitive dust may be emitted from general site work (which would require raising the elevation by three to four meters due to the site's proximity to the Vlore flood plain), road improvements (the existing dirt access road will require upgrades and resurfacing), and truck traffic (related to deliveries of materials and equipment). Concrete and asphalt batch plants may also contribute to particulate emissions. The operation of diesel power construction machinery and vehicles would also have air quality impacts.

Ground and surface water. Minor short-term lowering of the groundwater table may occur in the vicinity of the site during dewatering of foundation excavations. However, groundwater resources in this area are limited and the groundwater is not typically used for domestic or other purposes. Stormwater discharges would need to be managed to minimize water quality impacts to nearby surface water resources such as the Narta Lagoon, Bay of Vlore and the Vlore floodplain. Water from dewatering activities could impact surrounding surface water features because it often contains suspended solids, oil and grease. Accidental spills of fuels or other materials could contaminate coastal or inland waters.

Marine habitat. Installation of the cooling water intake and discharge outfall pipelines could have impacts on the marine habitat. The work may involve dredging and disposal of excavated material, which could cause sediment release to the surrounding marine environment. The excavated material may contain mercury, arsenic, nickel and chrome and therefore be regarded as hazardous waste.

Land acquisition for the transmission connection. Small parcels of land may need to be acquired for the foundations of the transmission towers for

- 14 - the 7 km of double circuit 220 kV transmission line needed to connect the plant to the Babica substation. The land acquisition is not expected to involve any resettlement.

Operation Phase

Emissions to air. Combustion of the distillate oil during plant operation would result in emissions of sulphur dioxide, nitrogen oxides, carbon monoxide, carbon dioxide, particulate matter less than 10 microns, and total suspended particulate. The particulates may contain small amounts of trace metals.

Marine environment. The plant would produce waste waters such as sanitary waste water, condensates containing oil, eluate from cleaning of the demineralization unit, and cooling water. Impacts on the marine environment could also result from oil spills during oil delivery via ship or barge, and the effect on marine life of the water intake structure.

Noise. High noise levels can result from operation of the turbines. The transformers in the switchyard can also generate significant noise levels.

Hazardous waste. The residue and ash from burning oil is regarded as hazardous waste.

Proximity to the Narta Lagoon. The site is located about one km south of the Narta Lagoon, which is approximately 4,200 hectares in size, has an average depth of 0.5 to 1.2 meters, and is home to a number of endangered species. The proposed project is not likely to have any significant adverse impact on the lagoon. Parliament is expected to designate the Narta Lagoon as a "Protected Area" under a new law which provides for the establishment of protected areas to ensure the conservation of natural resources, protect biodiversity, and restore and maintain habitats and species. The proposed Vlore power plant site is likely to be outside the boundaries of the Narta Lagoon protected area. The Vlore site would not necessarily be ruled out even if it were within the protected area since the activities related to construction and operation of the plant could be carried out with an Environmental License and approval by the Advisory Council of Territory Adjustment. The Bank has recommended that the Government take early decisions on the boundaries of the Narta Lagoon protected area and the restrictions to be imposed inside the area, and on approval of the use of the Vlore site for construction of a thermal power plant in order to enable an adequate assessment of the viability and cost of the proposed plant. It will be required that these decisions be taken prior to the pre-appraisal mission of the project.

Key Stakeholders

The key stakeholders include: KESH, as the project sponsor; the Government, which supports the initiative for new domestic power generation, but which also wants to minimize adverse environmental impacts; the general population of Albania, which is expected to have the same goals as the Government; and the residents of the Vlore area, who would benefit from the electricity produced by the plant, the employment creation resulting from the plant's construction and operation, and any other income brought to the community by the plant's activities, but would

- 15 - also have to bear any adverse local environmental impacts.

10. Contact Point:

Task Manager Iftikhar Khalil The World Bank 1818 H Street, NW Washington D.C. 20433 Telephone: Fax:

11. For information on other project related documents contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Web: http:// www.worldbank.org/infoshop

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

This PID was processed by the InfoShop during the week ending February 21, 2003.

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