RENEWABLE ENERGY RESOURCES PROJECT Page 2 of 6

CROATIA GEF Project Concept Note RENEWABLE ENERGY RESOURCES PROJECT Page 1 of 6

Summary Project Concept Note

A. Country: CROATIA B. Project Name & FY Croatia – Renewable Energy Resources Project C. Focal Area Climate Change D. GEF Operational Program: OP 6 E. GEF Implementing Agency: World Bank F. Country Implementing Agency: Ministry of Economy Hrvatska Elektroprivreda (HEP) G. Total Project Cost: US$10 million H. Financing Plan: GEF Grant US$ 4.0 million IBRD Loan US$ 2.0 million Commercial Loans US$ 2.0 million Project beneficiaries US$ 2.0 million Total US$10.0 million I. Project Summary The objectives of the proposed project are to: (i) promote RER projects nationwide; (ii) establish a utility-based ESCO to develop and aggregate the capital for RER projects and to implement them, following performance contracting principles; and (iii) develop in Croatia the knowledge and mechanisms necessary for financiers to fund RER projects.

J. Management Support The Country Unit (ECC02) and the Energy Sector Unit (ECSEG) have endorsed the project.

K. Ongoing Preparation Activities A PHRD grant (US$187,994) was approved. The grant would fund preparatory activities for the Croatian Electricity Utility (HEP) to establish an energy service company (ESCO) with possibly private sector participation. The ESCO would develop the market for RER projects, arrange for financing with participation of local banks for maximum sustainability, and guarantee contractual performance to the ESCO clients. The main preparatory activities, scheduled to begin in October 25, 1999, include: (i) the development of a Business plan for the ESCO subsidiary; (ii) the development and implementation of pilot RER projects following ESCO principles; and (iii) public participation program.

L. Timetable PCD not earlier than March 2000. CROATIA GEF Project Concept Note RENEWABLE ENERGY RESOURCES PROJECT Page 2 of 6 CROATIA – RENEWABLE ENERGY RESOURCES PROJECT

GEF Project Concept Note

(FY01 Project – GEF Operational Program #6)

Sector Background

The objectives of the Government of Croatia for the energy sector call for post-war recovery and transition towards energy security through: (i) efficient energy supply in an environmentally sustainable manner at realistic but socially acceptable prices; (ii) demonopolization and liberalization of the energy market; (iii) fostering competition in the energy market where possible through privatization; (iv) establishment of a regulatory framework; and (v) addressing market and institutional failures to promote energy efficiency and renewable energy resources and to protect the environment. Croatia meets two thirds of its energy requirements from domestic production (mainly oil and gas). However production is declining, and energy imports will need to increase dramatically if economic recovery is to be sustained. Croatia will have to pay full international prices for these imports, and with large investments needed for reconstruction and expansion of the energy infrastructure, the financial burden on Government would be high. This burden is best mitigated through creating an institutional and regulatory environment to attract private financing to the sector. In addition, the scarce energy resources will have to be used in a way which represents the highest value to the Croatian economy. This will require: (i) a more integrated planning approach to development of the sector than existed until now; (ii) creating tariff structures that recover the costs of supply each consumer imposes on the system and that lead to optimum interfuel utilization; and (iii) if subsidies are used for disadvantaged groups, it is best that these be transparent and provided directly from the government budget.

Main Energy Sector Issues

The main sector issues are: (i) large investments needed for reconstruction and expansion of the energy infrastructure, to provide sustainable energy services with minimum impact on the environment; (ii) the limited financial capacity of the sector under its current structure of state and municipal ownership; (iii) the increasing dependence on imported gas for which there is currently only a single supplier (Russia); (iv) the lack of competitive fuel supply options under the current institutional arrangements; (v) lack of adequate tariffs structures which reflect the true economic costs to the individual classes of consumer in the energy sector; and (vi) lack of the institutional and financing framework to create an enabling environment for EE and RER investment projects and to promote the energy efficiency agenda.

Bank Involvement in the Energy Sector

During the past year, the Bank has engaged in a substantial dialogue on energy sector issues with the Government of Croatia (GoC). This has been facilitated through the Energy Needs Assessment sector report (September 1998) prepared by Bank staff. The report has been extensively discussed with the Government which is fully supportive of its findings. The report has helped the Government and the Bank to agree on a new cooperation framework in the energy sector involving:

 continuing policy dialogue and supervision of sector reforms including: (i) restructuring and partial privatization of public utilities and the creation of a modern regulatory framework for public utilities (ongoing EFSAL condition); and (ii) the approval by the Parliament of the Energy Strategy and of the umbrella Energy Law and the specific laws for electricity, gas, heat and oil; and CROATIA GEF Project Concept Note RENEWABLE ENERGY RESOURCES PROJECT Page 3 of 6  new lending operations in gas, district heating, energy efficiency (EE) and renewable energy resources (RER), and possibly power. The latter will depend on satisfactory progress in restructuring and unbundling of the electricity utility (EFSAL condition).

Through the proposed lending program, the Bank would intensify its dialogue with the Government on important energy sector issues and ensure that those sector reforms already initiated are kept on-track. The two proposed district heating (FY00) and EE & RER (FY01) projects would be the Bank’s first investments in Croatia’s energy sector and would therefore break new ground in these sub-sectors.

Support of the Country and Sector Units

The Country Unit (ECC02) and the Energy Sector Unit have endorsed the above lending program.

In light of the above, a PHRD grant (US$187,994) was approved. The grant would fund preparatory activities for the Croatian Electricity Utility (HEP) to establish an energy service company (ESCO) with possibly private sector participation. The ESCO would develop the market for RER projects, arrange for financing with participation of local banks for maximum sustainability, and guarantee contractual performance to the ESCO clients. The main preparatory activities, scheduled to begin in October 25, 1999, include: (i) the development of a Business plan for the ESCO subsidiary; (ii) the development and implementation of pilot RER projects following ESCO principles; and (iii) public participation program.

Link to CAS Priorities/Bank Program

The proposed Bank strategy in the energy sector supports the CAS objectives of: (i) preserving macroeconomic stability; (ii) redirecting the role of the state and expanding the role of the private sector in the economy; (iii) promoting the effective operation of the markets; and (iv) refocusing infrastructure development. As part of the strategy to achieve these objectives, the CAS proposes the use of new methods of support and financing to help attract private investors in areas that heretofore have been seen as purely in the public domain (including the area of natural gas) to reduce the financial burden on public sector.

Sector Issues Related to Renewable Energy Resources

Current Situation. There are a number of institutional barriers to the development of Renewable Energy Resources (RERs). For Renewable Energy Resources: RER projects would become increasingly attractive only if environmental benefits are explicitly recognized and factored in energy pricing and if proper legislation and financial support mechanism are in place. In addition, RERs require active promotion and public awareness as price incentives in energy sector are not yet adequate and decision powers dispersed in Government. Current energy tariffs (structure and levels) are distorted and in turn distort inter-fuel competition/substitution to the disadvantage of RERs. Large account receivables / poor or non-payment by some customers also hinder financing for RERs development. The institutional framework to create an enabling environment for RERs investment projects, to ensure private sector participation and to coordinate among stakeholders (government institutions, local communities, public institutions, non-governmental organizations, private sector, local and foreign financial institutions and consumer / professional / industry / services associations) is lacking.

Potential for Renewable Energy Resources. Croatia has the same solar insolation as Greece but has to date only 1% of Greece’s installed solar capacity. Paradoxically, locally produced photovoltaic cells are exported as local demand for them is insignificant. Technical and economic potential for wind energy could be up to 3- 7% of final electricity demand and yet, there are no wind installations in Croatia. Croatia had a long tradition for using biomass energy, mainly wood for heating and cooking in rural areas. In 1970, 15% of total energy consumption was from biomass, but this share has dropped to 5.6% in 1996 as a result of urbanization and increased standard of living. The geothermal gradient in Croatia of 0.049 oC/m is higher than the European average of 0.03 oC/m, indicating existence of geothermal resources in the country. CROATIA GEF Project Concept Note RENEWABLE ENERGY RESOURCES PROJECT Page 4 of 6 Geothermal energy has so far been used for medical purposes and spa bathing from natural springs and shallow wells. The share of electricity generation from small-scale hydro power plants (HPPs) could increase from the present level of 0.7%. to up to 6.6% of total electricity production within Croatia. However, current legislation for developing HPP projects together with complex and lengthy procedures (minimum 3 years, often 5 years for obtaining construction permit for HPPs) represents major barriers to the proposed program. In addition, currently low off-take electricity prices by HEP make small-scale HPP and cogeneration facilities financially not attractive.

The Government Strategy in EE & RER

The Government of Croatia has appointed the Croatian Energy Institute to develop ten national programs in energy efficiency (EE) and renewable energy resources (RERs), comprising: (i) one program (entitled “PLINCRO”) for the development of the gas market in Croatia; (ii) five RERs programs covering solar energy (“SUNEN”), wind (“ENWIND”), biomass (“BIOEN”), geothermal (“GEOEN”) and small-hydro plants (“MAHE”); and (iii) four EE programs covering the promotion of energy efficiency in industry, services and public sectors (“MIEE”), the development of small cogeneration plants (“KOGEN”), and increasing energy efficiency in district heating (“KUENcts”) and in buildings (“KUENzgrada”). The national programs form an integral part of the Energy Strategy being currently reviewed by the Parliament, they are is timely and therefore deserve immediate support.

A number of other on-going activities could provide a background for setting priorities and ratifying the United Nations - Framework Convention on Climate Change (UN-FCCC), so that a proper framework for financial assistance is in place. This includes: (a) UNDP-GEF-financed “Removing Barriers to EE & RERs Study,” as first step before project development phase; (b) USAID-financed work on gas and electricity networks and on demonstration zones under SECI initiatives; and (c) development, by the State Directorate for Protection of Nature and Environment, of enabling activities and mitigation measures to reduce carbon dioxide emissions, for national communications with the UN-FCCC -- work also financed by UNDP-GEF.

Possible Bank Support

With the above programs, Croatia has undertaken a fair amount of analytical work which could provide a basis for the Bank support to specific RER demonstration projects in one or more programs, as well as to the establishment of suitable institutional framework and financial mechanisms that would: (i) promote RER projects nationwide; and (ii) demonstrate fuel switching and substitution for environmentally-friendly energy supply sources, all as a means of reducing local and global environmental pollution emissions. The Bank support could combine lending and non-lending services as well as grants from the Global Environmental Facility (GEF) or from the Global Carbon Initiative (GCI).

Project Next steps. The Energy Institute has a few project ideas but these are at an early identification / conceptual preparation stage. The priority task is for the Croatian authorities to formulate, at the earliest opportunity, specific project proposals and implementation arrangements in sufficient detail for the Bank to assess the most appropriate financing modalities. This might be: (i) regular Bank lending; (ii) Global Carbon Initiative; and (iii) Global Environmental Facility. The Bank will clear a few projects eligible for GEF funding (first) and for GCI funding (second). GEF grants would have to be tied to a loan from either the Bank or another international financial institution to cover the baseline cost of the investment.

Rational for Bank Involvement and Using a Utility-Based ESCO

The technical, economic, and environmental benefits to Croatia of using its renewable energy resources are well substantiated. The technologies involved are well-defined, standard and with proven effectiveness. However, the barriers as described above are preventing the widespread implementation of projects that would capture these benefits. The Bank’s support in the proposed RER project would seek to overcome three major barriers, CROATIA GEF Project Concept Note RENEWABLE ENERGY RESOURCES PROJECT Page 5 of 6 as described below: (1) financing mechanisms are not in place; (2) decision-makers lack information; and, (3) risks are perceived to be high.

First, the financing mechanisms are not yet in place in Croatia to permit the widespread implementation of RER projects. While ESCO-type financing arrangements have been used in many countries to capture substantial energy efficiency improvements, such ESCO arrangements have not yet been used extensively in Croatia. In response, one purpose of the Bank’s involvement in this project is to facilitate the widespread use of ESCO financing arrangements in Croatia by:

 Assisting all parties involved to identify and manage the inter-related technical and financial aspects involved in implementing a successful ESCO practice in Croatia;

 Reducing the perceived risk to local commercial banks, and encouraging their co-financing with the Bank of the overall RER program; and,

 Permitting the local commercial banks to consider the complete financing of future similar RER work by gaining experience within this project.

A second major barrier is that many decision-makers in the country lack adequate information about RER investments. Even though the technologies involved are well defined, standard, and have proven effectiveness, the owners/decision-makers do not know how to properly select, install and operate these measures/facilities. This situation relates to the third objective, avoidance of perceived high risks. The decision-makers are very reluctant to take risks, and so little happens. To overcome these related two barriers of insufficient information and risk avoidance, the second purpose of the Bank’s involvement is to facilitate the use of mechanisms in which technical risks from energy efficiency measures are assumed by a single entity -- the ESCO that has the expertise in selecting, installing and operating the key RER facilities.

Bridging the Knowledge Gap. Market incentives need to be in place as well serious institutional barriers and market failures need to be overcome in order to permit the tapping of the huge RER potential in Croatia. As previously stated, local banks are not familiar with such projects and are reluctant to finance them; generally, project owners lack capital for any required investments and are not sufficiently creditworthy to attract commercial financing at acceptable terms; and there are few mechanisms currently in place to help project owners deal effectively with rising energy prices and affordability of energy services. New approaches and financing mechanisms are thus needed and they must be built on the interest of the owners to RER investments, and on the interest of local banks to finance these measures and investments. The proposed ESCO structure and the ESCO could bridge the knowledge and financing gap between local banks and owners. GEF funds could be used to guarantee loans from local banks (as it was done for the IFC/GEF Energy Efficiency Project in Hungary), thereby leveraging local participation for maximum sustainability

In addition, HEP knows its market very well and already has a strong relationship with its customer base. Project owners/sponsors would perceive HEP-ESCO as being involved for "the long haul," extending well beyond the payback period of the ESCO project financing. As a result, its marketing costs should be low, and its marketing success rate high.

The Proposed RER Project

The objectives of the proposed project are to: (i) promote RER projects nationwide; (ii) establish a utility-based ESCO to develop and aggregate the capital for RER projects and to implement them, following performance contracting principles; and (iii) develop in Croatia the knowledge and mechanisms necessary for financiers to fund RER projects. CROATIA GEF Project Concept Note RENEWABLE ENERGY RESOURCES PROJECT Page 6 of 6 Tentatively, the project beneficiary will be either the Ministry of Economy or HEP. The HEP – ESCO would be the project beneficiary. The Bank together with GEF could help set up a national RER Fund, from which project sponsors could seek combinations of guarantees for commercial loans from local banks, subsidized loans, or grants.

A typical RER project could cost about US$10.0 million, covering (i) support to development programs for rural areas and Adriatic Islands involving small solar, biomass, wind, geothermal and hydro energy projects; (ii) anometer stations to assess wind energy potential, and (iii) technical assistance in helping increase consumer awareness through promotion and education campaigns, and in helping build up capability of local communities to participate in program components and implement them, as detailed in Table 1 below. Typical financing plan could include a GEF grant (US$4.0 million), an IBRD loan (US$2.0 million), commercial loans (US$2.0 million) and counterpart funds (US$2.0 million).

Table 1: Financing Plan for Typical RER Project Typical RER Project Components, Costs & GEF Grant Component Estimated Costs Typical GEF Grant 1 (US$ mln) (US$ mln) (% of Total) Development programs For rural areas and Adriatic islands 8.0 3.2 (40%) Measurement stations 0.5 0.0 ( 0%) Technical Assistance 1.5 0.8 (20%) Total 10.0 4.0 (40%)

Typical Financing Plan Financing Sources Amount (US$ m) GEF Grant 4.0 IBDR Loan 2.0 Commercial Loans 2.0 Counterpart Funds 2.0 Total 10.0

The project team is also envisaging a LIL operation which will still involve the establishment of the ESCO and the focus on a fewer number from the components identified above.

Tentative Timetable

 PCD not earlier than March 2000 (after completion of draft business plan & of preparatory activities for pilot projects)  Board Approval would scheduled to fit GEF Approval Process

1 Based on preliminary figures from other countries -- to be estimated using incremental costs.