Document of The World Bank

FOR OFFICIAL USE ONLY Public Disclosure Authorized Report No: 41755 - AZ

PROJECT APPRAISAL DOCUMENT

Public Disclosure Authorized ON A

PROPOSED LOAN

IN THE AMOUNT OF US$450 MILLION

TO THE

REPUBLIC OF

FOR A

Public Disclosure Authorized RAIL TRADE AND FACILITATION PROJECT

February 28,2008

Sustainable Development Department South Caucasus Country Unit Europe and Central Asia Region

Public Disclosure Authorized This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUJYALENTS (Exchange Rate Effective October 1, 2007) Currency Unit = AZN (Azeri New Manats) AZN0.8531 = US$1

FISCAL YEAR January 1 - December 31

ABBREVIATIONS AND ACRl NYMS ACG Azeri-C hirag-Gunashli I IAS International Accounting Standards AC Alternating Current I IBRD International Bank for Reconstruction and Development ADB Asian Development Bank ICB International Competitive Bidding ADDY Azerbaijan Railway IDA International Development Association AZN Azerbaijan New Manat IF1 International Financial Institution BTC --Ceyhan IFRS International Financial Reporting Standards CAPSAP Corporate and Public Sector IRR Internal Rate of Return Accountability Project CFAA Country Financial Accountability kPh Kilometer per hour Assessment CIS Commonwealth of Independent States LCS Least Cost Selection CPAR Country Procurement Assessment MED Ministry of Economic Development CPS Country Partnership Strategy MoE Ministry of Ecology and Natural Resources CQS Consultant’s Qualifications Selection MOF Ministry of Finance DC Direct Current MOT Ministry of Transport EA Environmental Assessment NCB National Competitive Bidding EBRD European Bank for Reconstruction and Development ECA Europe and Central Asia NGO Non-Governmental Organization EIRR Economic Internal Rate of Return NPV Net Present Value EMP Environmental Management Plan PHRD Policy and Human Resources Development Fund EMU Electric Motorized Unit PIU Project Implementation Unit EO1 Expression of Interest PPL Public Procurement Law EU European Union QCBS Quality and Cost-Based Selection FBS Fixed Budget Selection SBD Standard Bidding Documents FEX Foreign Exchange SIL Specific Investment Loan FRR Financial Internal Rate of Return SOCAR State Oil Company ofthe Azerbaijan Republic FSL Fixed-spread Loan SPPRED State Program on Poverty Reduction and Sustainable Development FY Fiscal Year TRACECA Transport Corridor Europe Caucasus Asia GDP Gross Domestic Product UNCITRAL United Nations Commission on International Trade Law GR Georgian Railways I VAT Value-Added Tax

Vice President: Shigeo Katsu, ECAVP Country Managermirector: Donna M. Dowsett-Coirolo, ECCU3 Sector Director: Peter D. Thomson, ECSSD Sector Manager: Motoo Konishi, ECSSD Task Team Leader: Gerald P. Ollivier, ECSSD Co-Task Team Leader: Martha Lawrence, ECSSD FOR OFFICIAL USE ONLY

AZERBAIJAN RAIL TRADE AND TRANSPORT FACILITATION PROJECT CONTENTS

Page I. STRATEGIC CONTEXT AND RATIONALE ...... 1 A . Country and sector issues ...... 1 B. Rationale for Bank involvement ...... 4 C . Higher level objectives to which the project contributes ...... 4 I1. PROJECT DESCRIPTION ...... 4 A . Lending instrument...... 4 B. Project development objective and key indicators ...... 5 C . Project components ...... 6 D. Lessons learned and reflected in the project design ...... 7 E. Alternatives considered and reasons for rejection ...... 8 I11. IMPLEMENTATION ...... 9 A . Partnership arrangements ...... 9 B. Institutional and implementation arrangements ...... 9 C . Monitoring and evaluation ofoutcomes/results ...... 10 D. Sustainability ...... 10 E. Critical risks and possible controversial aspects ...... 10 F. Loadcredit conditions and covenants ...... 11 IV. APPRAISAL SUMMARY ...... 12 A . Economic and financial analyses ...... 12 B. Technical ...... 14 C . Fiduciary ...... 15 D. Social ...... 16 E. Environment ...... -17 F. Safeguard policies ...... 17 G . Policy Exceptions and Readiness ...... 18

This document has a restricted distribution and may be used by recipients only in the performance of their official duties . Its contents may not otherwise be disclosed without World I Bank authorization . J Annex 1: Country and Sector Background ...... 19 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies ...... 31 Annex 3: Results Framework and Monitoring ...... 32 Annex 4: Detailed Project Description ...... 35 Annex 5: Project Costs ...... 38 Annex 6: Implementation Arrangements...... 39 Annex 7: Financial Management and Disbursement Arrangements ...... 40 Annex 8: Procurement Arrangements...... 51 Annex 9: Economic and Financial Analysis ...... 60 Annex 10: Safeguard Policy Issues ...... 79 Annex 11: Project Preparation and Supervision ...... 81 Annex 12: Documents in the Project File ...... 82 Annex 13: Statement of Loans and Credits...... 83 Annex 14: Country at a Glance ...... 85 Annex 15: Map (IBRD No. 35177R) ...... 87 AZERBAIJAN

RAIL TRADE AND TRANSPORT FACILITATION

PROJECT APPRAISAL DOCUMENT

EUROPE AND CENTRAL ASIA

ECSSD

Date: February 28, 2008 Team Leader: Gerald Paul Ollivier Country Director: D-M Dowsett-Coirolo Sectors: Railways (90%); Other domestic and Sector ManagerDirector: Motoo Konishi international trade (1 0%) Themes: Corporate governance (P);Infrastructure services for private sector development (P);Trade facilitation and market access (S) Project ID: PO83 108 Environmental screening category: Partial Assessment Lending Instrument: Specific Investment Loan ~ ~ ~ ~~~~ ~ ~~ Project Financing Data [XI Loan [ 3 Credit [ ] Grant [ 3 Guarantee [ 3 Other:

For Loans/Credits/Others: Total Bank financing (US$m.): 450.00 Proposed terms: US Dollars Fixed Spread variable rate loan with 17 year maturity, including a four yearsvears "gracemace period.Deriod. Financing Plan (US$m) Source Local Foreign Total Borrower 226 117 345 International Bank for Reconstruction and 0 450 450 Development Total: 226 568 795

Borrower: Republic of Azerbaijan

Responsible Agency: Azerbaijan Railways (ADDY) Azerbaijan Cumulative] 1.00 I 36.00 I 136.00 I 306.00 I 450.00 I Project implementation period: Start April 15,2008 End: March 30,2012 Expected effectiveness date: June 20, 2008 Expected closing date: June 30, 20 12 Does the project depart from the CAS in content or other significant respects? [ ]Yes [XINO Re$ PAD I.C.16 Does the project require any exceptions from Bank policies? Ref: PAD IKG. 79 [ ]Yes [XINO Have these been approved by Bank management? [ ]Yes [ IN0 Is approval for any policy exception sought from the Board? [ ]Yes [XINO Does the project include any critical risks rated “substantial” or “high”? [XIYes [ ]No Ref:# PAD IILE Does the project meet the Regional criteria for readiness for implementation? [XIYes [ ]No Re$ PAD IKG. 79 Project development objective Re$ PAD II.B.18 The main project objective is to improve railway services in Azerbaijan, as well as the competitiveness, financial sustainability, operating and cost efficiency, and capacity of ADDY in particular along the transport corridor toward (east-west corridor). Project description [one-sentence summary of each component] Ref: PAD II.C, Annex 4 The project includes renewal of critical assets (track, locomotives, power supply), implementation of IFRS accounting system and technical services to support the restructuring of the Azerbaijan railways, including for oil spill prevention and preparedness for rail transport, and support to project implementation. Which safeguard policies are triggered, if any? Ref: PAD IKF, Annex 10 Environmental Assessment (OP/BP/GP 4.0 1) Significant, non-standard conditions, if any, for: Re$ PAD 3. F Loan effectiveness: (i) The ADDY and the Ministry of Transport of the Borrower shall have approved the Project Implementation Manual satisfactory to the Bank. (ii) The Borrower has opened the Project Account in Manat with the initial deposit of US$l,OOO,OOO equivalent on terms and conditions acceptable to the Bank. (iii) The Subsidiary Agreement has been executed on behalf of the Borrower and the ADDY. Covenants applicable to project implementation: (i) Except as the Bank shall otherwise agree, the ADDY shall complete its transformation into a joint-stock company by June 30, 2009, in cooperation with the Borrower. (ii) Except as the Bank shall otherwise agree, the ADDY shall complete its conversion from a joint-stock company to a holding company with independent subsidiaries operating by line of business by January 15, 2010. (iii) Except as the Bank shall otherwise agree, ADDY will not incur any debt unless a reasonable forecast of the revenues and expenditures shows that ADDY would maintain a Debt Service Coverage ratio above 1.1, during the term of the debt. I. STRATEGIC CONTEXT AND RATIONALE A. Country and sector issues

1. In the early to mid-1990s, the collapse of the and the Armenian-Azerbaijan, Nagorno Karabakh, conflict resulted in massive economic dislocation, the loss of control of 20 percent of the land area, human displacement of up to 1 million from their home, and a 60 percent drop in GDP and hyperinflation. Much of the industrial sector was closed, and the agricultural sector was transformed into small holdings. The oil and gas sector emerged as the engine of economic growth. Azerbaijan’s economy now draws more than 50 percent of GDP from oil and gas extraction. Rapid investment in the oil and gas sector has spurred strong GDP growth-GDP increased at an annual rate of around 10 percent per year from 2000 to 2004, with 26 percent and 34 percent spurts in 2005 in 2006 respectively.

2. Azerbaijan’s oil production is expected to peak in 2010-2012, and decline in subsequent years. Although a large share of GDP, the oil and gas sector only provides about one percent of employment in Azerbaijan. Thus, Azerbaijan’s economic challenge is to use the oil boom resources to catalyze growth and employment in non-oil sectors and achieve sustainable reductions in poverty.

3. The Azerbaijan Country Partnership Strategy, FY07-10 (CPS) aims to support sustainable development through: (1) increasing the quality and transparency in public sector governance; (2) supporting sustainable and balanced growth of the non-oil economy; (3) increasing the quality and access to social services; and (4) improving environmental management and furthering the climate change agenda. The second pillar of the CPS will be accomplished by “developing essential infrastructure and services, with special attention to the rural economy and Central Asia-South Caucasus- regional transit routes”’.

4. One of Azerbaijan’s natural advantages is its location. Azerbaijan is located on the Western shore of the oil-rich , between Russia to the North, Georgia to the West and to the South. Azerbaijan is part of the shortest land corridor (Azerbaijan-Georgia) from the Caspian Sea to the nearest open sea, making it attractive as a transit country. Baku is the only major city on the Caspian Sea. It has managed to capitalize on its location by attracting significant volumes of transit cargo by rail (about six million tons annually) from Kazakhstan and Turkmenistan and more recently by pipeline.

5. Rail transit services generate significant income for Azerbaijan. In 2006, rail transit services produced the equivalent of five percent of non-oil export of goods and of the service credit in the balance of payment. Demand for these transit services and for export of goods from Azerbaijan by railways has been sustained over the past three years. Based on a review of markets in the Caspian Basin, this railway traffic is expected to continue a gradual expansion over the next ten years. While most crude oil from the Caspian Sea is expected to continue using pipeline as a primary mode of transportation, the railway across the Caucasus is expected to remain an important alternative for shippers, and a small increase in rail transport of oil and oil products is foreseen over the period.

1 IBRD/IDA/IFC, Country Partnership Strategy FY07-10 for Republic of Azerbaijan (November 8,2006) (R2006- 0203) p. v. 6. Two main rail corridors carry 96 percent of railway traffic. The most heavily used corridor runs east-west from Baku to the Georgian border. It is part of the larger corridor from Baku to Georgian ports that carries 87 percent of transit cargo. In 2006, this corridor carried 22 million tons, or 73 percent of railway total traffic. The other major corridor links Baku to the Russian border.

7. Azerbaijan Railway (ADDY) is a vertically integrated, state-owned that provides rail freight and passenger services using its own infrastructure. ADDY operates a small, loss-making passenger service, but is predominantly a freight railways (8 1 percent of traffic units). ADDY is profitable overall, based on available financial data2. It generated revenues of US$219 million and a net profit of US$30 million in 2006. This overall healthy financial performance is a direct consequence of traffic recovery in recent years. However ADDY has been under-investing in infrastructure and rolling stock for an extended period of time and will be unable to continue serving its market without significant new investments in the near term.

8. A detailed review of ADDY took place during project preparation, as requested by the Government of Azerbaijan and by the Presidential Decree No. 1974, dated February 21, 2007 that called for the development of a modernization program for the railways. This review, funded by a Japanese PHRD Grant, led to the drafting of a comprehensive “Government Program for the Development of Azerbaijan State Railways 2008-201 1“(the Program) entailing institutional modernization and a list of priority investments. This Program (Annex 1) for 2008- 20 11 , has been reviewed and approved by the Cabinet of Ministers and signed off by the Prime Minister on February 25, 2008. The Program will also be reflected in a Presidential Decree, which is being processed. This will further reinforce the strategy and objectives presented in this comprehensive reform program.

9. The main objectives of the Program are to: (i)satisfy the increasing demand from the population and the economy in railway transportation services; (ii)satisfy the security demands of the state; (iii)increase the transit potential of the country; (iv) improve the quality of railway services; (v) support social and economical development of the country by decreasing the costs of passengers and cargo transportation; while (vi) progressively attaining financial self- sustainability for freight services.

10. The first priority of this Program is to modernize ADDY institutionally. It aims at transforming ADDY’s structure to ensure proper incentives are in place, to offer services that respond to its clients’ needs in terms of price, quality and dependability. The reorganization will build on close monitoring of service delivery, revenue generated and cost of service. It will entail, as a first step, the conversion of ADDY into a state-owned joint stock company, with appropriate corporate governance and transparent accounting aligned with International Financial Reporting Standards (IFRS). As a second step, the railways will be reorganized by line of business, or profit center^.^ Each main line of business would become an ADDY subsidiary

* Azerbaijan State Railways, unaudited financial statements restated as per IFRS requirements. A line of business is defined by a set of services sold to a similar group of customers, using a common set of assets and employees to provide the service.

2 (or similar legal structure), as a holding company, and would have its own assets, employees and accounts. The lines of business foreseen in the program include passenger transport, freight transport, infrastructure, and non-core activities. Divestiture from major non core activities is expected to take place in parallel. This restructuring would draw on global experience in railway restructuring.

11. The second priority of this Program is to provide ADDY with suitable investments in infrastructure and rolling stock to allow it to maintain its capacity and provide a sound basis for future expansion of its operation. PHRD-funded consultants estimated that the 3-4 million tons annually, or the equivalent of US$13 - 18 million in revenues, are diverted to other routes because ADDY lacks the locomotive capacity. This situation is expected to worsen dramatically over the next four to five years with a large drop in capacity expected in case no investment in new locomotives takes place. To that end, the Program identifies a broad set of priority investments to be executed in phases over four years, building on technical assessments carried out during project preparation as well as on other national priorities defined in the earlier Presidential Decree No. 1974.

12. The Program includes investments in rail infrastructure on main corridors. Rail tracks have deteriorated severely as a result of significant deferred maintenance. ADDY lines were built to a heavy freight standard, which allowed 80 kph speeds for freight and 100 kilometers per hour (kph) for passengers. Over the last 15 years, however, ADDY could not invest sufficiently to keep its assets in good condition, leading to many speed restrictions on the main corridors. On the main east-west line, 24 percent of the track requires immediate track repair, as confirmed by independent visual surveys. This leads to less efficient use of rolling stock and creates significant risk of derailments caused by track failure. Given ADDY’s focus on oil and oil product transport, investment in upgrading rail tracks is required to reduce this derailment risk.

13. The Program also includes the renewal of the traction power on the east-west corridor. The electrification system and ADDY’s locomotives (1 19) are likely to experience major breakdowns in the short to mid-term, as the electrification system on the east-west corridor and most of the locomotive fleet are well past the end of their service life. ADDY currently needs a fleet of about 120 mainline locomotives in good condition. With improved operating practices, which depend in part on having more reliable locomotives, the number of required locomotives could be reduced to about 100 by 2011, and would increase in line with traffic growth afterwards. By contrast, within five years, ADDY is expected to have only 41 main line locomotives of less than 40 years in service. Even with operating improvements, ADDY would need to replace more than 50 locomotives over the next five years.

14. The poor state ofthe locomotives and electrification provided ADDY with an opportunity to define a long term strategy for traction. The main options were: (1) rebuilding the existing 3.3 kilovolt (kV) direct current electrification and purchasing 3.3 kV locomotives; (2) replacing the existing 3.3 kV direct current electrification with more efficient 25 kV alternating current electrification and purchasing 25 kV locomotives; and (3) purchasing diesel locomotives. There were substantial differences in cost between the various options. Rebuilding the existing system would cost an estimated US$330 million more than the diesel or 25 kV alternatives over 25 years. Considering long term operation and maintenance costs, environmental impacts, and the development of passenger traffic, the Government of Azerbaijan opted for the electrification of the east-west corridor with 25 kV power supply. This system is expected to lead to a reduction in energy used per net ton-km transported. Since there is a baseline for energy efficiency of rail transport, Azerbaijan may elect to pursue carbon finance opportunities during the life of this project related to those improvement.

B. Rationale for Bank involvement

15. The Bank is sought both as an advisor and as a financier at a time when proper management of oil proceeds will define the sustainability of Azerbaijan’s growth. With its depth of experience worldwide in restructuring railways, the World Bank is in a unique position to advise and support the government through the transition to a more commercial, efficient and sustainable railway sector and through regular contact with railways and transport operators in both Azerbaijan and Georgia. The Ministry of Transport (MOT) particularly seeks support in defining the relationship between the Ministry and the railway, and in implementing its modernization program for the transport sector. The Government seeks support in ensuring that the program of investment is accompanied by institutional reforms that will strengthen the commercial focus and sustainability of the railways.

C. Higher level objectives to which the project contributes

16. The project is expected to support the development of services, in line with the second pillar of the CPS, by enabling the railway to attract growing transit business to Azerbaijan. While such services remain related to the regional oil industry, they provide Azerbaijan with an opportunity to capitalize on its location by offering value added services for oil and oil products from neighboring countries. This will benefit not only the railway, but also other logistics businesses (port services, storage), that provide services for transit goods. As noted in the CPS, “[tlhe long term vision is for Azerbaijan to become a prosperous transit center for energy and goods flowing between Europe and Central Asia.”4 The project, outlined in the CPS, will also contribute to the first pillar of the CPS, improving quality and transparency in public sector governance, by improving the governance and transparency of a major state owned enterprise. It will reduce accidents and environmental hazards by improving track conditions on ADDY’s main line and upgrading ADDY’s oil spill prevention and response capabilities.

11. PROJECT DESCRIPTION A. Lending instrument

17. The lending instrument proposed for this project is a Specific Investment Loan (SIL) to the Republic of Azerbaijan in the amount of US$450 million. The Loan type for this loan is a US Dollar denominated fixed-spread variable rate loan (FSL) with annuity repayments and with a 17 year maturity including a four year grace period. The Government of Azerbaijan will on- grant the loan proceeds to ADDY for infrastructure related investments and on-lend the loan proceeds to ADDY for locomotive purchase and for the implementation of the modernization component. Other Government contributions will be granted to ADDY.

4 IBRD/IDA.IFC, Country Partnership Strategy FY07-10 for Republic ofAzerbaijan (November 8,2006) p. v.

4 B. Project development objective and key indicators

18. The main project objective is to improve railway services in Azerbaijan, as well as the competitiveness, financial sustainability, operating and cost efficiency, and capacity of the Azerbaijan Railways (ADDY) in particular along the transport corridor toward Georgia (east- west corridor).

19. The project will support the implementation of the first phase of the Government Program covering components, which are most time-sensitive and will most rapidly lead to cash flow generation. The project will focus on: (i)maintaining and increasing the railway business (increase revenue from US$219 million today to about US$283 million by 2015) by providing the profitable freight market segment with proper service, infrastructure and locomotive capacity; (ii)transforming the Azeri Railways into a financially self-sustainable operation in freight transportation, covering all its costs (including infrastructure maintenance and traction) from revenues, while improving its operational efficiency; and (iii)improving the transparency of the Railway sector by introducing International Financial Reporting Standards (IFRS) and profit centers5 (passengedfreight) and by separating on an accounting basis passenger service that could be self-sustained from others.

20. Other parts of the Government Program are expected to be covered through separate projects once the proper financial and technical due diligence has been completed.

21. Key Indicators. Project performance will be assessed through a number of qualitative and quantitative indicators. The specified indicators will be regularly monitored by ADDY and MOTusing a scorecard method on an index scale of0-100. The key proposed indicators are detailed in Annex 3 and include:

Project Outcome Indicators Volume and service quality oftransport on the East-West corridor as indicators ofthe overall impact ofmodernization. Operational cash flowhevenues and ADDY working ratio as indicators ofADDY financial sustainability. Net ton-km per new locomotive and train transit time using new locomotives as indicators of operational efficiency. Train revenue and cost per net ton-km as indicators ofimprovement in unit costs and revenues. Average energy consumption per net todpassenger-km as an indicator ofenvironmental impact. Locomotive availability as an indicator of operational capacity.

Intermediate Outcome Indicators Percentage oftrack in critical condition on East-West corridor. Number oflocomotives able to cross Azerbaijan reliably.

5 Accounting on the basis of profit centers will provide a good understanding ofthe revenues and costs associated with the provision ofpassenger and freight services respectively.

5 Locomotive reliability. Annual audit and systematic follow up of audit qualifications. 0 Transformation as joint stock company ofADDY and institutional separation by line of business.

C. Project components

24. The project total cost is estimated at US$795 million (US$674 million plus US$121 million of Value Added Tax), with US$450 million of World Bank lending, including the capitalized front-end fee of 0.25 percent (US$l million). Project costs include renewal ofcritical assets (track, locomotives, power supply), implementation of IFRS accounting system and technical services to support the restructuring. The components are shown below (See Annex 4 for additional detail). Retroactive financing of up to US$3 million became available for the implementation of components 1, 3 and 4, starting on February lst,2008.

25. Component 1: (total cost with contingencies - US$440 million). The Rehabilitation of East- West Main Line component includes track (US$117 million), signaling (US$17 million)- and power supply rehabilitation (US$307 million) along the east-west corridor. It will rehabilitate about 240 km of mainline track in poor condition. The investment will remove the most critical speed restrictions and allow ADDY to handle existing and potential traffic at up to 100 kph for passenger trains and 80 kph for freight trains without significant track delays on those 240 km. It will finance the conversion ofthe power supply on the East-West corridor to 25 kV, including new power stations, catenary and the related upgrade in signaling equipment.

26. Component 2: (total cost with contingencies - US$334 million). The New Mainline Locomotives component will finance about 50 new mainline electric locomotives to operate on the East-West corridor.

27. Component 3: (total cost with contingencies - US$17 million). The Modernization component will include support for the full implementation of IFRS accounting (US$2 million), provision of Advisory services to ADDY to implement its modernization program (US$9 million) and provision of equipment to ADDY to improve its oil spill prevention and response capacity (US$6 million).

28. The ZFRS Accounting System sub-component will fund the implementation of a computerized accounting system in ADDY and a first full audit of ADDY.

29. The Advisory Services for ADDY sub-component will provide technical services and training to ADDY and MOT to implement the modernization program. These services will include inter alia consultancy support to ADDY and MOT to: (a) establish an appropriate corporate governance and performance-based incentive structure for ADDY, (b) implement the separation of ADDY into lines of business; (c) define required passenger services, finalize a business plan for passenger services (including a review of the need for high speed train) and prepare public service obligation agreements; (d) define a new tariff policy for the railway and track access charges; (e) develop contracts with rolling stock providers; and (f) technical services required to design and supervise component 1 and 2.

6 30. The Oil Spill Prevention and Response sub-component will provide ADDY with the equipment, procedures and training required to meet the expectations of the population and oil shippers in the prevention of small oil spills that may occur as part ofrailway transportation (e.g. in case of derailment) and in the response capacity of ADDY to address such occurrences. This component will enable the implementation of recommendations identified under the oil spill response study prepared for the project.

31. Component 4: (total cost without contingencies - US$3 million). The Project Implementation Component will provide training and consultant services to the PIU for procurement, financial management, financial audit, monitoring as well as equipment required for project implementation.

D. Lessons learned and reflected in the project design

32. Even though this project will be the first cooperation between the World Bank and ADDY, the Bank has already drawn valuable lessons from preparing and implementing transport projects in Azerbaijan. The growing transport program of the Bank in Azerbaijan reflects the close partnership between the Bank and the Ministry of Transport. The experience gained through the implementation of past railways restructuring in the ECA region has been taken into account in the preparation of this project. Ongoing dialogue between the Bank and Georgian and Turkish Railways provides an opportunity for synergies and lessons as well.

33. Ensure ownership from all stakeholders involved in the restructuring. The project preparation entailed workshops and executive briefing sessions, aimed at involving relevant parties in the restructuring of the Railways and at increasing stakeholders’ ownership. Comprehensive reports on restructuring and technical aspects have been broadly shared with all major parties (Ministry ofFinance (MOF), Ministry ofTransport, ADDY, Ministry ofEconomic Development(MED)) in order to create a restructuring model that satisfies all stakeholders. Shippers were also associated in discussions on railway modernization.

34. Tailor the project objectives to the local institutional capacity. The project covers major pillars of the Government Program, targeting gaps identified as part of the PHRD studies. The recommendations of these studies have been discussed and captured under the Government Program for the Railways.

35. Ensure a balanced allocation of resources in the project objectives. The Government is seeking both the Bank financing in infrastructure and rolling stock renewal and advisory services based on international best practices. In order to meet this request, the project components include provision for modernizing railways infrastructure, replacement of locomotives, and technical services for, among other things, implementation of IFRS accounting and establishment and definition of freight and passenger profit centers.

36. Ensure proper corridor arrangements. The project addresses the Azerbaijan side ofan Azerbaijan-Georgian transport corridor. To make the corridor successful, however, both sides need to address their bottlenecks. The Bank is supporting a study of the Caucasus transport

7 corridor as a whole, which will identify both institutional and physical bottlenecks along the corridor. A major bottleneck, the capacity of ports in Georgia, is likely to be addressed in part following the decision of the State Oil Company of the Azerbaijan Republic (SOCAR) to invest in the development of the oil terminal in the Georgian port of Kulevi. The Bank is engaged in a dialogue with Georgian and Azerbaijan railways, both of which are pursuing a strategy of commercializing their railway. Cooperation between these railways is good at an operational level.

37. Over the last two years, (GR) invested much of its operating profit back into the railway. About two-thirds of its electric mainline locomotives are in serviceable condition and almost 90 percent of diesel locomotives are younger than 30 years. GR has adequate numbers of locomotives to handle current traffic needs. It has also been rehabilitating the electric power supply system that provides electricity to the locomotives, replacing deteriorated poles and wires throughout the network. Shippers interviewed for the Caucasus Corridor Study indicated that GR had substantially improved its operation in recent years, and were rebuilding the railway. They expressed confidence that if investments were needed to handle growing traffic, GR could raise the necessary investment funds.

E. Alternatives considered and reasons for rejection

38. A full range of restructuring alternatives was considered, before the Government selected its preferred option for ADDY. The right choices depend on relative importance of competing goals, traffic characteristics and capacity and willingness of Azerbaijan to manage complex institutional structures that could involve the private sector. Open access was considered but assessed as premature at this stage of restructuring. Rather, a system allowing for private ownership of rolling stock was designed to bring many of the benefits of closer cooperation between shippers and ADDY, at much less regulatory risk.

39. Consultants analyzed a range of options for providing needed traction, including replacing the existing 3.3 Kv DC electric power supply system and locomotives with more of the same, converting the electric power supply system to 25 kV AC and buying 25 kV locomotives, and converting to diesel locomotives with no power supply system. The electric power options require up-front investment in the electric power supply system, but offer lower locomotive investment and operating costs. e On the main east-west line, the 3.3 kV option proved to be the least attractive, because it would require investing in many more power substations than the 25 kV option. Given likely traffic volumes on this line, both the 25 kV option and the diesel option appeared reasonable. Diesel is more attractive in scenarios with lower traffic, higher discount rates, higher electricity costs, more private ownership of locomotives, and better locomotive utilization, while 25 kV is more attractive in scenarios with higher traffic, lower discount rates, higher diesel fuel costs, less private ownership of locomotives and poorer locomotive utilization. After considering its overall objectives, the Government opted for the 25 kV option, given its lower operating and maintenance costs, its lower impact on environment and its greater suitability for passenger transportation.

8 On the main north-south line, traffic is currently not high enough to justify investment in new power supply. The existing 3.3 kV power supply system is somewhat younger than on the east-west line and can be nursed along for another ten years. 3.3 kV locomotives will become available when power is converted on the east-west line. Therefore, investing in traction for this line can be deferred until major investment is required on the power supply system.

40. The project could have been packaged as the first phase of a programmatic lending. Considering the fiscal position of Azerbaijan and the growing business of ADDY, it is expected that ADDY will be able to secure most required financing by itself upon rehabilitation of its infrastructure and locomotive capacity upon completion of this project. ADDY will be able to build on transparent accounting and sustained cash flow from on-going operations to that end. As such, a specific investment lending operation is more appropriate at this stage.

111. IMPLEMENTATION A. Partnership arrangements

41. The World Bank has maintained regular contact with representatives of the Transport Corridor Europe Caucasus Asia (TRACECA), as well as the European Bank for Reconstruction and Development (EBRD) and the Asian Development Bank (ADB), to keep them informed and to consult with them on the content of the Project during its preparation phase. The Project concept fully complies with the objectives of TRACECA and is broadly shared and supported by this program. While ADB is not currently active in the railway sector, EBRD is negotiating a railway loan with the Government of Azerbaijan. The World Bank is coordinating with EBRD on the respective investments and approach to modernization of the railway to avoid any overlap and ensure synergies are achieved wherever feasible.

B. Institutional and implementation arrangements

42. Implementing Entity. ADDY will be responsible for Project management and coordination through an integrated Project Implementation Unit (PIU). The PIU will be responsible for the day-to-day management of the Project including procurement, financial management, and liaison with the Bank. Procurement of all items funded by the loan will follow World Bank procurement procedures and guidelines.

43. The successful implementation of the Project requires strengthening of the implementation capacity of ADDY and the PIU. ADDY has limited experience in International Financial Institution (IF1)-financed project implementation and acquaintance with the Bank procedures is likely to take some time. The core operational PIU staff includes a PIU Chief, a Procurement Specialist and a Financial Management Specialist. The two specialists are full-time staff (consultants) selected competitively. External independent consultants will be also be hired to provide support in preparing tender documents, reviewing designs and supervising works and delivery for all large contracts foreseen under this project. Incremental operational expenses of PIU will be financed out of the loan funds, with retroactive financing applied for the cost of those consultant services. Retroactive financing of up to US$3 million became available for the implementation of components 1, 3 and 4, starting on February 1st, 2008.

9 44. Specific financial management arrangements for the project were established. The current financial management and reporting systems of ADDY are in the process oftransition to IFRS system which includes strengthening of the management capacity and integration of the accounting and reporting systems, all of which are required for sound financial management at ADDY. The Government of Azerbaijan established the end of 2007 as a deadline for universal conversion to IFRS accounts in the country although some delays are expected. Progress with transition to IFRS accounts and building up the financial management capacity is monitored closely by the MoF and necessary technical support in the area will be provided through the project .

C. Monitoring and evaluation of outcomeshesults

45. Monitoring and evaluation of results/outcomes of the Project will be carried out by the PIU staff, with the assistance and guidance provided by MOT and ADDY. This will include review and monitoring of the Project performance according to the established Results Framework and Monitoring indicators (see Annex 3). The Project performance will be assessed through a number of quantitative indicators and qualitative assessments. Indicators are developed for measuring the Project progress and to timely detect and address gaps in Project implementation. To this end, the annual targets were established during appraisal and individual indicators will be measured against these targets. Project progress reports will be prepared by the PIU on a semi-annual basis and submitted to the Bank’s review.

D. Sustainability

46. Project sustainability stems from both the restructuring process to be launched through the project and the strategic identification of components that took place during project preparation. The introduction of transparent accounting, strengthened marketing and profit- center based organization will empower ADDY management to manage railways commercially through closer interactions with its clients. The proposed investments will address essential parts of the massive maintenance backlog that has accumulated on the east-west corridor, which generated US$137 million of revenues in 2006. It will ensure that the most profitable market segments are properly served with reliable equipment and proper infrastructure and avoid a drop in revenue by lack of capacity. By defining such components as part of a review of ADDY requirements for the next 15 years, the project addresses strategic needs.

E. Critical risks and Dossible controversial amects Risk Rating Risk Minimization Measure Residual Risk Rating Institutional resistance S Technical support will be provided to ADDY and MOT in M to change implementing the restructuring program. This program has been discussed and supported by MoF, MED, MOT and ADDY.

gain market share consultant during project preparation indicating sustained prevent sustainability growth in traffic in future years. Increasing transparency through suitable IFRS accounting will provide management with suitable data for tariff oolicies for the first time.

10 Commercialization of ADDY will provide stronger incentive to seek profitability as opposed to traffic volumes only. Continued deferred M ADDY used most of its profits in recent years strengthening M maintenance its balance sheet by increasing its working capital (paying its payable, increasing its receivables). By the time of mid-term review, substantial cash flow from operations will become available to ADDY to invest in maintenance of rolling stock and infrastructure in areas not supported by the project. Geopolitical S Strong incentives exist to maintain oil flows to Western M instability markets through the Caucasus region. Georgia and Azerbaijan in particular benefit from improving transit through their respective territories. Georgian railways have invested significantly in upgrading its capacity over recent years. No change in M Purchase of new locomotives will be subject to preparation M operation of of formal changes in operation guidelines and practices, to locomotives ensure that efficiency gains materialize. ADDY committed to implement such changes once locomotive condition allow for it. Difficulty in S Specific technical services will be available through the M implementing project to optimize the construction planning and assure conversion of power proper monitoring. The use of a design, supply and install supply from direct contract for this assignment will enable ADDY to build on current to alternating the experience of a supplier with proper track record. current Limited experience in A PIU with experienced consultants will be established S management of IFI- within ADDY to ensure that implementation proceeds at a financed projects sustained pace and external assistance will be hired for large contracts. Lack oftransparency TA to be provided during project implementation to M in financial reporting strengthen financial management capacity of ADDY in the and contracting transition to IFRS. Post reviews and assessments of continued adequacy of systems and controls. Training in financial management and procurement, and best practices. Overall Risk Rating M .isk Rating - H (High R k), S (Sub mtial Risk), M (Modest Risk), N (Negligible or Low Risk)

F. Loan conditions and covenants

47. Condition for Effectiveness: (i) The ADDY and the Ministry of Transport of the Borrower shall have approved the Project Implementation Manual satisfactory to the Bank. (ii) The Borrower has opened the Project Account in Manat with the initial deposit of US$l,OOO,OOO equivalent on terms and conditions acceptable to the Bank. (iii) The Subsidiary Agreement has been executed on behalf of the Borrower and the ADDY.

48. Project Covenants: (i) Except as the Bank shall otherwise agree, the ADDY shall complete its transformation into a joint-stock company by June 30, 2009, in cooperation with the Borrower.

11 Except as the Bank shall otherwise agree, the ADDY shall complete its conversion from a joint-stock company to a holding company with independent subsidiaries operating by line ofbusiness by January 15,2010. Except as the Bank shall otherwise agree, ADDY will not incur any debt unless a reasonable forecast of the revenues and expenditures shows that ADDY would maintain a Debt Service Coverage ratio above 1.1, during the term ofthe debt. The Borrower shall monitor and evaluate the progress of the Project and cause the ADDY and the PIU to prepare Project Reports in accordance with the provisions of Section 5.08 of the General Conditions and on the basis ofthe indicators agreed with the Bank. Each Project Report shall cover the period of one calendar semester, and shall be furnished to the Bank not later than one month after the end of the period covered by such report. The Borrower shall ensure, and cause the ADDY and the PIU to ensure, that all measures necessary for the carrying out of the Environmental Management Plan (EMP) shall be taken in a timely manner.

49. Financial Covenants: (i) The Borrower will maintain or shall cause ADDY to maintain a financial management system acceptable to the Bank. (ii) The Borrower shall cause the ADDY and the PIU to prepare and furnish to the Bank no later than forty-five days after the end of each calendar quarter, interim un-audited financial reports for the Project covering the quarter, in form and substance satisfactory to the Bank. (iii) The Borrower shall have its Financial Statements (Project and ADDY financial statements, Statement of Expenses and Designated Account) audited in accordance with the provisions of Section 5.09 (b) of the General Conditions. Each audit of the Financial Statements shall cover the period of one fiscal year of the Borrower. The audited Financial Statements for each such period shall be furnished to the Bank not later than six months after the end of such period.

IV. APPRAISAL SUMMARY A. Economic and financial analyses Economic (Cost-Benefit) Analysis: EIRR=19 percent; NPV=$250 million

50. The project comprises a set of investments-track rehabilitation, new locomotives, new system for providing electric power for traction, and oil spill response equipment-that will allow ADDY to provide safe, high quality transport service on the East-West corridor, including for oil and oil products business. These investments are necessary for ADDY to attract and serve this traffic. The benefits ofthe project are that ADDY can sustain and grow its profitable freight business and that it experiences lower energy and track maintenance costs.

5 1. The economic analysis of track rehabilitation compares a “do-nothing” scenario and a “do the investment” scenario. The model forecasts the cost to ADDY of these two scenarios, given the forecast traffic on the main East-West line. The benefits to rehabilitating the track include: (i)reduced track maintenance costs, (ii)reduced energy costs, (iii)improved equipment utilization due to reduced turnaround times for locomotives and wagons, (iv) reduced incidence

12 of derailments, and (v) improved service offered by ADDY to customers. The economic analysis of Component 1 quantifies (i)- (iii).To avoid any overlap with the analysis of locomotives, however, only the benefits of(i) and (ii)are counted in the economic analysis ofthe overall project.

52. The economic analysis of the motive power renewal also compares a “do-nothing” scenario and a “do the investment” scenario. In the “do nothing” scenario, ADDY does not replace the locomotives in its fleet as they become non-operational. As the fleet shrinks, ADDY can handle less and less traffic. In the “do the investment” scenario, ADDY does renew the fleet, together with replacing the electric supply system that powers the locomotives, so it can handle the traffic. The value of the traffic that would be lost is estimated as the revenue from the traffic less the variable operating expenses that would be saved if the traffic were not moved.

53. The economic net present value of the investment package is US$250 million on investment of US$661 million. The Internal Rate of Return (IRR) of the investment is 19 percent. Sensitivity analysis shows that the returns are somewhat sensitive to traffic volumes, but that even in the low traffic case (scenario l),the IRR remains at 17 percent. See Annex 9 for details.

Financial (See Annex 9) for entire Government Program, including this project NPV (at weighted average cost of capital 7.7 percent)= US$73 million; FRR4.4 percent

54. The financial analysis of ADDY assumes that the railway carries out the Government Program for the railways, (described in Annex 1) of which the project is a part. The forecast assumes that the Government of Azerbaijan will on-lend to ADDY for new locomotives, modernization and project implementation (US$216 million), from other IFI’s for the remainder of the rolling stock in the investment program (US$308 million), and that government will provide grant funding for the remainder ofthe investment program.

55. ADDY revenue grows gradually throughout the forecast period from AZN 169 million to AZN 244 million. After the initial revenue boost of 10 percent in 2008, freight rates are flat and revenue growth comes from increase in traffic (overall growth of 3 percent per year). Oil and oil products revenue grows quite modestly (a conservative assumptions, if ADDY reform and investment improve service levels), and most revenue growth is expected from other freight traffic. No real growth is included in passenger fares, and passenger revenue grows modestly together with traffic.

56. Operating expenses also show a gradual increase over the period. Reductions in track maintenance and locomotive operation and maintenance costs occur because of investments in locomotives, power supply and track. The working ratio improves from 74 percent to 56 percent. The operating ratio also improves, but less strongly because depreciation increases offset other reductions in operation expense.

57. ADDY is profitable and has positive cash flow from operations throughout the forecast period. Cash flow is sufficient to cover all financing needs (both World Bank and other IF1

13 financing). ADDY maintains a debt service coverage ratio over two throughout the period of the World Bank loan.

58. The cost of the comprehensive Government Program compared to the resulting cash flows, discounted at ADDY’s weighted average cost of capital (7.7 percent) is AZN 62 million. The financial Internal Rate of Return (FRR) of the investment is 8.4 percent and payback period is 15.4 years.

B. Technical

59. Electrification. The existing 3 kilovolt (kV) Direct Current (DC) electrification system on the railway is in poor condition. While the northhouth 3 kV systems is in slightly better condition and with repairs could last another 6-10 years, the east/west Baku-Georgia system needs to be reconstructed/replaced at this stage. As explained above, after review of all options the government opted for a switch to a 25 kV alternating current (AC) system on the east-west line. 25 kV AC System is well proven and used by many railways in the world and there are no known unsolved technical problems.

60. The changeover from DC to AC will be undertaken section by section from the Georgia end. The section under changeover will be operated by diesel locomotives (to be made available from ADDY fleet or leased); the section where changeover has been effected will be operated by new AC locomotives and the section still under DC by the existing fleet of DC locomotives. Assuming that electrification work will be undertaken between stations at a time, the total number of requirement is expected to be about two. The changeover to AC electrification under existing heavy traffic conditions will require meticulous planning to ensure that the changeover takes place at the planned pace and to avoid wastage of locomotives. It is expected that ADDY will establish a full project team for monitoring the changeover and making appropriate decisions to ensure continuity of traffic during the changeover. Specific technical services will be available to assist ADDY in preparing the bidding documents, evaluating the bids and monitoring progress through the project. The complete design, supply and installation of the AC electrification System is to be undertaken by a competitively-selected consortium of contractors/vendors. There are a number ofcompanies around the world that would be interested in competing for the job.

61. Motive Power. The decision to change over to 25 kV AC system on the east-west line automatically implies the purchase of new locomotives for the east-west line. However, the investment in new motive power would have been essential even without the changeover as 50 percent of the current operable fleet of 121 locomotives is over 40 years old and needs to be replaced. Fifty (50) new electric locomotives have been recommended for immediate purchase to cater for the projected traffic. The locomotive requirement has been computed for the projected traffic but assuming considerable increase in the utilization of locomotives after abandoning the current practice of changing locomotives several times along the route and improving maintenance practices. Without the proposed improvements, the number required would have been ofthe order of 75. The designs of electric locomotives are well established and there are several reliable manufacturers. The locomotives package will include: (a) sufficient spare parts to enable high availability and reliability for the initial years; (b) technical assistance

14 by the supplying firm to train ADDY staff in the maintenance and operation of the locomotives; and (c) special tools, jigs, and fixtures to ensure quality maintenance.

62. The locomotive delivery will be staggered to synchronize with the rate of progress of change from the DC to AC power supply. Staggered delivery will also make it possible to provide feedback after the operation of the first batch of locomotives to enable the manufacturers to make any necessary changes. Staggered delivery will also allow ADDY enough time to train maintenance and operation staff, establish maintenance facilities and ensure proper utilization of the locomotives. For achieving targeted utilization of locomotives, ADDY will need to adopt operating and maintenance practices as recommended by the locomotive manufacturers.

63. Track Renewal. ADDY’s two primary main lines are the east/west line (502 km) between Baku and the Georgian border, over which most of the oil and oil products move to Black Sea ports and the nortldsouth line (21 1km) to the Russian border. Train operations over these main lines are currently characterized by low average speeds and many enroute delays on account of speed restrictions. In addition, the poor track condition has been the cause of some serious derailments recently. Based on the assessment of the lines, comprehensive track renewal is proposed to be undertaken for 240 kilometers of the track length, i.e., about 25 percent of the total track length on the east/west line. Comprehensive track renewal will require 100 percent replacement of rails, sleepers, both wooden and concrete, fastenings, and about 70 percent of ballast. The remaining 30 percent of ballast is expected to be recovered through ballast cleaning. The comprehensive track renewal has become necessary as the rails and sleepers on the identified sections are life-expired and cannot last much longer. Comprehensive track renewal will enable speeds to be restored to 80 kph for freight and 100 kph for passenger services.

64. Track rehabilitation needs to be undertaken under heavy traffic load but the railways have in place processes to ensure that the work of track renewal does not affect traffic movements. Primarily, the railways: (a) switch to single line working on the sections where the renewal work is being undertaken; (b) assemble the track outside the track and then transfer the fully assembled track to site, thus saving time for track renewal.

65. Signaling works. The station to station block sections will need to be changed as a result of introduction of 25 kVAC. It is proposed to procure materials and equipment required for the changeover but the installation will be undertaken in house. No problems are expected in either procuring the materials or installing them.

C. Fiduciary

66. The PIU will be responsible for the day-to-day management of the Project including financial management -project accounting, financial reporting, disbursements and auditing arrangements.

67. Financial Management. The current financial management and reporting systems of ADDY require strengthening, including effective transition to IFRS as mandated under the Accounting Law. The current semi-automated accounting system will be replaced with a fully automated accounting system as part of the transition to international financial reporting

15 standards (IFRS). The progress with transition to IFRS and building up the financial management capacity of ADDY will be monitored closely by the Bank and necessary technical support in the area will be provided through the Rail Trade and Transport Facilitation and Corporate and Public Sector Accountability Projects. The latter project which will be implemented in parallel with the railway project is expected to support the state-owned entities including the ADDY in the implementation of the Accounting Law that mandates transition to international accounting standards.

68. Funds Flow. Similar to other Bank-financed projects, Designated Account (Bank loan funds) and Project Account (counterpart funds) will be opened in a commercial bank acceptable to the Bank. All payments to the contractors, suppliers and consultants will be made from these accounts with the endorsement of responsible senior staff. Other methods of disbursements on the Bank loan will include direct payments for large contracts, special commitments and statements of expenditures for small contracts. The counterpart funds will be transferred from budgetary allocations through the treasury system to finance Government share of project expenditures as expenditures are incurred.

69. Overall financial management risk rating is considered “moderate” with mitigation measures.

70. Procurement. The organization of procurement work will build on a procurement specialist selected on the basis of qualification and terms ofreference that have been agreed with the Bank and on external advisory services to support the PIU in the preparation of bidding documents, tendering procedures and supervision of contract implementation. The PIU was established and includes a procurement specialist satisfactory to the Bank.

D. Social

71. The project supports the Government’s policy to improve the country’s railway network and make rail transportation more effective and safe. The reform process of the Railways is scheduled in several phases. A retrenchment program that might be necessary to increase ADDY profitability is not considered as part of the first phase of restructuring. The proposed project will support ADDY in identifying a more suitable structure to respond efficiently to market requirements.

72. The Bank’s Azerbaijan Extended Poverty Profile for 2002-2004 points out that recent important developments in employment growth and poverty reduction have mainly been skewed in favor of Baku. As a result, people in rural areas and non-Baku urban areas are the poorest groups of all. In improving the railway network and in particular in offering better efficiency along the East-West corridor, the project will lead to an improvement of railway connections within Azerbaijan and facilitate access for citizens and businesses.

73. No land acquisition through expropriation is anticipated, nor is loss of access to income expected. OPBP 4.12 is therefore not triggered.

16 E. Environment

74. No significant environmental issues are anticipated for this project. In accordance with the World Bank’s safeguard policies and procedures, including OP/BP/GP 4.0 1 Environmental Assessment the modernization of the rail network has been classified as a Category B project for environmental assessment purposes.

75. ADDY specialists prepared the Environmental Assessment (EA) together with an Environmental Management Plan (EMP) which were published on May 1’‘ 2007 on the World Bank website. The EA identifies possible impacts of the project activities and mitigation measures. This document is publicly available and can be obtained from ADDY (Environmental Department), the Aarhus Convention Center of the Ministry of Ecology and Natural Resources, and through the World Bank external internet site. A series of public consultations were carried out by ADDY in April 2007 in the project areas, namely in Agstafa, Ganja, Hajigabul, Kurdemir, Yevlakh and Sangachal.

76. Prior to the consultations, the EA was translated into Azeri and sent to these rayons. The public was informed through newspapers of local circulation that the document could be accessed and reviewed at the relevant Executive Authorities offices. The consultations were attended by local executive and environmental authorities, representatives of municipalities and communities, local NGOs and other stakeholders. Minutes of the consultation meetings have been recorded in Azeri and are kept at ADDY’s office for reference.

77. The replacement of rails is the primary investment of the project that is covered by the EMP; this will allow expanded and more efficient transport of goods such as heavy oil products. Impacts are expected to be temporary and related to the direct replacement of these rails including: noise in residential areas; rehabilitation of the track; dust and exhaust emissions from equipment; vibration; and waste management. The metal wastes and oil stained wooden bars from rail and sleeper replacement will be collected into special containers and transported to a disposal site.

78. ADDY is responsible for the successful implementation ofthe EMP and ensuring that: (i) Azeri and Bank policies on environment and social protection will be followed; (ii)consultation with the public, as needed, will take place; (iii)information will be disclosed to the public, as needed; and (iv) information as needed, will be provided to the Bank on environmental matters. The environmental capacity of ADDY regarding the proposed components is assessed to be good. They are cognizant of good practices related to the proposed investments and their responsibilities for environmental management. The project will also contribute to strengthen ADDY’s prevention and preparedness in oil spill response as well as transportation of dangerous goods and wastes.

F. Safeguard policies

Natural Habitats (OP/BP 4.04)

17 Pest Management (OP 4.09) [I [XI Cultural Property (OPN 11.03, being revised as OP 4.1 1) [I [XI Involuntary Resettlement (OP/BP 4.12) [I [XI Indigenous Peoples (OP/BP 4.10) [I [XI Forests (OP/BP 4.36) 11 [XI Safety ofDams (OP/BP 4.37) [I [XI Projects in Disputed Areas (OP/BP 7.60)* [I [XI Projects on International Waterways (OP/BP 7.50) [I [XI

G. Policy Exceptions and Readiness

79. The Project complies with all applicable Bank policies. The project implementation team is in place. The procurement plan has been agreed upon and technical specifications for the locomotives have been prepared. Procurement packages will be prepared in accordance with the procurement plan timeline.

' By supporting the proposedproject, the Bank does not intend to prejudice thefinal determination of the parties' claims on the disputed areas

18 Annex 1: Country and Sector Background AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

Background

80. In the early to mid-1990sYthe collapse of the Soviet Union and and the Armenian- Azerbaijan, Nagorno Karabakh, conflict resulted in massive economic dislocation, the loss of control of 20 percent of the land area, human displacement of up to 1 million Azerbaijanis from their home, and a 60 percent drop in GDP and hyperinflation. Much of the industrial sector was closed and the agricultural sector was transformed into small holding. The oil and gas sector emerged as the engine of economic growth. Azerbaijan now draws more than 50 percent of GDP from oil and gas extraction. Rapid investment in the oil and gas sector has spurred strong GDP growth-GDP increased at an annual rate of around 10 percent per year from 2000 to 2004, with 26 percent and 34 percent spurts in 2005 in 2006 respectively.

81. Azerbaijan’s oil production is expected to peak in 2010-2012 and decline in the years following. To have sustainable economic performance, therefore, non-oil sectors must grow.

82. The provision of railway services fits into this agenda as it depends only in part on the Azeri oil extraction industry. Based on traffic projections prepared by independent consultants during project preparation, rail transportation is forecast to generate an estimated US$ 2.5 billion in revenue over the next ten years6. To secure these revenues, ADDY needs to strengthen its commercial focus while renewing its rail infrastructure and motive power to offer suitable capacity to its new and existing customers. These renewal needs are considerable, and require external funding.

83. This section presents Azerbaijan Railways (ADDY) and the main elements of the “Government Program on the Development of Azerbaijan State Railways 2008-201 1”.

ADDY’s Role in Transport Market

84. The transport market in Azerbaijan has grown rapidly, with freight and public assenger traffic increasing by 81 percent and 22 percent respectively between 2000 and 2006? ADDY over a third of the freight ton-km moved in Azerbaijan and about 5 percent of public passenger-km.8 Despite rapid growth in motorization, rail’s share of freight traffic has held steady because of the large increase in oil transit traffic.

85. Even with this rapid growth, Azerbaijan Railway (ADDY) carried significantly more traffic during the Soviet era than it does today. As shown in the graph, passenger traffic declined throughout the 1990~~recovered partially in the last five years and is now at some 35 percent of its level in 1990. Freight traffic plunged even lower-to a mere six percent of its peak level-

Consulting Services for Restructuring and Revitalizing the Railway of Azerbaijan (Dec. 2006), PHRD funded. 7 2007 Statistical Yearbook of Azerbaijan. Ibid.

19 before recovering in the second half of the 1990s. It now stands at 38 percent of the 1990 volume.

ADDY Traffic

50,000 2,500

c. 40,000 2,000 S -.-0 30,000 1,500 rE 20,000 1,000 Ec .-0 e! L 10,000 500

86. Measured by traffic, ADDY is predominantly a freight railway. Passenger service represents only 9 percent of ADDY traffic volume and 13 percent of its revenue. Passenger service does however, use a larger share of ADDY’s infrastructure and locomotive capacity, consuming 30 percent oftrain-km and 27 percent of locomotive-km.

87. Passenger Service. ADDY carried 5.8 million passengers and 964 million passenger-km in 2006, or about 6 percent of the public passenger traffic in Azerbaijan. Bus is the most important competitor, with a 70 percent market share. Private automobile, although not captured in the travel statistics, is likely to become a significant and growing competitor as well.

88. ADDY has three passenger market segments: domestic intercity, international and commuter. Over the last five years, ADDY traffic has grown in all passenger market segments, but at different rates. With a 78 percent increase from 2002 to 2006, domestic intercity service is ADDY fastest growing passenger service. As a result, domestic intercity service represents two- thirds of ADDY’s passenger-km. It is closely followed by international services, which has almost doubled over the period 2002-2006. ADDY international trains travel between Baku and Tbilisi, , St. Petersburg and Kiev. This market segment produces 16 percent of ADDY’s passenger-km. Because of stronger competition from private minibuses, ADDY EMU commuter service for the Baku region lags behind with a 3.3 percent rise in traffic from 2003 to 2006 and accounts for 18 percent ofADDY passenger-km.

89. The revenues produced by the three market segments contrast greatly with the traffic volumes, because the rates charged to commuter, domestic and international customers are very

20 different. International passenger tariffs are defined by a tariff board of the CIS railways, which applies a uniform rate per passenger-km to all railways. This service has the highest rate, around US13 cents per passenger-km in 2006. Domestic and commuter rates are proposed by the ADDY passenger department to the Ministry of Transport for approval, and are significantly lower than international rates, around US$O.8 and 0.2 cents per passenger-km in 2006. ADDY indicates that international passenger service breaks even (i.e., covers its direct operating costs), but that domestic intercity and commuter are loss making, particularly commuter.

90. Freight Service. ADDY carried 30.2 million tons and produced 11.1 billion ton-km in 2006. Nearly all of this traffic moves on the two main lines between Baku and the borders with Georgia and Russia. The largest market segment for ADDY is oil and oil products, which ADDY moves in oil unit trains between Baku terminals and the Georgian border. The oil and oil products continue by rail to the ports of and Poti, for further distribution to European markets. Oil and oil products represent 72 percent of ADDY's ton-km and 65 percent of its freight revenue. Azerbaijan is seeking to expand such transit business. The joint development between Georgia, Azerbaijan and to construct a railway link between Akhakalaki in Georgia and in Turkey, provides a new transport link to European markets.

91. The remaining 28 percent of ADDY's traffic is a mix of movements. Domestic distances are quite short, so most domestic traffic moves by truck. ADDY carries a small amount of domestic construction materials. Imported grains, food stuffs, automobiles and consumer goods move from Russia and over the north-south main line and from Europe over the east- west main line. Considerable construction materials and equipment for the oil industry transit Azerbaijan on their way to Russia and Kazakhstan.

92. Rates for export, import and transit traffic (representing 80 percent of ADDY ton-km and freight revenue) are set by the CIS tariff setting organization'. The international tariff (MTT") applies to all CIS railways and is structured as rates per ton, which change over distance and over the quantity of tons loaded per wagon." The basic MTT rates are quite high, and each country applies a series of discount factors to the rates. The discount factors allow each railway to differentiate its rates according to its perception of freight demand and competition. ADDY sees that it is part of a transit route which competes with other transit routes, so it uses the discount factors rather aggressively. International rates must be approved by the head of the railway and agreed with the Ministry of Transport.

93. For domestic traffic, rates are a function of distance, load of wagon, type of wagon, and commodity and numerous other factors.12 Domestic rates must be approved by the Tariff Council of the Republic of Azerbaijan, which regulates tariffs of all monopoly businesses.

94. ADDY freight service faces considerable competition from truck for domestic movements and from other modes, routes and sources of oil production for transit, export and

9 TapU@Ha8 KoH@epeHuuH ~eJIe3HOnOpOXHbIXaAMUHUCTpaUMfi - )JYaCTHUUTapU@Horo COrnaUIeHUH (Tariff Conference ofthe Railroad Administrations - Participants ofTariff Agreement) loMeXAyHapOnHbIfi XeJle3HOnOpOXHbIfi TpaH3UTHbIfi Tap@ (MTT) I1 The MTT rates have two commodity groups. I' I' The tariff is essentially the Soviet tariff 10-01 converted to Manat.

21 import traffic. l3 The most immediate competitive challenge comes from the Baku-Tbilisi- Ceyhan (BTC) pipeline, which delivered the first oil to Ceyhan in May 2006. This pipeline has a capacity of 1 million bbl/d, or about 50 million tons per year.14 Up to its capacity limit, the pipeline is likely to attract any high quality, high volume movements of crude oil moving through the Caucasus, leaving small shipments of crude and petroleum products to move on the railway. In 2006, 54 percent of ADDY’s petroleum traffic and 40 percent of petroleum revenue came from shipments of crude oil while the remainder was from shipments of oil products.

95. Crude oil production in the region will increase sharply over the next 5-10 years as the ACG fields in Azerbaijan are fully developed and as the major Kazakhstan fields, particularly Kashagan, increase production. By 2010, exports are expected to nearly double to over 140 million tpa. By 2015, the volume of exports needing transport to market is expected to rise further to 150-225 million tpa. Refined product will make up only a small proportion of this volume, coming mostly from Turkmenistan and Azerbaijan.

Figure 1: Forecast Caspian Export of Oil & Oil Products

Low Forecast High Forecast

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

96. As shown in the graphs above, Azeri exports are expected to fill the BTC pipeline by 2008/2009 and keep it full through 20 15. Thus any diversion of Kazkah oil to the BTC pipeline would be short lived. In a longer term perspective, Kazakhstan’s oil exports are expected to grow to 90-100 million tons per year by 201 1 and remain at more than 60 million tons through 2030. Viable transport outlets for this oil include the Caspian Pipeline Systems (CPS, with capacity of -28 million tons per year), Transneft through Russia, Kazakhstan-China Pipeline (capacity 10 million tons), Baku-Novorossiysk Pipeline (capacity -6 million tons), rail through Russia, or rail through the Caucasus. Expansion of the CPS pipeline and development of a pipeline through Iran are long term possibilities under discussion. With such major growth in the market, ADDY could maintain and even expand its transit oil traffic. But with many competitive

13 Rail has the greatest advantage for imported products, which is reflected in imported goods bearing rates almost twice the average rate. l4 ADDY carried about 2.6 million tons of transit oil and 5.8 million tones of export oil (mostly product) in 2007.

22 options in the marketplace, ADDY will have to offer timely, reliable and appropriately priced service to attract this additional traffic.

Structure of Railway

97. ADDY is a state enterprise that is governed by the Ministry of Transport. The Ministry of Transport has the authority to regulate railway activities, but lacks the administrative structure to do so. The railway is organized into operational units as shown in the chart below.

ADDY Organization Structure

Tariff & Transport Finance & Services Accounting Security (Safety)

Social Issues Locomotive Economics

Construction For. Relation

Electrification Water Econ SNS. Tech. Issues

Statistics

I Paassenger I

98. The operational departments (Locomotive, Wagon, Track, Electrification, Signaling and Communications, Freight and Passenger) have field staff organized on a regional basis, reporting to headquarters departments. All other departments are centralized. The Ministry of Transport exercises the government’s authority over the railway. It approves rate changes and investment and operating plans.

99. ADDY’s current structure is production-oriented and not designed respond directly to client needs. Under the reform program approved by the Government, significant steps will be taken to change the structure to a more market-oriented one. The role of the Ministry will be more clearly defined, so that commercial responsibilities and incentives can be established within ADDY. The railway’s organization and accounts will be changed to profit centers, which will allow commercial performance to be measured. This will be supported by the implementation of IFRS accounting.

23 Railway Operations

100. ADDY built infrastructure, hired staff and acquired rolling stock to serve the high level of traffic ofthe 1980~~so the last fifteen years have been ones of retrenchment and consumption ofassets. But these assets are exhibiting age and wear, and greater maintenance and renewal will be needed in the near future.

101. StajJ ADDY has 30,600 employees. This figure is comparable to the number of staff ADDY had in the late 1980 when its traffic was more than three times current levels. Salaries account for some 27 percent of operating expenses-a modest percentage compared to many railways. Nonetheless, staff productivity is 1/1lth of the productivity figures for the railway in Estonia, and well below the productivity of all the other benchmark railways shown in the table,” so much room for improvement exists.

Employee Productivity Benchmarks

:c1B (d of of Q) c! of 3 .- C A .-of eu SW f=W .-cdu mu ag ‘Z g zg SO 30 so 4hl 2% dm Gz 3% k4CN cdz Traffic units 12,023 16,265 13,327 10,267 294,039 143,537 2,325,800 (millions) Employees 30,600 12,599 10,827 2,345 371,141 98,273 1,200,000

Traffic- 392,908 1,290,975 1,230,858 4,378,252 792,258 1,460,594 1,938,167 unitdemp.

102. Track. ADDY has 2,122 route-km, of which 828 km are double-tracked and 1,278 are electrified. The east-west line between Baku and Tbilisi carries the most traffic (73 percent or 45-50 trains per day), while the line north from Baku to the Russia border carries the second highest (24 percent, about 20 trains per day). These lines are double-tracked and electrified. The remaining lines are single-tracked and mostly diesel operated. About 240 km of track were destroyed due to Armenian-Azerbaijan, Nagorno Karabakh, conflict. ADDY’s traffic densityI6is about half that ofLatvia and Estonia, a third ofKazakhstan and Ukraine and a fifth ofRussia.

Track Asset Productivity Benchmarks

of *s :c1s .- of of 27 of m s .- .eB .- e, ’5: w =u Cu ofu mhl ag -0 zg SO 4g sg &cr 2s clhl 4% 3CN k4CN3s dhl Traffic units 12,023 16,265 13,327 10,267 294,039 143,537 2,325,800 (millions)

IsLatvia, Lithuania and Estonia are ofa similar size and traffic mix to ADDY, so are particularly good railways for benchmarking. l6 Measured by traffic units per track-km, gross ton-km per track-km, and net ton-km per track-km.

24 Track-km 2,95 1 3,403 2,187 1,622 29,037 18,400 123,000

Traffic- un its/km 4.1 4.8 6.1 6.3 10.1 7.8 18.9 (millions)

103. All of ADDY’s mainlines were designed to be operated at 80 kmh for freight and 100 km/h for passenger. The east-west mainline has about 240 km of track in need of urgent capital repair. The north-south line has about 116 km of track in need of urgent capital repair. ADDY considers that to bring these two lines to their original speed design capacity as well as the supporting railway stations a total of 550 km require investments.

104. Electrification. Electrified track length in ADDY is 1278 km, of which 791 are double track and 478 single track. The network is electrified at 3.3 kV DC and power is purchased on the regulated power market from local suppliers. The network has 1,571 km of overhead line and 57 substations, many of which are in very poor condition, particularly on the East-West corridor where they require replacement.

105. Locomotives. ADDY operates a fleet of 3.3 kV DC mainline locomotives. The locomotive fleet is old and suffers from considerable deferred maintenance. ADDY currently needs a fleet of about 120 mainline locomotives. With improved operating practices, which depend in part on having more reliable locomotives, the number of required locomotives could be reduced to about 100.

106. More than half of ADDY’s fleet in service consists of VL-8 locomotives, which are well past their service life and need urgently to be replaced. Approximately 50 of these VL-8s can be nursed along for another five years, to provide motive power while a major renewal of ADDY’s locomotive fleet takes place. Some 28 of the VL-8s should be retired sooner. This means that, even with operating improvements, ADDY would need to replace some 50 locomotives in the next five years.

Locomotives in Service

Type I Quantity I Age ] Comment E2M62 (passenger) 1 6 rebuilt VL114E (passenger) 5 <5 rebuilt VL-11 new 6 <5 VL-10/11 29 15-19 VL-8 78 >35 about 50 can last - five more years with repairs Total 119 remaining 28 should be scrapped

107. ADDY’s operating practice is to assign crews to locomotives, with the thought that a dedicated crew will take greater care of the aging locomotives. As a result, locomotives are changed frequently. On the main line to Georgia, for example, freight locomotives are changed twice in a 502 km route. Such frequent locomotive changes reduce locomotive productivity and require the railway to own and maintain a larger locomotive fleet than with run-through trains. When ADDY eliminated the locomotive changes for passenger service, it reduced its locomotive requirement by 25 percent (from 20 to 15 locomotives). With more reliable locomotives, a similar change in operating practice will be made for freight service.

25 108. Optionsfor Motive Power. Given that much of its fleet and power supply infrastructure needs to be renewed, ADDY reviewed in details three major options, with support of the PHRD consultant: (i)rebuilding the existing power system (3.3 kV direct current); (ii)upgrading the motive power technology it uses to the more modern and efficient 25kV AC technology; or (iii) use diesel technology. The choice of traction technology is a major long-term decision for ADDY that involves trade-offs between investment in power supply system, investment in locomotives and different fuel and maintenance costs over time.

109. For both electrical power options, the cost of power supply infrastructure is much higher than the cost of locomotives and needs to be taken into account in assessing the best long term option. Purchase of diesel locomotives avoids these large power supply infrastructure costs, but investment costs in new diesel locomotives, as well as operating costs are higher than the electrical option. Financial analysis by the PHRD consultant showed that replacing the 3.3 kV power supply system is the most costly option. On the east-west main line, both diesel and conversion to 25 kV appear to be viable options. Converting to 25 kV is estimated to have the lowest total cost over 25 years and diesel has the lower Present Value at a 12 percent discount rate. Sensitivity analysis shows the preferred option swings between diesel and 25 kV, depending on assumptions about traffic, discount rate, private ownership of locomotives and locomotive utilization making both options quite comparable.

110. Considering long term operation and maintenance costs, environmental impacts, and the development of passenger traffic, the Government of Azerbaijan opted for the electrification of the east-west corridor with 25 kV power supply.

111. On the north-south line, replacing the power supply system is less urgent, since the system is newer. Accordingly ADDY will retain the 3.3 kV power supply for the next 5-10 years, and use locomotives freed up in the power conversion on the east-west line. When the power supply system is not longer operable, the line can be converted to diesel if traffic remains low or 25 kV if volumes grow substantially.

112. Wagons. ADDY has many more wagons in aggregate than it needs. Currently, 8,745 wagons are in the working fleet. Another 10,977 wagons are surplus. ADDY currently experiences shortages of tank wagons and expects shortages in semi-wagons. l7 These wagons are often used in high volume repetitive movements such as oil and mineral unit trains. About 50 percent of the wagon fleet needs to be upgraded to meet CIS safety requirements for wagon interchanges (new wheel pairs and bearings are required). ADDY's Current Freight Wagon Fleet

KR Covered 4,827 1,086 3,832 0 PL Platforms 2.816 489 2.649 0

" Russian shippers also report shortages oftank wagon and semi-wagons.

26 PV Open semi 3,562 2256 1,309 0 TS Tank 3,653 3091 550 1,317 RF Refrigerated 1,615 600 1095 0 Others 2,718 1,223 1,545 0 Total 19,191 8,745 10,977 1,317 Data provided by ADDY (2007) 113. Addressing the shortage of locomotives would help address the shortage of tank wagons. Loaded wagons spend many hours waiting for locomotives, causing wagon turn around time to be poor. If locomotives were available when needed, wagon cycles would be shortened and each wagon could carry more loads. Nonetheless, investment in tank wagons will be needed in the short to medium term to meet traffic demand. Investments in other wagon types are expected to be needed around 2020, while the existing fleet would need to be upgraded in parallel to meet safety requirements.

114. Passenger Rolling Stock. ADDY has some 490 usable passenger coaches out of a total fleet of 727. Ofthem, 460 are due for major repair. Average age is 25 years and the condition of the coaches is very poor. ADDY’s daily requirement for coaches is 420 to 490, which is the full amount in usable condition. ADDY has been experiencing sustained growth in passenger business, with all usable coaches being employed. Continued growth in passenger traffic would require steady increase in the fleet of 20 - 40 coaches per year.

115. Commuter service in the Baku area is provided with Electric Motorized Units. Of a fleet of 140 Electric Motorized Units, 30 are in usable condition and operated on a daily basis. These are in very poor condition, suffering from lack of maintenance.

Investment and Modernization Program

116. After considering economic, strategic and social impacts of the railways, the Government defined the “Government Program on the Development of the Azerbaijan State Railways from 2008 to 2011” and prepared a draft Presidential Decree to approve the program and assign implementation responsibility to the Cabinet of Ministers. This program built on the PHRD- funded studies carried out as part of project preparation.

117. As stipulated in the Government Program, “the main goals are: (i)to satisfy the increasing demand from the population and the economy in railway transportation services; (ii) to satisfy the security demands of the state; (iii)to increase the transit potential of the country; (iv) to improve the quality of railway services; (v) to support social and economical development of the country by decreasing the costs of passengers and cargo transportation; (vi) while progressively attaining financial self-sustainability for freight services.

118. The Government Program seeks to achieve the following objectives in railway sector:

- To carry out the reforms and improvement of legal and regulative base to allow ADDY to operate as a commercial entity through four separate lines of business (passenger,

27 infrastructure, freight and non-transport activities) responsible for their respective operational and financial performance. To separate non-core assets from the railway, with the exception ofthe Baku Hospital. To develop and implement market-based tariffs, define and implement a policy for track access charges, and encourage provision and renting of wagons by private companies through its tariff policies. To identify, develop and implement a strategy for passenger transport services, focusing on service that are either profitable or respond to national social interest (in which case commensurate government contribution will be sought). To carry out measures on renewal of the infrastructure of railway and rolling stock in accordance with modern requirements, while ensuring the financial sustainability of these new investments. To satisfy the increasing demand in international traffic by the implementation of Baku- Tbilisi-Kars new railway project. To widen direct transport connections of Caspian basin region and Central Asian countries with Europe by using the railway transportation. To apply scientific and technological achievements and new technologies in railway transport. To provide for security oftransportation means, passengers and goods.”

119. The Government identified accordingly an investment program, estimated at AZN 1.14 billion (excluding VAT for World Bank funded components), including the following main components :

Technical services required for the modernization of railway sector, including ADDY, and full implementation of IFRS throughout ADDY. Rehabilitation of the east-west and north-south corridors to allow for passenger trains to operate at 100 kmh. Renewal of the locomotive fleet with purchase of 50 new mainline locomotives and rehabilitation oflocomotives with at least 20 years of remaining service life. Selective upgrade ofthe wagon fleet to meet traffic and safety requirements. Renewal of passenger coaches fleet, after preparation of a business plan for passenger transport. Updating and upgrading of signals and communication to enhance railway management and safety . Capital repair ofthe existing electric power supply on the north-south line and conversion of the east-west line to 25 kilovolts. Development ofthe oil spill prevention and response capacity ofthe railways.

120. The Program can be described as including three broad phases that could be implemented once the proper financial and technical due diligence has been completed.

28 Phase I estimated at $795 million- ready for implementation (to be covered by the Proposed Project). It includes the most time sensitive components and it is self standing with an estimated rate of return of 16 percent. Its goal is to ensure that freight cargo on the East- West corridor, which generates most revenue, has proper technical conditions to operate, while launching the modernization of ADDY, improving oil spill prevention and preparedness and developing a detailed business plan for passenger services indicating clear priorities. Phase Iwill enable ADDY to generate cash flows needed for phase 111.

Phase I1 is expected to start concurrently when technical and financial due diligence is carried out and funding is secured (interest from EBRDKfW). It would include: rehabilitation of tracks on the North-South corridor, finalizing improvements on East-West track to allow 100 km/hour track speed throughout, investing in wagons, rehabilitating locomotives with at least 20 years of remaining life.

Phase I11 is expected to start upon completion of the business plan for passenger services to be carried out under Phase Iand proper technical and financial due diligence. It would include investments in priority passenger services identified in phase one. It is subject to having proper IFRS accounting in place and a solid business plan for passengers.

121. This investment program outlined above will take place in the context of a major restructuring of ADDY. The process of restructuring will be steered by an executive Committee, made of representatives of MOT, MED, MoF and ADDY. The Committee will have oversight on the implementation of a detailed restructuring program, prepared by MOT,and will facilitate the implementation of reforms.

122. Some of the major restructuring milestones follow:

123. By June 30, 2008. Full audit of ADDY, with inventory of assets. ADDY accounts will be audited annually (completed by June 30 of the following year), and audit comments of the previous year’s audit will be addressed in the subsequent year, so that ADDY’s financial controls are progressively strengthened.

124. By June 30, 2009. Incorporation of ADDY. Reorganization of the company along line of business with IFRS based accounting for each line of business. (IFRS will be implemented company wide as of January lSt,2008 but by line of business by June 30, 2009). Launch the separation of non core assets, except for the hospital.

125. By January 15, 2010. Establishment of a new holding company with four subsidiaries (or similar legal structure), operating by line of business in charge respectively of passenger operations, freight operations, infrastructure and non-core activities.

126. Within the framework of this project, the Government plans to restructure the railways progressively following the three stages described above. This approach defined after extensive discussions within and with the government, is expected to provide the desired transparency and commercial management structure for railways and position the government to take further restructuring steps at a later stage, if desired.

29 127. The first stage is to establish ADDY as a state owned joint stock company, with appropriate corporate governance. The corporate board would be chaired by the Ministry of Transport and include representatives from the Ministry of Finance, the Ministry of Economic Development and ADDY management. The management committee would include key management staff such as the Chief Executive Officer, Chief Financial Officer, Chief Marketing Officer and Chief Operating Officer. As a corporate entity, the railway would implement more transparent accounting, with all financial information collected and reported on an IFRS basis and verified with annual independent audits by qualified firms.

128. At this stage the responsibilities of the Ministry of Transport will be clarified, and appropriate structures within MOT developed to manage them. These responsibilities will include development oftransport policy for railway, oversight of rail safety and, at a later stage, management of public service obligation contracts for passenger services. Tariff oversight would remain the responsibility ofthe Tariff Council, with a clear tariff policy articulated.

129. In the next stage, the railway would be organized by lines of business, or profit centers." Each main line of business would become a subsidiary (or similar legal structure) of the ADDY holding company and would have its own assets, employees and accounts. The lines of business foreseen by ADDY include passenger transport, freight transport, infrastructure, and non-core activities. All stakeholders favored the option of making infrastructure a separate subsidiary. While this is somewhat more complicated-requiring calculation and payment of access fees-it segregates the assets that are required by law to remain in Government hands.

130. The proposed structure will provide valuable information on the revenues, assets, and expenses associated with ADDY provision of various services. Among other issues, this will enable ADDY to know the profitability or losses associated with passenger services, and provide the information base for optimizing value-for-service in ADDY provision ofpassenger transport. The project will contain technical assistance to define a business plan for passenger services and potentially design a public service obligation contract for such services.

131. The ADDY business plan present in more detail the restructuring approach and a draft Presidential Decree, capturing the key milestones ofthe restructuring, has been forwarded by the Government to the President.

'* A line of business is defined by a set of services sold to a similar group of customers, using a common set of assets and employees to provide the service.

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08 N Annex 3: Results Framework and Monitoring AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

Results Framework of Outco To improve railway services in Quality of services (client survey) Overall impact of modernization on Azerbaijan as well as the competitiveness competitiveness, financial Volume oftransport in tons (oil sustainability, operating and cost products/east-west corridor) efficiency and capacity of the Azerbaijan Railways (ADDY) in Operating cash flowhevenue Determine ADDY financial particular along the transport Working ratio sustainability corridor toward Georgia (east-west corridor) Net ton-km per new locomotive Review ADDY operating efficiency Train transit time using new locomotives

Train operating codnet ton-km Review economic efficiency of Train operating revenuehet ton-km ADDY

Average energy consumption per Environmental impact transport unit

Locomotive availability (percentage Review operational capacity of mainline fleet available for service)

Component One: backlog of critical Component One: define the infrastructure on the E/W corridor maintenance filly addressed as normalized investment needs for is in proper condition. measured through condition surveys regular maintenance. and allowing for 100 kph travel speed for passenger trains and 80 kph for freight trains Component Two: the locomotive Component Two: availability of Component Two: Confirm ability fleet for transportation on the east freight locomotives able to cross of ADDY to respond to client needs. west corridor filly fulfills traffic Azerbaijan reliably without changes requirements. along the itinerary.

Locomotive reliability (mean distance between operational failures for mainline komotives) Component Three: ADDY is Component Three: Systematic Component Three: turned into a JSC, focused on follow up of audit qualifications. Demonstrate capacity of ADDY to clients, with an independent board, become more client oriented, given a transparent IFRS accounting, with a Implementation of modernization proper transparency and clear split between regulatory measures (Audit by June 2008, JSC accountability framework finctions assumed by MOT and conversion with IFRS by line of commercial functions assumed by business by June 2009, Holding by ADDY. January 20 10)

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v) 8 IS Annex 4: Detailed Project Description AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

By Component (including contingencies and value added tax):

132. Component 1: (total cost with contingencies - US$440 million). The Rehabilitation of East- West Main Line component will include track, signaling and power supply rehabilitation along the east-west corridor.

133. Track Renewal. The component will rehabilitate about 240 km ofmainline track in poor condition identified under the PHRD study as priority sections on this corridor. It will include replacement ofrail, sleepers, ballast, fastenings, switches and joints on worn sections. The investment will remove critical speed restrictions and allow ADDY to handle existing and potential traffic at up to 100 kph for passenger trains and 80 kph for freight trains without significant track delays on those 240 km. The investment will reduce ADDY’s annual track maintenance expense, reduce energy consumption, generate savings in locomotives and wagon capital and maintenance costs and improve safety on the line. The Government of Azerbaijan opted to fund these works themselves, while quality control will be carried out using the loan proceeds.

134. The component will finance the conversion to 25 kV of the east-west corridor, including power stations and catenary (component 8.2 of the Government Program) and the related upgrade in signaling equipment (component 7.2 of the Government Program).

135. Component 2: (total cost with contingencies - US$334 million). The New Mainline Locomotives component will finance the mainline locomotives (about 50) ADDY needs to replace in the next five years to be able to handle existing traffic. The component will include adequate spare parts to maintain the locomotives as well as training for ADDY staff in maintaining this new equipment and special tools, jigs and fixtures for maintaining the locomotives.

136. Component 3: (total cost with contingencies - US$17 million). The Modernization component will include support for the full implementation of IFRS accounting, provision of Advisory services to ADDY to implement its modernization program and provision of equipment to ADDY to improve its oil spill prevention and response capacity.

137. IFRS Accounting System (US2 million). The project will fund implementation of a computerized accounting system in ADDY and the first full audit of ADDY. This will include: e Audit. First full audit ofADDY, including full asset inventory. e Computer System. This will include accounting and database software, client server software, application and database servers with dual processors, disk arrays and backup storage, client servers, and a local area network. It will include funds for

35 adapting the system to ADDY’s specific needs and for training and implementation support. e Training. This will include training, as needed, in applying IFRS and in using the new computerize accounting system.

138. Advisory Services for ADDY (US9 million). This component will provide technical assistance and training to ADDY and MOT to implement the modernization program. The studies will include:

Assistance in implementing corporatization. This will include services to MOT to transform ADDY into a Joint-stock Company. It will support inter alia the establishment of a system of corporate governance aligned with this new legal status, and the definition and implementation ofa performance-based incentive structure within ADDY.

0 Separate lines of business. This will include consultancy support to ADDY to restructure along lines of business. It will include an asset inventory that assigns each asset to a line of business, assignment of ADDY liabilities to business units, assignment ofADDY staff to lines of business and all necessary changes to the accounting system to prepare accurate financial statements for each line ofbusiness agreed in the restructuring.

Passenger services agreement. The consultancy will assist ADDY to develop a business plan for passenger services, including a feasibility study for high speed passenger service. It will then support MOTin identifying the passenger services it wants ADDY to provide and monitor the provision of such services. It will support the development of a contract between MOTand the Passenger units for services that are not commercially viable, but are required from a social perspective.

Locomotive and infrastructure charging. In the new structure, the Infrastructure unit will contract with the Passenger and Freight units for service, and the Passenger unit will likely contract with the Freight unit for locomotives. This consultancy will assist ADDY to develop a methodology for fair charging of infrastructure and locomotives services and develop terms and conditions for sale of such services. It will support MOT in defining a tariff policy fulfilling the interest ofAzerbaijan.

Regulatory oversight. This study will assist MOTto develop standards for its oversight of rail safety. It will help MOT develop the capacity to implement this oversight responsibility.

Rollingstock contract. This technical assistance will support ADDY in designing attractive conditions to stimulate provision ofwagons by third parties or clients.

0 Technical services required to prepare the design, bidding documents, evaluate bids, and monitor progress for the supply and installation of the power supply and signaling along the east-west corridor.

36 139. The Oil Spill Prevention and Response sub-component (US$6 million) will provide ADDY with the equipment (most funds), procedures and training required to meet fully the expectations of oil shippers in oil spill prevention and response capacity. This component will enable the implementation of component 9.1 in the Government Program and the implementation of recommendations identified under the oil spill response study prepared for the project.

140. Component 4: (total cost with contingencies - US$3 million). The Project Implementation Component will provide training and consultant services to the PIU for procurement, financial management, financial audit, monitoring of the environmental plan implementation, as well as equipment required for project implementation.

Cost Table-Components by Financiers Azerbaijan Rail Trade and Transport Facilitation Components by Financiers (US6 Million) GOA World Bank ADDY Total Value Added ------Amount % Amount % Amount % Amount % Taxes A. Rehabilitation of East-West Main Line Track Renewal (240 km on E-W Corridor) 117 100 - 117 15 18 Conversion to 25 kV E-W 86 28 221 72 - 307 39 47 Signaling conversion to 25 kV E-W ------5 28 12 72 - 17 2 3 Subtotal Rehabilitation of East-West Main Line 208 47 233 53 - 440 55 67 B. New Mainline Locomotives Mainline Locomotives (50 electric) 132 40 202 61 - 334 42 51 C. Modernization of ADDY IFRS 0 15 2 72 0 13 2 0 0 Restructuring of ADDY 2 28 6 12 9 I 1 Oil Spill Prevention and Response 1 15 4 72 1 13 6 1 1 Subtotal Modernization of ADDY ------4 22 12 72 1 6 17 2 3 D. Project ImplementationComponent Consultant Services and Audit 0 15 2 12 0 13 2 0 0 Training and ImplementationCosts ------0 15 0 72 0 13 1 0 0 Subtotal Project ImplementationComponent ------0 15 2 12 0 13 3 0 0 Total PROJECT COSTS 344 43 449 57 1 0 794 100 121 Front-end fees ------1 100 1 0 Total Disbursement 344 43 450 57 1 0 795 100 121 N. B. Thefigures in this table are rounded to the nearest unit.

37 Annex 5: Project Costs AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

Azerbaijan Rail Trade and Transport Facilitation Components Project Cost Summary (AZN Million) (US% Million) Local Foreign Total Local Foreign Total A. Rehabilitation ofEast-West Main Line Track Renewal (240 km on E-W Corridor) 34 49 83 40 58 98 Conversion to 25 kV E-W 65 138 203 77 161 238 Signaling conversion to 25 kV E-W 3 9 11 3-- 10 13 Subtotal Rehabilitation of East-West Main Line 102 196 298 120 230 349 B. New Mainline Locomotives Mainline Locomotives (50 electric) 42 204 245 49 --239 288 Subtotal New Mainline Locomotives 42 204 245 49 239 288 C. Modernization of ADDY IFRS 0 1 2 0 2 2 Restructuring of ADDY 1 6 7 1 7 8 Oil Spill Prevention and Response 1 3 4 4 5 Subtotal Modernization of ADDY 2 10 12 2 12 14 D. Project Implementation Component Consultant Services and Audit 1 0 1 1 1 1 Training and Implementation Costs 0 0 0 o-- 0 0 Subtotal Project Implementation Component 1 1 2 1 -- 1 2 Total BASELINE COSTS 147 410 557 172 481 653 Physical Contingencies 18 48 67 21 57 78 Price Contingencies 28 25 53 33 --29 63 Total PROJECT COSTS 193 484 677 226 567 794 Front-end fees 1 1 -- 1 1 Total Costs to be Financed 193 485 678 226 568 795 N. B. Thejgures in this table are rounded to the nearest unit

14 1. The components above include value added taxes.

38 Annex 6: Implementation Arrangements AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

142. ADDY will be responsible for Project management and coordination through an integrated Project Implementation Unit (PIU). The PIU will be responsible for the day- to-day management of the Project including procurement, financial management, liaison with the Bank and MOT, and monitoring of project progress. Procurement of all items funded by the loan will follow World Bank procurement procedures and guidelines.

143. The core operational PIU staff includes a PIU Chief, a Procurement Specialist and a Financial Management Specialist. The two specialists are full-time staff (consultants), which were selected competitively. External independent consultants will be also be hired by the PIU to provide support in preparing tender documents, reviewing designs and supervising works and delivery for all large contracts foreseen under this project. Incremental operational expenses of PIU will be financed out of the loan funds, with retroactive financing applied for the cost ofthose consultant services.

144. The successful implementation of the Project requires strengthening of the implementation capacity of ADDY and the PIU. ADDY has limited experience in IFI- financed project implementation and acquaintance with the Bank procedures is likely to take some time.

145. Specific financial management arrangements for the project were established. The current financial management and reporting systems of ADDY are in the process of transition to International Financial Reporting Standards system which includes strengthening of the management capacity and integration of the accounting and reporting systems, all of which are required for sound financial management at ADDY. The Government of Azerbaijan established the end of 2007 as a deadline for universal conversion to IFRS accounts in the country although some delays are expected. Progress with transition to IFRS accounts and building up the financial management capacity is monitored closely by the MoF and necessary technical support in the area will be provided through the project.

146. Monitoring and evaluation of results/outcomes of the Project will be carried out by the PIU staff, with the assistance and guidance provided by MOTand ADDY. This will include review and monitoring of the Project performance according to the established Results Framework and Monitoring indicators. The Project performance will be assessed through a number of quantitative indicators and qualitative assessments. Indicators are developed for measuring the Project progress and to timely detect and address gaps in Project implementation. To this end, the annual targets were established during appraisal and individual indicators will be measured against these targets. Project progress reports will be prepared by the PIU on a semi-annual basis and submitted to the Bank’s review.

39 Annex 7: Financial Management and Disbursement Arrangements AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

A. FINANCIAL MANAGEMENT ARRANGEMENTS.

Executive Summary

147. Assessment of financial management arrangements for the Rail Trade and Transport Facilitation Project was carried out during project preparation to evaluate the adequacy of systems and controls in place for project implementation. Such systems include: project accounting and financial reporting, capacity and experience of staff selected to implement the project, internal controls, flow of funds mechanism and auditing arrangements. The project will be implemented by a PIU within ADDY, and which will have overall responsibility for day-to-day management of the Project including financial management, procurement, monitoring and liaison with the Bank, the Ministry ofTransport and ADDY.

148. The MOT-PIU that was implementing the PHRD Grant for project preparation has in place a 1C Bookkeeping sofiware/system that is already customized to automatically generate the required quarterly Interim Financial Reports (IFRs). Although the accounting system is considered adequate for project accounting, the Chart of Accounts has been updated to accommodate the proposed project. The 1C accounting system was transferred to the PIU within ADDY. Risk rating for the financial management arrangements for project implementation is considered moderate.

149. ADDY's accounting system, however requires strengthening to be considered capable of recording correctly all transactions and balances supporting preparation of regular and reliable financial statements in accordance to International Financial Reporting Standards (IFRS), safeguarding project and entity assets, and subject to auditing arrangements in accordance to International Standards on Auditing (ISA). Technical assistance will be provided to ADDY to strengthen its institutional capacity and systems through the proposed project, and with some technical assistance from the proposed Corporate and Public Sector Accountability Project (CAPSAP). The latter project would provide support to selected State-owned enterprises, including ADDY in embedding International Financial Reporting Standards (IFRS) that promote transparency and accountability in financial reporting, as mandated in the new Accounting Law. This will include provision oftechnical assistance in upgrading accounting systems, valuation of assets and training in international accounting/auditing and best practices, a necessary step towards production of IFRS statements. The financial management risk for ADDY is considered to be substantial to moderate with mitigation measures.

Country Issues.

150. Azerbaijan ranks 96th out of 178 economies in overall "ease of doing business" as measured by the Doing Business 2008 survey. The BaMBRD Business Environment

40 Enterprise Perceptions Survey (BEEPS) in 2005 indicates that weak governance is widely perceived as an obstacle to doing business in Azerbaijan. The Government has taken several initiatives to combat corruption, including passage of a new anti-corruption legislation, strengthening anti-corruption institutions under a State Program on Anti- Corruption, creation of an anti-corruption office in the Prosecutor General’s Office, and an anti-corruption department in the Ministry of Interior. However, the impact to-date has been modest.

15 1. Country Partnership Strategy (CPS). The joint IDA/IBRD/IFC Country Partnership Strategy (CPS) for Azerbaijan covers the four-year period from FY07 to FYlO. The previous Country Assistance Strategy (CAS) was discussed by the Board in May 27,2003 (Report No. 25790-AZ), based on Azerbaijan’s then new poverty reduction strategy, the State Programme for Poverty Reduction and Economic Development (SPPRED). In collaboration with civil society and other stakeholders, the Government is preparing the follow-on to the SPPRED, the State Programme on Poverty Reduction and Sustainable Development (SPPRED) 2006-15. The CPS reflects the objectives of the SPPRED, which are closely aligned with the vision and challenges addressed in the CPS. The first pillar of the CPS focus on improving the quality and transparency in public sector governance, by maintaining a stable macroeconomic framework that makes prudent use of oil revenues; improving public expenditure planning and management; strengthening financial management and procurement systems; establishing proper public sector and corporate governance, accounting, and auditing; creating an administrative and regulatory environment conducive to growth; and strengthening the judicial system. Implementation of the public governance and anti-corruption agenda will be closely monitored and prioritized on the basis of a framework prepared by the Government with participation of civil society, and in partnership with donors.

152. A Country Financial Accountability Assessment (CFAA) for Azerbaijan was carried out in 2003 with the objective of identifying strengths and weaknesses of the country’s financial accountability arrangements and the risk that these may pose to the use of Bank funds. The report identified weaknesses and made recommendations to strengthen public and corporate sector accounting, auditing, governance and financial accountability frameworks. With respect to the public sector, the Government, with support from the Bank and other development partners, has made efforts to strengthen public financial management through enactment of a Budget System Law, modernization of the Treasury operations, and strengthening capacity of the Chamber of Accounts -the country’s supreme audit institution. The Government continues to receive support from the donors to continue its efforts in reinforcing public financial management, particularly on improving budget preparation and allocation, introducing internal audit function and overall accountability and transparency in financial reporting. Regarding corporate sector, the report recommended: (a) introduction, development and application of international financial reporting standards and establishing Council of Accountants with responsibility for preparing and determining accounting standards; (b) developing a plan to harmonize various sources of accounting guidance; (c) introduction and application of international standards on auditing and relying more on auditor’s conclusions to determine compliance with relevant accounting standards; (d) capacity building of the

41 Chamber of Auditors -the country’s auditing services regulator and standard-setter, and revising the Law on Audit Service in line with international standards; and (e) developing training and capacity building programs to enhance and sustain the reforms. The ongoing IDF Grant on Accounting and Auditing Reforms and the proposed Corporate and Public Sector Accountability Project will provide support to corporate sector development and investment, improve public financial management and accountability, and establish a sustainable training capacity in accounting and auditing, thus integrating Bank support into the Government’s overall program of accounting and auditing reform in the country.

153. The Country Procurement Assessment (CPAR) carried out in 2002 reviewed the current two-stage control by the Ministry of Finance following budget allocation. The contract-by-contract control compares the prices of bids to some “average market price” and rejected to the extent that the successful bid price exceeds the hypothetical market price. The CPAR recommended that this control should be abandoned as it leads to widespread inefficiencies and corruption. Another recommendation that has impact on Project financial management was strengthening total budget control to ensure the value of all contracts entered into in any one budgetary year does not exceed the budget allocation for that year.

154. The Accounting Law enacted in September 2004 mandates Public Interest Enterprises (PIES); including State Owned Enterprises (SOEs) apply International Financial Reporting Standards (IFRS) in preparation of their financial statements. The Law focuses on changing the role and significance of accounting and financial reporting in Azerbaijan, aligning it with good international practices, and thus promoting transparency and accountability in financial reporting. Under the Presidential Decree on “Enforcement of the Law on Accounting of Azerbaijan Republic”, the Ministry of Finance has selected ADDY as one ofthe key SOEs to start transition to IFRS.

155. Risk Analysis and Mitigating Strategy. Azerbaijan is considered a high risk country. Consistent with risk based approach in financial management, high reliance to risk when assessing corruption and mitigation measures in the project will be made with due consideration for inherent risks of the country. Key measures to mitigate project risks will focus on disclosure of project information, timely handling of complaints, strengthened supervision integrating financial management and procurement, enhanced focus on controls on audits and reviews, and readiness for the PIU to implement the project .

42 E E

21 E L A P cl E E

d d

E m E Risk Mitigating Strategy

156. Country financial management risk - the Government of Azerbaijan has initiated accounting and auditing reforms in line with international standards and best practices. These reforms include enactment of new Accounting Law that created a legal basis for large-scale comprehensive accounting reforms. Aligning statutory and institutional framework with international standards in Azerbaijan will require support from the Bank and development partners. Additional support to meet achievable accounting, auditing, legal and regulatory reforms conducive to improved governance, financial transparency, accountability and reduction of corruption in both corporate and public sectors will be provided through the proposed Corporate and Public Sector Accountability Project, thus mitigating country financial management risks.

157. Control Risk. The existing PIU within the Ministry of Transport has limited experience in managing and implementing Bank financed projects having only implementing the ongoing PHRD Grant for project preparation. The project implementation arrangements will be strengthened by recruiting qualified technical specialists who will devote their full time to the project. Training in Bank operations in financial management, procurement and other technical aspects of project management and implementation will be provided during project implementation.

158. The auditing arrangements for the ADDY will be geared towards improving the financial management systems of ADDY, as well as establishing a sound control environment. ADDY engaged consultants to conduct detailed review of internal controls and financial management framework aimed at supporting the ADDY in the transition to IFRS and best practices in accounting and auditing. The action plan to strengthen identified weaknesses in the systems will be implemented through the proposed project. The Bank, through supervision missions, will monitor implementation of the action plan to strengthen financial management and controls in ADDY.

159. Implementing Entity The project will be implemented by a PIU, within ADDY. The PIU will have the overall responsibility for project accounting and financial reporting, disbursements, auditing and procurement arrangements. It will draw on staff from ADDY to provide technical supervision support. Coordination between the PIU, the Ministry of Trnasport and the Bank will be closely monitored to mitigate risks of delays in project implementation, in particular on monitoring and evaluation ofproject activities.

160. Accounting and Financial Management Systems The PIU will be responsible for consolidated project accounting and financial reporting based on modified accrual basis of accounting. The existing 1C accounting system was strengthened by updating the Chart of Accounts, the primary tool for achieving consistency in project accounts classification, commensurate with overall project activities. It is therefore critical that that all relevant project related documents and records for the railways component are provided to the PIU on timely basis to facilitate timely and accurate consolidation of unaudited IFRS and project financial statements.

45 161. ADDY system. Accounting at ADDY is centralized at the accounting department at the headquarters where accounts from regiondcenters are ‘consolidated’. The current information system is inadequate and insufficient as a management tool. The system is not capable of integrating detailed accounting and reporting in the main system and facilitating proper consolidation of accounts and financial statements. The system is paper-based or semi- automated, despite the fact that a 1C computer-based system is available and is used in four departments, resulting in duplication of tasks as data is transmitted from the field to the Accounting Department in Baku for compilation and reporting. There is no network connection between regions and the headquarters, and there is no central data base for financial data storage. To address these deficiencies ADDY is considering implementation of an integrated system which will include a management information system, related hardware, software and procedural standarddguidelines. ADDY systems will be relied upon to generate entity financial statements in line with IFRS. Technical support to the ADDY in strengthening its systems, transition to IFRS and local and international training in international accounting and auditing will be provided during project implementation financed under this project and under the parallel CAPSAP. The Bank will closely monitor progress on strengthening ADDY’s systems and controls. The risk associated with ADDY’s financial management systems is assessed as substantial to moderate with mitigation measures.

162. Staffing. The PIU includes a Chief from ADDY, as well as a financial management specialist, and a procurement specialist to be financed from the project. A secretary/translator and other technical specialists will be hired as needed. Hiring of the staff will be on competitive basis to ensure selection of qualified and experienced specialists. As this is the first Bank- financed project for this PIU, and the ADDY, training in Bank procedures and requirements in financial management, reporting, disbursements and auditing will be provided during project implementation. The risk associated with staffing is considered moderate.

163. Internal Controls and Internal Audit. The internal control environment at the PIU facilitates maintenance of accurate and up-to-date accounting records for the preparation Grant, with clear delegation and segregation of responsibilities (financial management, procurement, and authorization). The systems and controls provide sufficient financial information for managing and monitoring project activities. There is no internal audit function within the Ministry of Transport. There is however an investigation team at the ADDY which investigates irregularities noted in the institution.

164. Accounting Policies and Procedures. Accounting policies and procedures at the PIU for the implementation of the project are documented in an Operational Manual. ADDY’s policies and procedures are documented in various bound manuals which are not updated regularly. All accounting policies and procedures will be updated and documented in the Manual for the implementation ofthe proposed project.

165. Financial Reporting and Monitoring. The PIU will maintain project records and accounts and prepare consolidated Interim Financial Reports (IRS) using the existing 1C accounting software. These reports will be submitted to the Bank no later than 45 days after end of each quarter, for monitoring project financial performance. Project output and procurement

46 progress throughout the life of the project will be reported on a semi annual basis. The risk associated with project financial reporting is assessed as moderate.

166. External Audit. The audit for the project financial statements and ADDY’s financial statements will be carried out by independent auditors in accordance with auditing standards acceptable to the Bank (International Standards on Auditing), and under terms of reference acceptable to the Bank. The contract for the audit will be awarded during the first year ofproject implementation and extended subject to satisfactory performance. The cost of such audit will be eligible for financing under the Loan.

167. Strengths and Weaknesses. ADDY lacks experience in implementing Bank-financed project, except for the implementation of the PHRD Grant for project preparation. There are no IFRS financial statements that have been audited in accordance with ISA for ADDY. The Bank through this project and CAPSAP will support ADDY in the transition to international standards that promote transparency and accountability in financial reporting. In addition, the Bank supervision missions will monitor implementation of the action plan to strengthen the systems and controls ofthe PIU and ADDY,

168. Financial Covenants. The PIU and ADDY will be required to maintain a financial management system, including accounts and records sufficient to monitor sources and uses of funds for project implementation. The project financial statements and the entity financial statements (ADDY) will be audited annually by independent auditors and under terms of reference acceptable to the Bank, and report submitted to the Bank no later than six months after end of such year audited. Un-audited interim financial statements will be submitted to the Bank no later than 45 days after end ofeach quarter.

169. Supervision Plan. The Bank will conduct financial management supervision every six months to monitor progress of project implementation, paying particular attention to: (i)loan disbursements and financial management arrangements; (ii)review of the project’s Interim Financial Reports and audited financial statements; and (iii)review of implementation of auditor’s recommendations on strengthening systems and controls as outlined in the auditors Management Letter.

170. Conclusion. It is concluded that financial management systems for project implementation at the PIU meet Bank requirements. Technical assistance to strengthen ADDY systems and institutional capacity building will be provided through the project, providing sound financial management environment and reliance on ADDY systems and controls. The following action plan is proposed to address the deficiencies in the ADDY financial management environment:

47 Action Plan

B: FLOW OF FUNDS AND DISBURSEMENT ARRANGEMENTS

17 1. The Country Financing Parameters for the Republic ofAzerbaijan approved in December 2004 will be applied to determine the level of IBRD financing. These parameters allow cost sharing of up to 100 percent, no country-level limit on financing ofrecurrent costs, and local and foreign costs may be financed in any proportions required for the project. No taxes and duties are judged to be unreasonable. The Loan can therefore finance all taxes and duties associated with project expenditures. Bank financed projects approved after January 1, 2008 are subject to VAT at the current rate of 18 percent. The Government contribution will separately cover these VAT related costs. It was agreed that invoices submitted to the Bank will exclude VAT.

172. The total project cost estimate of US$795 million will be financed with IBRD fixed- spread loan of $450 million, and counterpart funds of US$345 million (of which $344 million from MoF, US$1 million from ADDY). The allocation of the Bank Loan proceeds will be as follows:

48 Table 1: Allocation of Loan Proceeds

Category Amount ofthe Loan Percentage of Expenditures to be Allocated financed (expressed in USD) (1) Goods, works, consultants’ 232,875,000 85% services (including audits), training and incremental operating costs for Component 1 of the Project

(2) Goods for Component 2 of 202,000,000 72% the Project

(3) Goods, works, consultants’ 14,000,000 85% services (including audits), training and incremental operating costs for Components 3 and 4 ofthe Project (4) Front-end Fee 1,125,000 Amount payable pursuant to Section 2.03 ofthis Agreement in accordance with Section 2.07 (b) ofthe General Conditions

(5) Premia for Interest Rate Caps 0 Amount due under and Interest Rate Collars Section 2.07 (c) of this Agreement

TOTAL AMOUNT 450,000,000

I I

173. Terms of the Loan. The IBRD Loan funds will be provided on standard IBRD loan terms, as a Fixed Spread Loan (FSL) to meet the needs of the project and support the Borrower’s debt management strategies, and suited for their debt servicing capacity. The loan will be disbursed through transaction-based disbursement methods that include: reimbursements with full documentation, reimbursements on basis of Statements of Expenditures for small expenditures with defined thresholds, payments against Special Commitments, direct payments to third parties, and payments through the Designated Account.

174. Designated Account. To facilitate project implementation, a Designated Account for IBRD Loan funds will be opened in a commercial bank, on terms and conditions acceptable to Bank. The Designated Account will be replenished regularly, at least every three months or more frequently as required, and audited in conjunction with the annual audit of the project financial statements. The ceiling for the Designated Account will not exceed US$50 million.

49 175. Statements of Expenditure (SOEs). Disbursements on basis of SOEs will be made for (a) goods contracts less than US$300,000 each; (ii)works contracts less than US$2.0 million each; (iii)consultant's services contracts with firms less than US$lOO,OOO each and individuals up to US$50,000 each; (iv) training contract for less than US$50,000; and (v) incremental operating costs. For all expenditures financed under the SOE disbursement method, full documentation in support of the SOE will be retained in the PIU for at least two years after the project closing date. This information will be available for review by Bank missions during project supervision and by the project's auditors. SOEs will be audited in conjunction with the annual audit of the project.

176. GovernmedADDY Contribution. The Government contribution of US$344 million will be disbursed from budgetary allocations expended through the Treasury System to a Project Account opened for the Ministry of Transport and for ADDY. In order to ensure adequate counterpart funds are made available to the Project on timely basis, an initial deposit in local currency equivalent to US$l,OOO,OOO will be made before the project becomes effective, to be replenished on quarterly basis. The PIU will closely inform the Government before larger contracts are awarded to ensure proper budget allocation and flow of funds to the Project Account.

50 Annex 8: Procurement Arrangements AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

A. General

177. Procurement of goods and works for the proposed project will be carried out in accordance with the World Bank's "Guidelines: Procurement under IBRD Loans and IDA Credits" dated May 2004 (Procurement Guidelines) and the relevant provisions stipulated in the Loan Agreement. Selection of contracts for consulting services will be carried out in accordance with the "Guidelines: Selection and Employment of Consultants by World Bank Borrowers'' dated May 2004 as well as and the relevant provisions stipulated in the Loan Agreement. The various items under different expenditure categories are described in general manner below. For each contract to be financed by the Loan, the different procurement methods or consultant selection methods, the need for pre-qualification, if any, estimated costs, prior review requirements, and time frame will be agreed between the Borrower and the Bank and documented in the Procurement Plan (PP). The PP will be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. The project components not financed directly by the Bank will be procured in accordance with national regulations, or co-financing institutions' procurement regulations.

178. Advertisement. A General Procurement Notice (GPN), acceptable to the Bank, will be published online in the United Nations Development Business (UNDB) and in the Development Gateway's dgMarket. The GPN will give a description of the goods, works and consulting services contracts to be procured under the project and will invite all potential suppliers, contractors and consultants to express interest and request additional information from the respective Borrower. Specific Procurement Notices (SPN) for International Competitive Bidding (ICB) procurement packages and Expression of Interest (EOI) for consulting assignments estimated to cost US$lOO,OOO equivalent per contract will be published in UNDB (on-line), dgMarket and a national newspaper of broad circulation as the corresponding bid documents become available.

179. The Borrower will respect debarment decisions by the Bank and will exclude debarred firms and individuals from the participation in the competition for Bank-financed contracts. Current listing of such firms and individuals is found at: httd/www.worldbank.org/debarr.html

180. Procurement of Works. Works estimated to cost more than US 2.0 million shall be procured using International Competitive Bidding (ICB) procedures. Works estimated to cost less than US$2.0 million may be procured using National Competitive Bidding (NCB). Works estimated to cost less than US$lOO,OOO may be procured using shopping procedures. The bidding documents will be prepared by ADDY and will be reviewed and agreed with the Bank prior to their issuance to the interested contractors for ICB.

18 1. Procurement of Goods including Supply and Installation. Goods procured under this project will include but not be limited to: the design, supply and installation of a 25 kV electrical system including substations, power supply and catenary for the East West corridor, procurement of electric mainline locomotives, signaling equipment and IT procurement for a financial and

51 accounting system for ADDY including supply of hardware and software for the system. The procurements will be done using the Bank’s Standard Bidding Documents (SBD) for all ICB procurement of goods and IT procurement document for IFRS procurement. Goods and equipment estimated to cost more than US$300,000 will be procured through ICB. Goods estimated to cost less than US$300,000 each may be procured through National Competitive Bidding. Small contracts for supplies and minor equipment estimated to cost less than US$lOO,OOO each may be procured under Shopping procedures based on a model request for quotations satisfactory to the Bank, on the basis of three or more written price quotations obtained from suppliers. Where certain goods are available from one particular supplier or in case where compatibility with existing equipment requires that goods must be procured under Direct Contracting and have obtained prior approval from the Bank can be purchased in accordance with paragraphs 3.6 and 3.7 ofthe Procurement Guidelines.

182. Procurement of non-consulting services. The project will not finance any non- consulting services contracts or technical services contracts.

183. Selection of Consultants. Consulting services under this project will include: (i) technical assistance for preparation ofbidding documents, evaluation of bids, and monitoring of progress for works, goods and consultancy contracts for the electrifications system, locomotives, signaling material and consultancies; (ii)technical assistance to ADDY for management, accounting, marketing and training; (iii)technical assistance for the Ministry of Transport to support the implementation of the Development Program for ADDY; (iv) financial audit services of the project and ADDY; (v) technical assistance for certifying quality and quantity of electrification and track rehabilitation contracts; and (vi) technical assistance to the PIU.

184. Short lists of consultants for services estimated to cost less than US$lOO,OOO equivalent per contract may be composed entirely of national consultants in accordance with the provisions ofparagraph 2.7 ofthe Consultant Guidelines.

185. Single-Source method may be used for certain assignments with prior approval of the Bank in accordance with paragraphs 3.9 through 3.13 ofthe Consultant Guidelines.

186. Training. There will be a number of training activities in the form of study tours, workshops, travel costs, participation fees and related expenses for attending conferences, etc. Most of these training activities are planned to be financed from the proceeds of loan. Financing of contracts and related expenditures will be made in agreement with procedures acceptable to the Bank and detailed in the Procurement Section of the Operational Manual. The Operational Manual will also describe criteria for selection of trainees as well as training institutions. The Bank will clear the plans upfront, while changes and additions to the plans will be reviewed separately as they occur and will cover the list ofparticipants, agenda for the training events and estimated budget.

B. Assessment of the agency’s capacity to implement procurement

187. The project will be implemented through a PIU in ADDY. ADDY has no previous experience with procurement under World Bank funds. ADDY has already appointed a project

52 Chief, to lead a PIU staffed with specialists appointed as consultants on the basis of their qualifications, including one procurement specialist and one financial management specialist. Technical experts will be seconded to the project by ADDY. Implementation activities for the project will be supervised and controlled by ADDY through the PIU.

188. Given the large size ofthe procurement packages for electric locomotives design, supply and installation of 25 kV electrical system, and consultancies, ADDY will select a consultant firm to provide technical assistance for the preparation of design and technical specifications, pre-qualification and bidding documents, evaluation of pre-qualification applications and bids, and supervision of project implementation and coordination between various suppliers, civil contractors- subcontractors and ADDY to provide time slots for construction activities. As part of the TOR for this assignment, ADDY will require this consultant to provide a part - time procurement specialist with knowledge of large scale works and goods procurement under Bank financed projects at least for the initial 18 months of the project implementation. ADDY will also select another consultant firm to provide technical assistance for certifying quality and quantity ofelectrification and track rehabilitation works.

189. An assessment of the capacity of the Implementing Agency to implement procurement actions for the project made during the February 2007 mission was updated by the project PAS, during the Appraisal mission. The assessment reviewed the organizational structure for implementing the project and the interaction between the project’s staff responsible for procurement and financial management and the ADDY’s relevant central unit for administration and finance.

190. The key issues and risks concerning procurement for implementation of the Project have been identified and include the following:

191. At the country level, a comprehensive analysis of the public procurement system in Azerbaijan was carried out during the Country Procurement Assessment review (CPAR) in 2002 and finalized on June 2003. This assessment included all relevant aspects of procurement operations such as the legislative framework, the effectiveness of regulatory institutions, strengths of the enforcement regime, capacity of its institutional and human resources. The CPAR concludes that, although certain progress has been made and procurement reform has been highlighted as priority in Azerbaijan in the last two-three years, there is still significant progress that could be made. In 2001 Azerbaijan adopted a Public Procurement Law (PPL) based extensively on the model of the United Nations Commission for International Trade Law (UNCITRAL). The CPAR concluded that Azerbaijan should be rated as medium to high-risk country in respect ofpublic procurement system. A new CPAR is proposed in FY 08.

192. At the project level ADDY lacks experience with the Bank’s procurement. A procurement specialist and financial management specialist have been recruited for the PIU.

193. The overall procurement risk level in Azeri procurement environment is deemed to be “high ” before mitigation measures.

53 Mitigation Measures

194. The Bank team intends to maintain customary oversight and will carry out prior review of all major contracts according to the thresholds that will be regularly reviewed and adjusted as needed in Procurement Plan. Initially set up thresholds are provided below in Table 1 of Section E of this Annex. The following measures will be carried out to mitigate risk:

(a) Specialized training of Borrower’s fiduciary staff: all fiduciary staff will be given specialized training focusing on the necessary connection between proposals or bids and the resulting contract as well as the need to assure that payments are not directed to any party other than the one performing the contract.

(b) Prior review: intensive and close supervision by Bank procurement accredited staff, including all goods and works contracts during the first year of implementation and majority of contracts thereafter. In addition, all contract amendments will be subject to prior approval by the Bank.

(c) Post review: one in two contracts will be post reviewed (the ratio is high due to the limited number of contracts that will be subject to post review).

(d) Publication of Advertisements and Contracts: all publications of advertisements and contract awards, including the results of the awards will be done in accordance with the Guidelines requirements.

(e) Debarred Firms: appropriate attention will be given to the need to ensure that debarred firms or individuals are not given opportunities to compete for Bank-financed contracts.

(f) Complaints: all complaints by bidders will be diligently addressed and monitored in consultation with the Bank.

(g) Evaluation Committee: the Bank will review and comment on qualifications and experience of proposed members of the Evaluation committee(s) with a view to avoid that unqualified or biased candidates are nominated. All members will be required to sign a disclosure form (sample will be included in Operational Manual)

(h) Monitoring Payments: all contracts shall include bank account information. The bank account shall be in the name of the same contractor/supplier/consultant as the one that submitted the bid and got the contract award.

(i) Timeliness of Payments: Payment to contractors, suppliers and consultants will be monitored through semi-annual interim unaudited financial reports (IFRs) to ensure timely payments.

54 C. Procurement Plan

195. The Borrower, at appraisal, updated a procurement plan for project implementation which provided the basis for the procurement methods. This plan has been agreed between the Borrower and the Bank at negotiations and is available at ADDY. It will also be available in the project’s database and in the Bank’s external website. The Procurement Plan will be updated in agreement with the Project Team annually or as required to reflect the actual project implementation needs and improvements in institutional capacity.

D. Frequency of Procurement Supervision

196. In addition to the regular prior and post review supervision to be carried out by the project PAS, the capacity assessment of the Implementing Agency has recommended an average of two supervision missions per year to visit the field. Contracts to be post reviewed will be selected from the procurement plan. Due to relatively small number of contract subject to post review, it is currently planned that no less than 50 percent of contracts subjected to post review will be reviewed ex-post.

E. Details of the Procurement Arrangements

197. Thresholds for procurement methods and prior review requirements are summarized below in Table 1. The correspondence between procurement thresholds and prior review requirements is based on the Bank team’s assessment of the capacities of the agency carrying out procurement. The risks of corruption and fraud in the country as well as the capacities of the manufacturing, construction and consulting industries in Azerbaijan have also been taken into consideration.

55 Table 1: Summary of Procurement and Prior Review Thresholds (in thousand US$)

Exp Category Proc Method Proc Threshold Prior Review Threshold *

Services - firms** OBS NA All contracts > 100 FBS NA All contracts >lo0 Lcs NA All contracts >loo* * as <200 None ** sss NA All contracts 4.2 Individual -IC NA All contracts > 50 and all Consultants sole source contracts

ICB: International Competitive Bidding, NCB: National Competitive Bidding, S: Shopping, DC: Direct Contract, AP: Agreed Procedures, QCBS: Quality and Cost Based Selection, QBS: Quality Based Selection, FBS: Fixed Budget Selection, LCS: Least Cost Selection, CQS: Selection based on Consultant Qualifications, SSS: Single Source Selection, IC: Individual Consultant Selection

* All amendments require justification and prior review by the Bank **Short lists for contracts estimated at < US$lOO,OOO may comprise national consultants only.

198. Goods, Works, and Non Consulting Services

(a) List of contract packages to be procured following ICB and direct contracting (exclude contingencies-See Annex 5).

56 -1 2 3 L 5 6 -7 R 9 10 11

Ref. Contract Estimated Procure P-Q Dome Revi Invitatio Expected Contract Contra NO. [Description) cost nent stic ew n to Bid Bid- Award ct (mill. US%) Method Prefer by Opening Compl ence Bank Date etion (yesln (Prio 0) rl - Post) S&I Design, Supply 202 [CB No No Prior Nov 08 Feb 09 Aug 09 Jun 11 and Installation of25 kV. System including substations, power supply, and catenary (Two stage Supply and Install contract)

Procurement of 244 ICB Yes No Prior Oct 08 Feb 09 Mar 09 Dec 11 GI new electrical (invitati locomotives on to PIQ in Apr 08)

Procurement of 11 ICB No No Prior Apr 08 Jun 08 JulO8 JulO9 G2 Signaling Equipment

IT Procurement 0.5 ICB No No Prior Oct 08 Dec 08 Jan 09 Sep 09 G3 of ADDY Financial System

G4 Oil Spill 4.1 ICB No No Prior Oct 08 Dec 08 Jan 09 Sep 10 Prevention and Response (multiple contracts)

G5 IT equipment 0.2 S No No Prior procurement for I PIU Post (multiple contracts)

(b) All ICB contracts for goods and works, first two NCB contracts for goods and works, all NCB contracts for goods estimated to cost US$200,000 or larger, all NCB contracts for works

57 estimated to cost US$l,OOO,OOO or larger, first two shopping contract for goods and works and all direct contracting will be subject to prior review by the Bank.

199. Consulting Services

(a) List of consulting assignments with short-list of international firms (excluding contingencies). - -1 2 3 4 5 h 7 8 9 Expected Expected Ref. Description of Estimate Selection Review Expected Proposal Contract Expected No. Assignment d Method by Bank Proposal Submission Award Contract cost (US (Prior I Invitation Date Completion $ Post) Date - million) s1 Support to ADDY 2.5 QCBS Prior Oct 08 Nov 08 Jan 09 Dec 11 management, accounting, marketing, training, etc. (multiple contracts)

s2 Technical 2.0 QCBS Prior Nov 08 Dec 08 Feb 09 Jan 1 Assistance for certifying quality and quantity of electrifications and track rehabilitation co

s3 Technical 2.0 QCBS Prior Mar 08 May 08 JulO8 Dec 11 assistance to ADDY for preparation of bidding documents, evaluation ofbids and monitoring of progress for works, goods and consultancy contracts viz electrification system, locomotives, signaling material, and consultancies s4 IFRS 1.o QCBS Prior Oct 08 Dec 08 Feb 09 Sep 10 - Implementation

58 including full audit s5 Project Financial 0.2 LCS Prior Sep 08 Oct 08 Jan 09 Jan 12 Audit

S6 T.A. to PIU 0.2 CQ I IC Prior I Post

Training, 0.4 N. A. Prior seminars. etc.

(b) All consultancy services under QCBS and LCS, and the first two contracts under CQ and all contracts with firms estimated to cost more than US$lOO,OOO per contract and all contracts with individuals for assignments estimated to cost more than US$50,000 will be subject to prior review by the Bank.

(c) Short lists composed entirely of national consultants: Short lists of consultants for services estimated to cost less than US$lOO,OOO equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines.

F. Ex-Post Review:

200. All other contracts for goods and consulting services below prior review thresholds are subject of Bank’s selective ex-post review. Periodic ex-post review by the Bank will be undertaken during regular supervision missions. Procurement documents, such as bidding documents, bids, bid evaluation reports and correspondence related to bids and contracts will be kept readily available for the Bank’s ex-post review during supervision mission or at any other point of time. Bank’s mission will review at least one out of every two contracts which are subject of ex-post review.

201. Record Keeping: The PIU will maintain complete procurement files which will be reviewed by supervision missions. All procurement related documents that require prior review will be cleared by the Procurement Accredited Staff (PAS) and related technical staff. Procurement information will be recorded by the PIU and submitted to the bank as part of semi- annual progress reports. A simple management information system with a procurement module will be established to assist the PIU procurement officer to monitor procurement information.

59 Annex 9: Economic and Financial Analysis AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

202. This annex presents the economic and financial analysis of the project. It comprises three main sections: (i)the actual and potential traffic; (ii)the economic analysis of each component including a sensitivity analysis; and (iii)the financial analysis of ADDY.

A. Traffic forecasts*’

203. Over the forecast period of 2005-2015 overall growth in freight traffic volume is expected to reach 46 percent with a total traffic forecast of 39 million tons in 2015. Growth for crude oil and oil products which are representing almost half of annual traffic volume is expected to grow by 16 percent. In volumes, the fastest growing market segments are expected to be in construction materials (+5 million tons), crude oil (f3 million tons) and grain and grain products (fl.7 million tons).

Basic traffic forecast assumptions for 2005-2015 204. The forecast generally assumes that there will be relative political and economic stability in the region throughout the 10-year period and that the trend toward free-market business ideals will continue. Also, that growth in oil production and economic development in general will not be negatively impacted in a significant way by any internal or external disruption. The forecast also assumes that there will be a continuation of the ongoing development of transportation- related infrastructure throughout the region, helping to provide the capacity necessary to support growth. Examples of the type of projects that are necessary are the expansion of port facilities, especially near Baku, at Batumi and at Poti, capacity expansions at Caspian oil terminals, and improvements in grain handling facilities, at manufacturing plants and refineries. While the forecast does assume a general level of supporting investment in the years to come, it should be mentioned that there does not appear to be any single issue or project that will be critical to the accuracy of the forecast. What is important, however, is that the basic “free-market” economic and political factors that are providing the foundation for much of the growth today be continued in the future. Should there be any changes in current policies or relationships that hinder investment, limit capacity or result in prices that are non-competitive, the result would most likely be that actual traffic levels would fall short of what is shown in the forecast.

205. The issues mentioned above together with the information provided in the various tables has been considered while preparing ADDY’s traffic forecast for the upcoming 10-year period. The forecast itself expected tonnage by product group is provided in table 1 below and illustrated at graph 1.

27 Based on the Marketing Report, Padeco, Seneca and Sulaco, September 2006.

60 Graph 1: ADDY traffic assumptions for 2005-2015 by commodity

40000

35000 0 c & 30000 GRAIN /GRAIN PRODUCTS s g 25000 m CHEMICALS MINERALS .e 20000 0 CONSTRUCTION MATERIALS - 15000 0 METALS 10000 0 COAL COKE ETC i; Lc E 5000 c 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 act act Years

Source: Marketing Report, Padeco, Seneca and Sulaco, September 2006 updated by ADDY’s actual freight traffic statistics for 2005-2006

Forecast assumptions by category

206. Crude oil - transit. This category covers all crude oil flows that pass through Azerbaijan. Included are “all-rail” movements such as Russia-Baku-Georgia as well as Caspian Sea - Baku port - Georgia movements. Crude oil transit traffic has decreased from 2005 to 2006 as the railway’s emphasis on moving domestically produced oil impacted the ability to haul transit products. The railway’s capacity is still assumed to be constrained throughout 2007, however, as locomotive and track upgrades are not yet complete. The years 2008 and beyond show growth in proportion to expected increases in regional oil production, with many oil producers expected to use the railway for a certain percentage oftheir output.

207. Crude oil - export. This category includes oil produced within Azerbaijan moving for export. Traffic grew dramatically from 2004 through 2005 and peaked in 2006, due primarily to the increased demand caused by the inability of the new BTC pipeline to accommodate increasing production from ACG fields. The BTC’s load in 2007 has reached 85 percent of its designed capacity, which is around 50 million tons per year. According to ADDY traffic statistics available for 8 months of2007 this already resulted in a decline in rail traffic from 2006 to 2007. Nonetheless, 2007 traffic appears likely to be nearly double the level in 2005. In the years beyond 2007, export oil is expected to remain relatively flat as the railway is used as a secondary outlet for oil hauled primarily by the pipelines. The majority of the growth that is expected in oil production during those years is expected to move out of the country using expanded pipeline capacity.

208. Crude oil - other. The last category of crude oil covers both imported and domestic movements. At present, ADDY does not handle a material amount of this traffic and it is not expected that there would be any significant traffic flows in the future for the railway.

61 209. Oil products - transit. This category covers all refined oil products that move through Azerbaijan in transit, with those products being primarily fuel oil, motor oil, benzene, jet and diesel fuel. As was the case with transit crude oil, the volume of transit oil products has fallen slightly from 2005 to 2006 and expected to slightly recover in 2007. In the years beyond 2007, volume in this category is not expected to grow significantly, as most refinery output from neighboring countries is expected to be consumed within their countries rather than be exported.

210. Oil products - export. Within this category is the oil products produced at Azeri refineries that move for export. This category has slightly increased in 2006 but expected to show declining volumes going forward. The assumption is based upon the belief that demand for oil products created by the country’s rapidly growing economy will outpace increases in domestic refinery output. This would result in a decline each year in the amount that would remain to be exported. Statistics available for 8 months of 2007 supports this assumption.

21 1. Oil products - other. This category covers imported and domestic movements of oil products. At present, there are no significant flows of oil products being imported into Azerbaijan. Domestic movements, on the other hand, are strong and are expected to grow in the future. The growth can be expected for the reasons stated in the “export” category above, with the development of the economy driving increased consumption of oil products in the years to come with the railway participating in the movement of many of those products.

212. Coal / Coke. It is understood that the principal flow of traffic in this group occurs within the city of Baku. It is a movement of petroleum coke from a Baku refinery to the for export to Russia. This flow has doubled in 2006 and expected to continue in the years ahead with volume increasing slightly along with expected increases in refinery output. There are no significant movements of coal within Azerbaijan and none are foreseen, given the country’s reliance upon oil for its energy needs.

213. Metals. Products in this group include bars and structural steel for construction, coiled steel used in manufacturing and wire and cable used for a variety of projects. These products are produced domestically and are also imported from Ukraine and Russia in large amounts. The forecast assumes that these flows continue to move in the years ahead with volume increases being driven primarily by increases in both construction and in industrial output. These assumptions have been proven by 2006-2007 statistics.

214. Construction Materials. This category includes the more basic materials used in construction, such as cement and raw materials used in cement production, sand, gravel, wallboard and brick. Traffic volume in this group is expected to continue to grow in the years to come, driven by the expanding domestic economy. These assumptions have been supported by 2006-2007 statistics.

215. Chemicals / Minerals. The principal flows in this relatively small group are comprised of both solid and liquid forms of fertilizer being imported to the country. Traffic in this category is expected to increase in the years ahead as demand for agricultural chemicals increases along with the development of the country’s agricultural sector. 2006 statistics was at 2005 level but still expected to grow steadily in the upcoming years.

62 216. Grain / Grain Products. The more significant flows of traffic in this category are movements of grain for domestic consumption with that grain originating both domestically and internationally. Relatively heavy flows have been moving in from Russia in recent years to support increasing Azeri demand for grain, which has recently been exceeding domestic production levels. In addition to supporting domestic needs, a new flow is expected to become significant in the future, that being transit movement of grain via Baku to Georgia and points west. As mentioned previously in this report, investments are being made in grain handling facilities in the Baku area that should facilitate the movement of this traffic. These assumptions have been supported by 2006-2007 statistics.

217. Other Cargo. This category covers all products moving on the railway that are not included in one of the previously mentioned groups. Given that the products included in this group are very diverse and cover nearly all aspects of the country’s activities, it is expected that demand for transportation will grow along with the overall economy. The portion of this sector that the railway will transport will then depend upon its ability to compete effectively. The assumption is that volume in certain sectors of this group - such as food products - is expected to fall in the years ahead due to increasing competitive pressure from trucks. On the other hand, many other sectors, such container movements, are expected to increase steadily. The overall impact of the numerous individual traffic gains and losses is expected to be that the railway will realize net increases in its traffic base for this category. While competitive losses will certainly occur, it is expected that strong economic growth will drive increases in traffic via the railway that should overcome losses and result in a generally increasing trend in the years to come. These assumptions have been proven by 2006-2007 statistics.

63

B, Economic analysis29

218. The project comprises a set of investments that, together, will allow ADDY to provide safe, high quality transport service on the East-West corridor, including for its oil and oil products business. These investments are necessary for ADDY to attract and serve this traffic. The benefits of the project are that ADDY can sustain and grow its profitable freight business and that it experiences lower energy and track maintenance costs. The net present value of the investment package is expected to be US$250 million on investment of US$ 661 million. The IRR of the investment is 19 percent. Sensitivity analysis shows that the returns are somewhat sensitive to traffic volumes, but that even in the low traffic case (scenario 1) the IRR remains at 17 percent.

Scenario NPV@12% IRR US$ millions % 3 Most likely forecast (see section A) 250 19 I Flat trafJic to 201 0, moderate growth after 2010 239 17 2 25% growth to 201 0, moderate growth after 43 1 22 I 2010

2 19. The economic analysis has been performed for the following physical investments in the project:

Component 1: Track Rehabilitation. This component will rehabilitate critical sections of ADDY’s main line infrastructure, where assets are substantially deteriorated. The investment would include rail, sleepers, ballast, rail fastenings, turnouts and switches to be installed by ADDY forces. Estimated cost is US$ 99 million.

Component 2: Motive Power Renewal. This includes purchase of 50 new 25 kV locomotives and conversion of the overhead electric power supply system from 3 kV DC to 25 kV AC. Estimated cost is US$ 557 million.

Component 3: Oil Spill Response Capability. This component will properly equip ADDY’s emergency response staff to respond to potential oil spills. Estimated cost is US$4 million.

220. A separate economic analysis has been carried out for the track rehabilitation and the motive power components. The oil spill response investment has been folded into the analysis of the motive power investment. The analysis demonstrates that each main component is economically sound.

29 Based on PADECO Infrastructure Report, November 2006.

65 B.l. Economic Analysis of Component 1: Track Rehabilitation

221. The economic analysis of Component 1 uses a model that defined a “do-nothing” scenario and a “do the investment” scenario. The model forecasts the cost to ADDY of these two scenarios, given the forecast traffic on the main East-West line. Traffic on the main line, which carries more than 70 percent of total ADDY freight traffic, has been assumed to follow the same growth rate as the projected total freight traffic described in the previous section.

222. The poor track condition in many sections of the East-West corridor has extended transit times and created unreliability for the route, reducing its competitiveness. These conditions also increase the amount on energy needed to move trains and the cost of track maintenance. Improving the track condition will constitute a significant step in improving the efficiency and competitiveness of the route.

223. The benefits to rehabilitating the track include: (i)reduced track maintenance costs, (ii)reduced energy costs, (iii)improved equipment utilization due to reduced turnaround times for locomotives and wagons, (iv) reduced incidence of derailments, and (iv) improved service offered by ADDY to customers. The economic analysis of Component 1 quantifies (i)- (iii).To avoid any overlap with the analysis of locomotives, however, only the benefits of (i)and (ii)are counted in the economic analysis of the overall project.

224. Reduced Track Maintenance Cost. ADDY, annual maintenance cost over the whole network averages to 4,874 AZN/track km. However, the cost of maintenance on the most heavily used and deteriorated sections is estimated to be 7,311 AZN/track km, as these sections will require more frequent inspection and temporary repairs to maintain traffic.

0 In the “do-nothing” scenario, the tracks will continue to deteriorate and more restrictive speed limitations will apply. In order to keep the lines open, maintenance is forecast to increase by 20 percent annually to 2010; after which it will remain constant. Speed over substantial sections of the line will fall to 15kmih by 2010 and remain at that level thereafter (some sections of the line are already under 15kmih speed restrictions).

In the “do the investment” scenario, maintenance costs will increase in 2007, after which the benefits of the project will begin to be felt. By 2013, the unit cost of track maintenance returns to the level experienced in 2005, and remains at that level throughout the forecast period.

225. Energy Savings. Currently, ADDY consumes one GWHr of electricity for traction of every 94,000 tons of freight hauled by electric locomotives. If track conditions deteriorate, as described above, electric locomotives will operate more hours to haul the same freight. Frequent braking and acceleration due to speed restrictions will be the norm, causing ADDY’s energy efficiency on the corridor to fall to an estimated 58,000 ton/GWHr over five years. By contrast, the improvement in track conditions

66 caused by the rehabilitation investment would increase ADDY’s productivity to nearly 118,000 todGWHr. The savings in energy efficiency would provide substantial savings in ADDY’s energy costs.

226. Locomotive Savings. Rehabilitating the railway infrastructure will have an important effect on locomotive requirements and turnover costs. If track conditions deteriorate, trains will move more slowly and more locomotives will be needed to carry the same traffic. By contrast, if speed restrictions are eliminated, trains will move faster and fewer locomotives will be required to move comparable tonnage. The difference in the number of locomotives needed between the “do nothing” and “do the investment” scenarios amounts to 20 locomotives by 2010 and 50 by the end of the forecast period. The cost ofthe locomotives, including capital cost, overhaul costs and maintenance costs, annualized over a 30 year life amounts to US$762,000 per year per locomotive.

227. Costs / Benefits Results. The costs and benefits of the investment are shown in the graph below. In each case the benefit ofthe investment is measured as the difference between the costs if the track is allowed to continue to deteriorate and the cost if the track is rehabilitated over a three year period. All costs and benefits are without VAT, and reflect current prices. They have been discounted back to present value terms using a discount rate of 12 percent.

Costs & Benefb of Track Rehabilitation

. . ------

Locomotlve Savings

2006 2009 2010 2011 2012 2013 2014 2015 2016 2017 2016 2019 2020 2021 2022

228. This net present value of the track rehabilitation investment is US$ 240 million and the IRR is 67 percent when including the locomotive benefits. Considering only the track maintenance and energy savings, the net present value of the investment is US$ 64 million and the IRR is 27 percent. Thus, the economic analysis concludes that the component 1 is economically viable.

229. Sensitivity Analysis. Sensitivity analysis has been undertaken to test the impact of the traffic forecast scenario. The results are shown in the table below.

67 Maintenance & Energy Maintenance, Energy & Savings Locomotive Savings NPV@12% IRR NPV@12% IRR Scenario US$ millions % US$ millions % 1 Flat traffic to 2010, 45 25 222 58 moderate growth after 2010 2 25% growth to 2010, 74 28 267 66 moderate growth after 2010 3 Most likely forecast (see 64 27 240 67 section A)

230. The analysis reveals that component 1 is very robust to a change in the traffic forecast scenario. Even if locomotive savings are not considered, in the most pessimistic scenario, the rate of return never falls below 24 percent.

B.2. Economic Analysis of Component 2: Motive Power Renewal

231. The economic analysis of Component 2 uses a model that defined a “do-nothing” scenario and a “do the investment” scenario. In the “do nothing” scenario, ADDY does not replace the locomotives in its fleet as they become non-operational, and can handle less and less traffic with the shrinking fleet. In the “do the investment” scenario, ADDY does renew the fleet, together with replacing the electric supply system that powers the locomotives.

232. Lost Traffic. The benefit of the investment is that ADDY is able to handle the forecast traffic. Without the investment, ADDY can handle only a share of the available traffic. We forecast that the traffic on the corridor would decline in proportion to the decline in the operational fleet of freight locomotives. Over five years, ADDY goes from 78 to 38 locomotives in this fleet, so traffic on the East-West corridor declines substantially. (See figure.)

68 Traffic Forecast - With and Without Investment

40

Without Locotnotie Inestment

10 \

O-I,,, #I\##IIII8I ##,I 2005 2007 2009 2011 2013 2015 2017 2019 2021

233. The value ofthe traffic that would be is lost is estimated as the revenue from the traffic less the variable operating expenses that would be saved if the traffic were not moved. The variable expenses include electric energy for traction, and maintenance materials expenses for both locomotives and wagons. Electric energy expenditure foregone is estimated based on the tonnage lost and ADDY’s GWHr/ton consumption of energy for traction. Locomotive maintenance materials expenditure foregone is estimated based on the reduction in the size of the locomotive fleet. Wagon maintenance materials expenditure foregone is based on the change in tonnage on the East-West corridor. The estimate does not capture the savings in operating costs coming from the use of more energy efficient locomotives.

Costs i3 Benefit of Motive Power Renewal

160

140

120

100 v) C 0 -.-R 80 E

6o # 40

20

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 20221 (20)

69 234. Costs / Benefits Results. The costs and benefits of the investment are shown in the graph above. All costs and benefits are without VAT, and reflect current prices. They have been discounted back to present value terms using a discount rate of 12 percent.

235. This net present value ofthe motive power investment is US$186 million and the IRR is 18 percent. Thus, the economic analysis concludes that the component 1 is economically viable.

236. Sensitivity Analysis. Sensitivity analysis has been undertaken to test the impact of the traffic forecast scenario. The results are shown in the table below. The analysis indicates that component 2 is quite sensitive to the level of traffic, but remains above 12 percent in all cases.

Scenario NPV@12% IRR US$ millions % 1 Flat traffic to 2010, moderate growth after 2010 181 16 2 25 percent growth to 2010, moderate growth 356 21 after 20 10 3 Most likely forecast (see section A) 186 18

C. Financial Analysis

C.l Past financial performance of ADDY

237. This section provides an overview ofADDY past financial performance. It is based on un-audited ADDY financial statements prepared on an Azeri Financial Reporting Standards basis, restated to International Financial Reporting Standards (IFRS) basis.

23 8. Revenues. ADDY has experienced strong revenue growth over the last four years (see Figure 1). Revenues. Figure 1: ADDY revenue drivers This trend was driven by ADDY freight business, which is representing an increasing share of total revenues, from 75 percent in 2003 to 81 percent in 2006. The main drivers behind the growth of freight revenue are (i)a 48 percent increase in traffic from 2003 to 2006 and (ii) a 26 percent increase in average freight tariff over the same period3'. Passenger service only accounted for 11 percent of total

30 The cumulated inflation over the same period was about 23 percent.

70 revenues in 2006, despite an increase in traffic and tariff of 47 percent and 56 percent respectively over the last four years. operating costs including depreciation idn . 80.00% expenses have increased by 23 ’- I 120 70.00% percent mainly because of a 93 60.00% 5 100 percent rise in staff expenses, an 82 - 50.00% I 80 percent spurt in fuel expenses. The 1 40.00% 60 share of staff cost in operating costs 30.00% 40 jumped from 16 percent in 2002 to 28 20.00% percent in 2006. Although this ratio 20 10.00% remains low comDared to manv other 0.00% railways, this upward staff cost trend is driving ADDY fixed costs up and will increase the company’s financial risk in the future. The rise in material unit cost results from excessive deferred maintenance leading to an increase in the cost of railway operations.

240. Profitubility. Over the period 2004-2006, ADDY has improved its operating ratio from 74 percent to 67 percent and working ratio from 60 percent to 58 percent. ADDY achieved this performance by increasing its revenues by 40 percent while containing the rise in its operating costs to 27 percent. The 27 percent rise in operating costs was mainly driven by a rise in staff expenses and maintenance.

241. The combination of Figure 3: ADDY recent financial performance improved operating ratio, 30.0% 1.60 stable interest expenses and the 1.40 recovery of bad debts in 2004 25.W and 2005 has led to a rise in the 1.20 net profit margin from 19 E 20.0x 1.00 percent to 27 percent. 8 t 4 15.0% 0.80 e However in 2006 interest I B 3 E 0.80 4 expenses doubled and some 10.0% increase in provision for bad 0.40

5.0% debts and non-operational 0.20 losses reduced this margin back to 14 percent. ADDY’s net 0.0% profit margin still compares favorably to that of its peers and to the industry average, around 6.10 percent3’. In addition, the railway company has improved the revenue generation capacity of its asset base3* as evidenced by the slight increase of the asset turnover (the ratio revenue divided by assets).

3’ Georgian Railway Assessment Report, Booz Allen Hamilton, 2005.

71 242. Accounts Receivables. ADDY customers’ and suppliers’ relationships are not yet fully based on commercial principles and large short-term assets from and liabilities to other state-owned companies are contained in ADDY balance sheet (see table below).

Table: Current assets and liabilities turnover analysis 2003 2004 2005 2006 Collection period of receivables in months 7.7 8.3 6.7 6.8 Source: ADDY un-audited financial statements

243. Although the receivables’ collection period has improved over the last four years, ADDY’s balance sheet as of 31 December 2006 displayed US$ 124 million in accounts receivable representing almost 7 months of revenues. Accounts receivable due solely from the State Oil Company amounted to about 19 percent of the total balance at the end of 2006. ADDY has indicated that these high accounts receivable stem from previous periods and that current collection policy is effective, but the trend in 2006 indicate a potential reversal of progress over previous years. As stated in ADDY financial statement^^^, there is a significant risk that these accounts receivable may not be recoverable in full and state bodies may intervene to settle these issues. ADDY is expected to continue to provide transportation services to the Oil Company regardless of the outstanding balance for past services provided. Although ADDY is pressing collection of old accounts through the courts, it may have to write off as much as half these old accounts.

244. Need for Investment. Since the early 1990~~ADDY has not been investing at a rate that would sustain the railway’s assets. This was very sensible when traffic dropped and the railway found itself with significantly more assets than it needed to serve a diminished traffic base. However, with increasing traffic, many asset groups now need investments.

245. Growing Working Capital. Over the last five years, ADDY investment has been curtailed because of more pressing short-term cash issues. About 55 percent of ADDY revenues on average (net of operating and financing costs, but excluding depreciation) have been absorbed by a growing working capital funding need. In 2006, ADDY used more cash flow from operation (US$65 million) to increase its working capital (US$ 40 million increase in account receivable, inventory and other current assets) than to cover its large investment requirements (US$ 28 out of US$65 million). This use of funds appears untimely given the urgent need for new investments.

246. Liquidity. Increased inventories, accounts receivable and other current assets outweighed growth in accounts payable, improving ADDY current ratio, which stood at

32 Some indicators of asset productivity such as traffic density and km per electric locomotives have recently improved. 33 Azerbaijan State Railways, Compiled financial statements for the year ended on December 3 1,2005, note 3.37

72 1.8 in 2006. However, given the poor liquidity of the company’s inventory, the quick ratio is a much more reliable indicator of the company’s liquidity. In both 2005 and 2006, the quick ratio was less than one. This appears insufficient to provide the company with sufficient flexibility to avert a liquidity crisis given that probably half of ADDY accounts receivable may need to be written off.

Table: Liquidity analysis 2003 2004 2005 2006 EBITDAhterest expenses 27.73 14.48 27.49 12.03 Current ratio 1.10 1.26 1-71) 1.76 Quick ratio 0.78 0.82 0.92 0.92 Days’ sales in cash 1.9 3.0 1.4 1.8 Source: ADDY un-audited financial statements

247. Financing Imbalance. ADDY financing policy has mainly relied on self and short term financing through the accumulation of retained earnings and short term credits from the International Bank of A~erbaijan~~.This has undercut its ability to plan for and fund the significant investment program it needs to implement so as to remain competitive. Since 2003, the accumulation of retained earnings has brought up the share of equity to 79 percent of total assets. This is well above the industry average of 55 percent3’ and that of its European peers, which range from 42 percent to 66 percent. On the liability side, expensive short term loans have represented about 60 percent of ADDY total debt since 2003.

C.2 Financial Impact of the proposed Government Program

248. Key Assumptions. ADDY’s financial results were forecast based on the traffic forecast described in Part A and the comprehensive investment program for the railways described in Annex 1. (The World Bank project is a subset of this investment program.) The forecast assumes that the Government of Azerbaijan will onlend to ADDY funds from the World Bank loan for new locomotives (US$202 million) and for modernization and project implementation (US$ 14 million) and from other IFI’s for the remainder of the rolling stock in the investment program (US$ 308 million), and that the government will provide grant funding for the remainder of the investment program.

249. Other key assumptions of the forecast include.

0 The financial analysis has been prepared in real prices with a constant AZN/US$ exchange rate of 0.8531. 0 ADDY traffic gradually increase (- 3.3 percent per year for freight). ADDY freight tariff would increase by 10 percent in 2008 and be constant afterwards. Passenger tariffs do not increase.

I 34 This commercial bank provides a revolving credit facility to ADDY with an interest rate amounting to 15 ercent. p5 httu://~~~.~tock~elector.com/industrv,asu?rank=4,for companies from North America and East Asia. Last accessed 08/07/06.

73 0 Staff number will rise by 3.7 percent from 2006 to 2008 up to 27,000 and remain constant thereafter. 0 ADDY will be transformed into a holding structure with four separate subsidiaries: freight, passenger, infrastructure and non-core activities.

250. Together, these assumptions form a conservative basis for evaluating the impact of the overall investment program.

25 1. Financial Results. ADDY revenue grows gradually throughout the forecast period from AZN 169 million to AZN 244 million. After the initial revenue boost of 10 percent in 2008, freight rates are flat and revenue growth comes from increase in traffic. Oil and oil products revenue grows quite modestly (a conservative assumptions, if ADDY reform and investment ADDY Revenue Forecast improve service levels), and most revenue growth is expected from other freight traffic. No real 300 3growth is expected in passenger fares, and passenger revenue grows - 200 modestly together with traffic. c -P - 150 252. Operating expenses also show a gradual increase over the 100 period. Reductions in track

50 maintenance and locomotive operation and maintenance costs 0 occur because of investments in 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 locomotives, power supply and 1 oii a oii Products Other Fresght Passenger H Other I track, while other costs continue to increase. The working ratio improves from 74 percent to 56 percent. The operating ratio also improves, but less strongly because depreciation increases offset other reductions in operation expense.

253. ADDY is profitable throughout the forecast period. Net income, diminishes from about AZN 30 million p.a. in 2008-2010, to about AZN 20 million in 201 1-2013, because the investment program boosts interest and depreciation. As the benefits of the program are realized through both traffic growth and improved productivity, however, profit begins to grow again in 2014-2016, reaching AZN 27 million by 2016.

254. Cash flow from operations is positive throughout the forecast period, gradually rising from AZN 54 million in 2007 to over AZN 86 million by 2016. Cash flow is sufficient to cover all financing needs (both World Bank and other IF1 financing). ADDY’s debt service coverage ratio remains at or above 2 throughout the period of the World Bank loan.

255. The financial statement forecast through 2016 is detailed at the end of this annex.

74 ADDY Finanad Forecast Debt Semce Coverage Ratio Over Life of World Bank Loan

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256. Impact of Investment Program (including all three phases). The investment Program is a comprehensive appioach to the asset Investment Program 8, Resulting Cash Flow rebuild base of ADDY and ensure it 450 7 has the physical capacity to 400 4- serve its clients. The overall 350 program allows the railway to

300 generate cash through its s mlnwstment 250 operations. The investments

200 compared to the resulting cash flows are shown in the graph. 150 The net present value of these 100 cash streams, discounted at 50 ADDY's weighted average cost 0 of capital (7.7 percent) is AZN 62 million. The IRR of the investment is 8.4 percent and payback period is 15.4 years.

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E ti 3 Annex 10: Safeguard Policy Issues AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

A. Environmental Safeguards

257. In accordance with the World Bank policies and procedures the project is rated environmental category B for environmental assessment purposes. The ADDY has prepared an Environmental Management Plan.

258. The project is expected to have no significant environmental impact. The impact will mainly be associated with construction works (rehabilitation of mainline track). The Environmental Management Plan has identified the following environmental issues: a. Impact on air quality: dust and exhaust emissions from operation of construction equipment will be mitigated by using water spraying, ensuring proper ventilation of internal areas and regular checkup ofengines. b. Impact on water: contamination of water by discharge of untreated waste waters during the construction phase will be mitigated by treatment of water prior to discharge into water reservoirs. c. Impact on land: impact caused by excavation during construction / rail and sleepers replacement and by improper disposal of wastes, metal garbage and oil stained wooden sleepers will be mitigated by taking/disposing of excavated materials from/at approved sites; collection, transportation in special containers and proper disposal ofwastes during and upon completion of construction phase. d. Impact ofnoise and vibration in residential areas, caused by operation ofthe construction equipment will be mitigated by keeping noise level below maximum permissible level for each type ofequipment.

259. Capacity of ADDY - Azerbaijan State Railways (ADDY) has been a member of the Railway Organization for CIS Countries since 1992. This organization provides guidance to its member countries on environmental matters, spill management and procedures for the transport ofhazardous materials.

260. The Technical and Production Service Department in ADDY is responsible for environmental management including the development and implementation of this EMP, and is based in Baku. They have three staff in their central office that has specific responsibility for environmental management. Environmental issues are managed on a day to day basis through local departments who each have a staff member assigned to environmental matters.

261. The local departments are responsible for the preparation of ‘Ecological Passports’ and action plans for each section of rail line in their district. These passports are issued by the Ministry of Ecology and Natural Resources (MoE) and include limits for pollution. They are renewed every 2 years following MoE audit. The Technical and Production Service Department is responsible for ensure overall compliance with the passport conditions.

79 262. The capacity of ADDY is assessed to be good. They are cognizant of good practices and their responsibilities for environmental management, emergency response and spill management as well as transportation of dangerous goods and wastes. The project will provide training and operational budget required for ADDY to carry out its monitoring functions for this EMP.

263. The TPSD will have primary responsibility for the implementation of the EMP. The TPSD will ensure inclusion of environmental provisions into construction / rehabilitation and locomotive purchase contracts, and will supervise operation of contractor to ensure compliance with the environmental provision of the contracts. The specifications for locomotives should include maximum permissible emissions.

Oil Spill Prevention, Preparedness and Response

264. In 2006, ADDY carried 30.2 million tons of freight. The infrastructure has received limited capital investment over the past decade and significant sections are due for rehabilitation. ADDY’s rolling stock, both freight and passenger, are also aging. ADDY provides a freight transport service to a number of international oil and gas corporations; with 75 percent of ADDY’s freight traffic being oil and oil products. Facilities are old and are prone to accidents.

265. Investments in better spill prevention and response are needed not only for environmental protection but also to support overall sector modernization. To meet the needs of its international customers ADDY needs to be able to respond quickly and effectively in the event on an incident, including oil spills. While ADDY has internal procedures for oil spill response they recognize that these need some improvement to (i)bring them up to international standards (ii)to develop an interface with the emergency response systems of their customers (iii)to ensure that adequate internal resources (staff and equipment) are allocated to implement their response procedures.

266. A study was carried out to review ADDY’s existing oil spill response procedures and capacity to respond in the event of a spill and to outline the steps to be taken to bring this response in line with international standards. This included the preparation of a prioritized and costed (in terms of required manpower) action plan to address the gaps of ADDY’s response capacity, and preparation of a detailed Oil Spill Contingency Plan determining procedures as well as roles and responsibilities for all parties/organizations involved.

267. The study specified measures required to upgrade ADDY’s capacity in such areas as equipment (emergency trains, station refueling infrastructure, rail tanker cars etc.), training of personnel, proper supply and storage of oil spill response materials, and procedures for spill notification and mobilization of response. The project, through a specific component, will provide support to ADDY to address these deficiencies and help bring ADDY’s oil spill prevention and response capacity closer to international standards.

80 Annex 11: Project Preparation and Supervision AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

Planned Actual PCN review 0 1/10/2006 0 1/10/2006 Initial PID to PIC 0 1/19/2006 0 1/19/2006 Initial ISDS to PIC 0 1/19/2006 01/19/2006 Appraisal 05/22/2007 11 /O 1/2007 Negotiations 05/22/2007 1/15/2008 Board/RVP approval 07/12/2007 3/27/2008 Planned date of effectiveness 06/20/2008 Planned date of mid-term review 06/30/20 10 Planned closing. date 06/30/20 12

268. Key institutions responsible for preparation of the project: Ministry of Finance Ministry of Transport Azerbaijan Railways (ADDY)

269. Bank staff and consultants who worked on the project included:

Name Title Unit Gerald Ollivier Task Team Leader ECSSD Martha Lawrence Co-Task Team Leader ECSSD Ahmet Gokce Sr. Procurement Specialist ECSPS Arnaud Delarue Transport Consultant ECSSD Christian Petersen Country Sector Coordinator ECSSD Gaetane Tracz Financial Analyst ECSSD Gulana Enar Hajiyeva Environmental Specialist ECSSD Hadji Huseynov Project Officer ECSSD Hannah Koilpillai Sr. Finance Officer LOA Ida N. Muhoho Sr. Financial Management Specialist ECSPS Jane Ebinger Environmental Specialist ECSSD Juderica Dias Program Assistant ECSSD Junko Funahashi Sr. Counsel LEGEC Nijat Valiyev Infrastructure Specialist ECSSD Olivier Le Ber Program Team Leader-South Caucasus ECSSD Salim Benouniche Sr. Procurement Specialist ECSPS Vusala Asadova Team Assistant ECCAZ Zaur Rzayev Translator ECCAZ

270. Bank funds expended to date on project preparation: Bank resources: US$594,000/Trust funds: US$900,000/Total: US$1,494,000

27 1. Estimated Approval and Supervision costs: 1. Remaining costs to approval: US$50,000 2. Estimated annual supervision cost: US$l00,000

81 Annex 12: Documents in the Project File AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

A. Project Information Document, Appraisal Stage.

B. Environmental Assessment and Management Plan, May 1s',2007.

C. Bank Staff Assessment.

0 Appraisal mission Aide Memoire. 0 Pre-Appraisal mission Aide Memoire. 0 Preparation Mission Aide Memoire.

D. (( Restructuring and Revitalizing the Railways of Azerbaijan)) Study.

0 Inception report, PADECO, June 2006. 0 Marketing report, PADECO, August 2006. Infrastructure and rolling stock renewal reports, PADECO, NovemberDecember 2006. 0 IFRS accounting report, PADECO, November 2006. 0 Restructuring, railway administration, PADECO, March 2007. 0 Business Plan for ADDY, June 2007. 0 Oil Spill Response Study, Briggs Marine, November 2007.

82 Annex 13: Statement of Loans and Credits AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

Difference between expected and actual Original Amount in US$ Millions disbursements Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev’d P100582 2007 REAL ESTATE REG. 30.00 0.00 0.00 0.00 0.00 29.50 -0.33 0.00 PO96213 2007 WATER SUPPLY 230.00 0.00 0.00 0.00 0.00 230.00 5.00 0.00 PO99201 2006 JUDICIAL MOD 0.00 21.60 0.00 0.00 0.00 21.47 -0.94 0.00 PO94488 2006 Highway 2 200.00 0.00 0.00 0.00 0.00 174.01 40.68 0.00 PO94220 2006 Health Sector Reform Project 0.00 50.00 0.00 0.00 0.00 50.97 8.55 0.00 PO90887 2006 ADCP-I1 0.00 29.20 0.00 0.00 0.00 28.30 7.28 0.00 PO89751 2005 IDP ECON DEVT SUPPORT 0.00 11.50 0.00 0.00 0.00 3.56 1.88 2.57 PO83341 2005 POWER TRANSMISSION 48.00 0.00 0.00 0.00 0.00 42.32 25.82 0.00 PO81616 2005 FIN SERVS DEVT 0.00 12.25 0.00 0.00 0.00 11.75 6.48 0.00 PO66199 2005 RURAL ENVIRONMENT 0.00 8.00 0.00 0.00 0.00 7.78 3.31 0.00 PO76234 2004 RURAL INVSMT (AZRIP) 0.00 15.00 0.00 0.00 0.00 4.17 -1.88 0.00 PO49892 2004 PENSION & SOC ASST 0.00 10.00 0.00 0.00 0.00 5.38 4.53 2.43 PO70989 2003 ED SECT DEV (APL # 1) 0.00 18.00 0.00 0.00 0.00 2.17 0.20 0.00 PO08286 2003 IRRIG DIST SYS & MGMT IMPROVMT 0.00 35.00 0.00 0.00 0.00 28.40 10.13 0.00 PO66100 2002 AVIAN FLU (formerly IBTA 2) 0.00 9.45 0.00 0.00 0.00 2.97 -2.07 I .04 PO40716 2001 HIGHWAY 0.00 40.00 0.00 0.00 0.00 1.99 -4.93 -4.93 Total: 508.00 260.00 0.00 0.00 0.00 644.74 103.71 1.11 Difference between expected and actual Original Amount in US$ Millions disbursements Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev’d P100582 2007 REAL ESTATE REG. 30.00 0.00 0.00 0.00 0.00 29.50 -0.33 0.00 PO962 13 2007 WATER SUPPLY 230.00 0.00 0.00 0.00 0.00 230.00 5.00 0.00 PO99201 2006 JUDICIAL MOD 0.00 21.60 0.00 0.00 0.00 21.47 -0.94 0.00 PO944 8 8 2006 Highway 2 200.00 0.00 0.00 0.00 0.00 174.01 40.68 0.00 PO94220 2006 Health Sector Reform Project 0.00 50.00 0.00 0.00 0.00 50.97 8.55 0.00 PO90887 2006 ADCP-I1 0.00 29.20 0.00 0.00 0.00 28.30 7.28 0.00 PO89751 2005 IDP ECON DEVT SUPPORT 0.00 11.50 0.00 0.00 0.00 3.56 1.88 2.57 PO83341 2005 POWER TRANSMISSION 48.00 0.00 0.00 0.00 0.00 42.32 25.82 0.00 PO8 16 16 2005 FIN SERVS DEVT 0.00 12.25 0.00 0.00 0.00 11.75 6.48 0.00 PO66 199 2005 RURAL ENVIRONMENT 0.00 8.00 0.00 0.00 0.00 7.78 3.31 0.00 PO76234 2004 RURAL MVSMT (AZRIP) 0.00 15.00 0.00 0.00 0.00 4.17 -1.88 0.00 PO49892 2004 PENSION & SOC ASST 0.00 10.00 0.00 0.00 0.00 5.38 4.53 2.43 PO70989 2003 ED SECT DEV (APL #1) 0.00 18.00 0.00 0.00 0.00 2.17 0.20 0.00 PO08286 2003 IRRIG DIST SYS & MGMT IMPROVMT 0.00 35.00 0.00 0.00 0.00 28.40 10.13 0.00 PO66100 2002 AVIAN FLU (formerly IBTA 2) 0.00 9.45 0.00 0.00 0.00 2.97 -2.07 1.04 PO40716 2001 HIGHWAY 0.00 40.00 0.00 0.00 0.00 1.99 -4.93 -4.93 Total: 508.00 260.00 0.00 0.00 0.00 644.74 103.71 1.11

AZERBAIJAN

83 STATEMENT OF IFC’s Held and Disbursed Portfolio In Millions of US Dollars Committed Disbursed

IFC IFC FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic. Azerigazbank 3 .OO 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2003 Azerigazbank 0.90 0.00 0.00 0.00 0.90 0.00 0.00 0.00 2006 Azerigazbank 0.00 2.30 0.00 0.00 0.00 0.00 0.00 0.00 1999 Baku Hotel 1.46 0.00 0.00 0.00 1.46 0.00 0.00 0.00 2002 MFB Azerbaijan 0.00 1.60 0.00 0.00 0.00 1.60 0.00 0.00 2006 MFB Azerbaijan 3.00 0.00 0.00 0.00 3.00 0.00 0.00 0.00 2003 Rabitabank 0.90 0.00 0.00 0.00 0.90 0.00 0.00 0.00 UniBank 5.00 0.00 0.00 0.00 2.39 0.00 0.00 0.00 Total portfolio: 14.26 3.90 0.00 0.00 8.65 1.60 0.00 0.00

84 Annex 14: Country at a Glance AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION Europe (L Lower- POVERTY and SOCIAL Central middle- Jevelopment dlamond' ArerbalJan Asla Income 2006 Population, mid-year (millions) 8.5 460 2,276 Life expectancy GNi percapita (Atlas method, US%) 1850 4,796 2,037 GNI (Atlas method, USS billions) 15.7 2206 4,635 Average annual growth, 2000-06 Population (Sy 0.9 0.0 0.9 GNi Gross Laborforce (%J 2.5 0.5 14 Per primary Most recent ertlmate (latest year available, 2000-06) capita enrollment Po varty (%of populatio n below natm naipo vertyline) 50 Urban population (%of total population) 52 e4 47 Life expectancy at birth (pars) 72 89 71 1 Infant mortality (per 1000 live births) 74 28 31 Child m ainut rit io n (%ofchildren under 5) 7 5 Q Access to improvedwatersource Access to an lrnprovadwater source (%ofpopulation) 77 92 61 Literacy (%ofpopulationage ?5+j 97 89 Gross prirnaryenmllment (%ofschool-agepopulation) €3 a2 m -A zerbagan Male 97 u3 m - Lowr-middie-mcome group Female 95 DO M I KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1986 1996 2006 2006 Economic ratios' GDP (US$ billions) .. 3.2 Q.2 20.1 Gross capital formation/GDP 29.0 42.0 37.7 .. Trade Ewrtsof goods and senices/GDP .. 29.5 62.9 72.5 Gross domestic savlngslGDP .. 3.0 52.0 60.8 Gross national savings/GDP .. 3.1 40.9 47.9 Current account balancelGDP .. -25.9 -Q.O -3.2 Interest payments/GDP .. 0.1 0.2 Total debVGDP .. 13.6 14.2 Total debt service/exports .. to 5.2 Present value of debtlGDP n5 Present value of debt/eqmrts 33.5 Indebtedness 1986-96 1996-06 2006 2006 2006-10 (average annual gm Mh) GDP -15.7 9.2 26.4 34.5 9.5 -A zerbailan GDP percapita -6.8 112 25.2 33.1 8.6 Lowr-middle-income gmup Exports of goods and services .. 6.9 46.5 45.5 30.9

STRUCTURE of the ECONOMY

1986 1996 2006 2006 (%of GDP) Agriculture 27 5 DO 8.6 industry 39 1 62 3 67.0 Manufacturing n6 76 Services 33 4 27 7 24.5 Household final consumption expenditure 85 0 36 3 30.3 General gov't final consumption expenditure 120 n6 9.0 Imports of goods and services 55 5 52 9 49.5

1986-96 1996-06 2006 2006 Growth of exports and imports (oh) (average annual gm wth) Agnculture 69 75 6.0 60 T Industry 141 43 4 315 M anufactunng 39 48 services 93 TI6 112 Household final consumption expenditure Q4 n6 8.9 07 02 0-3 04 05 General gov't final consumption expenditure 34 04 3.9 1 I Gross capital formation 28 6 n2 6.7 OSl Imports of goods and services 82 09 37.7

Note: 2006 data are preliminary estimates. This tablewas pmducedfrom the Development Economics LDB database. 'Thediamonds showfourkeyindicators in thecountry(in bold) cornparedwithits income-groupaverage. lf data aremissing,thediamondwill be incomplete

85 Azerbaiian

PRICES andGOVERNMENT FINANCE 1986 1996 2005 2006 /Inflation (Oh) Domestic prices (%change) I2020 T I Consumer pnces 99 95 Implicit GDP deflator 26 4 81 53 10 Government finance 5 (%of GDP. includes current grants) 0 Current revenue 67 876 5 W2266 87,784 1 01 02 03 04 05 06 Current budget balance .8,378 2 18,498.7 8 6910 061 Overall surplusldeficit 13,904 0 769 3 5922

TRADE 1986 1996 2005 2006 Export and import levels (US$ mill.) (US$ millions) 3,697 Totalexports (fob) 789 5 067 16,000 T Crudeoil 3,lV 4 449 Petroleum products 402 Manufactures 286 580 618 Total imports (cif) 1,339 3.84 3 548 Food 382 Fuel and energy 213 1.88 1181 Capital goods 226 00 Oi 02 03 04 05 06 Export pnce index (2000-WO) 71 m3 133 I Import price index (2000=Wo) 115 133 136 exports mlmports Terms of trade (2000=WO) 62 99 97 I

BALANCE of PAYMENTS 1986 2005 1996 2006 Current account balance to GDP (%) (US$ millions) Exports of goods and services 936 4,215 5 69 0 Imports of goods and sewices 1,765 5,003 5 237 Resource balance -827 -788 382 -10 Net income -62 -706 -1156 Net current transfers 67 V3 136 -20 Current account balance -823 -1,321 638 -30 Financing items (net) 771 1,569 1430 I Changes in net reserves 52 -248 791 Memo: ReSeNeS including gold (US$ millions) 1,069,440 899 1028 Conversion rate (DEC,locaUUS$) 09 09 09

EXTERNAL DEBT and RESOURCE FLOWS 1986 1996 2005 2006 Composition of 2005 debt (US$ mill.) (US$ millions) Total debt outstanding and disbursed 438 1,881 IBRD 0 0 5 G: %6 IDA 64 501 583 1 Total debt Service 13 237 IBRD 0 0 1 IDA 0 6 8 Composition of net resource flows Official grants 43 93 Official creditors 47 70 Pnvate creditors 0 9 Foreign direct investment (net inflows) 627 1.680 Portfolio equity(net inflows) World Bank program Commitments 20 92 0 A - IBRD E- Bilataal Disbursements 36 48 65 B-IDA D-Othermitilatad F-Private Principal repayments 0 2 4 C-IMF 0- Short-term I Net flows 36 46 62 Interest payments 0 4 6 Net transfers 35 41 56

Note This tablewas producedfrom the Development Economics LDB database 9/28/07

86 Annex 15: Map AZERBAIJAN: RAIL TRADE AND TRANSPORT FACILITATION

87

45°E46°E47°E48°E49°E To This map was produced by the Map Design Unit of The World Bank. RUSSIAN YalamaYalama The boundaries, colors, denominations and any other information BalakenBalaken shown on this map do not imply, on the part of The World Bank GEORGIA Group, any judgment on the legal status of any territory, or any To To Tbilisi ZagatalaZagatala endorsement or acceptance of such boundaries. Tbilisi FEDERATION

BoyukBoyuk KesikKesik GusarGusar KhachmazKhachmaz GakhGakh To CharkhyCharkhy Vanadzor GubaGuba SalahlySalahly SarvanSarvan To ShekiSheki Vanadzor PoyluPoylu AgstafaAgstafa DevechiDevechi GilgilchayGilgilchay OghuzOghuz GizilburunGizilburun TatlyTatly GazakhGazakh K SiyazanSiyazan ° 41°N ur 41 N TovuzTovuz a ZaratZarat Mingechevir GabalaGabala ZayamZayam GovlarGovlar Reservoir GileziGilezi DellerDeller KhiziKhizi ShemkirShemkir NabiagalyNabiagaly IsmailliIsmailli MingechevirMingechevir To ZazalyZazaly Vanadzor GanjaGanja GoranGoran AgdashAgdash YevlachYevlach GoychayGoychay ShamakhyShamakhy KurakchayKurakchay Caspian Sea GedabayGedabay SumgayitSumgayit KhanlarKhanlar GeranboyGeranboy MalayMalay AlikendAlikend AkhsuAkhsu MarazaMaraza UdjarUdjar KhyrdalanKhyrdalan MususluMususlu GuzdekGuzdek DashkesanDashkesan BilajaryBilajary BardaBarda TartarTartar GarabujagGarabujag HeybatHeybat ARMENIA Lake KyurdamirKyurdamir BAKUBAKU SighirlySighirly KarrarKarrar To Sevan ZardabZardab Sevan PadarPadar GarasuGarasu To MuganMugan Gazi-MammadGazi-Mammad Yerevan KelbadzharKelbadzhar Kura ° 40°N AgdzhebediAgdzhebedi NavahiNavahi 40 N SabirabadSabirabad PirsaatPirsaat AgdamAgdam 50°E51°E KhodzhalyKhodzhaly SaatlySaatly AliAli BayramliBayramli ImishliImishli KhodzhavenoKhodzhaveno ShushaShusha AZERBAIJAN

TURKEY BeilaganBeilagan A SadarakSadarak raz LachinLachin RAIL TRADE AND FizuliFizuli SharurSharur SalyanSalyan TRANSPORT BilasuvarBilasuvar FACILITATION PROJECT GubadlyGubadly ADDY FREIGHT ONLY TRAFFIC DENSITY A ShakhbuzShakhbuz NeftchalaNeftchala ra DzebrailDzebrail z (Million Gross Tons Per Kilometer)

NAKHCHIVANNAKHCHIVAN JalilabadJalilabad To ZangilanZangilan 0.4 Salmas BabekBabek 0.8 MasallyMasally 6 ° 17 39 N ° DzhulfaDzhulfa 39 N EAST/WEST LINE SECTIONS TO BE REPAIRED OrdubadOrdubad UNDER THE PROJECT YardymlyYardymly To Tabriz SELECTED TOWNS To LerikLerik Tabriz LenkoranLenkoran RAYON CAPITAL

To CAPITAL OF AUTONOMOUS REPUBLIC Tabriz NATIONAL CAPITAL AstaraAstara RIVERS 0 10 20 30 40 50 Kilometers To ISLAMIC REPUBLIC IBRD 35177R OCTOBER 2007 PORTS

0 10 20 30 40 50 Miles OF IRAN MAIN ROADS RAILROADS

45°E 46°E47°E48°E49°E INTERNATIONAL BOUNDARIES