PROJECT INFORMATION DOCUMENT (PID) CONCEPT STAGE Report No.: 39111 Project Name Alchevsk Steel Mill Revamping and Modernization Region EUROPE AND CENTRAL ASIA

Public Disclosure Authorized Sector Other industry (100%) Project ID P101615 Borrower(s) OJSC ‘Alchevsk Iron and Steel Works’ Implementing Agency OJSC ‘Alchevsk Iron and Steel Works’ Shmidt str.4 Alchevsk Lugansk Region P.O.94202 Tel: +38-06442-9-33-01, +38-06442-9-32-10 Email: [email protected] Environment Category [ ] A [X] B [ ] C [ ] FI [ ] TBD (to be determined) Date PID Prepared January 30, 2007

Public Disclosure Authorized Estimated Date of Review April 10, 2007 of CFEM Estimated Date of ERPA June 29, 2007 Signing

1. Key development issues and rationale for Bank involvement

After a decade of economic decline following the collapse of the Soviet Union, Ukraine entered a period of strong growth and macroeconomic stability showing the highest GDP growth rates in Europe – average of 8.4% per annum between 2000 and 2004. With inflation under control, Ukraine achieved significant poverty reduction reporting some of the lowest poverty levels in the region. Democratic transformation of the country initiated in 2004 opened new opportunities for Public Disclosure Authorized economic growth and foreign investment as new government declared Euro-Atlantic integration the main policy priority. However, economic slowdown started beginning 2005, with GDP growth declining to 2.6% in 2005. Inflation increased to over 10% per annum due to an expansive monetary policy and increased social payments. Ukraine is an export-driven economy with an export reaching nearly 52% of GDP. The main exporters are traditional energy and resource intensive heavy industries – steel, chemical and machine building. The industrial revival in early 2000s has been triggered by the favorable international trade situation with the growing demand and therefore rising steel prices, and subsidized fuel costs. Until the new gas deal with Russia early 2006, Ukraine has been able to benefit from the low cost of gas imports, providing an implicit subsidy to the economy in the order of 2.5% of GDP. The gas subsidy, however, encouraged energy waste and the growth of shadow economy, accounting for up to 40% of the Ukrainian economy, according to some

Public Disclosure Authorized estimates. Energy intensity of Ukraine is several times higher than in developed countries with industrial sector consuming 22 times more gas than Germany on a GDP basis. Ukraine’s labor force is among the lowest paid in Europe with the share of salaries in the cost of end production only about 10% comparing to the 60% in OECD countries. Additionally, the Ukrainian industry did not have to bear significant environmental protection costs. High costs of pollution inflicting health damage and extensive degradation of natural ecosystems were absorbed by the public, particularly in the Eastern regions (Luhansk, Donetsk, Zaporizhzhia, Dnipropetrovsk oblasts), where the largest industrial enterprises are located. However, its mainly due to its rich and cheap iron ore deposits, the steel sector is one of the Ukraine’s most competitive sectors, accounting for 36% of total Ukrainian exports and 25% of industrial production. Ukraine is the seventh largest steel producing country in the world and the third largest exporter after Japan and Russia. It exported 74% of its domestic production in 2004. The city of Alchevsk is one of the biggest industrial centers of the Luhansk oblast and Donbas region (Eastern Ukraine). It is situated in the northwest of the Luhansk oblast, 45 kilometers from the city of Luhansk. Alchevsk’s territory is 50 square kilometers and population 118 thousand people. The largest metallurgy enterprises situated in the city are OJSC ‘Alchevsk Iron and Steel Works’ (AISW; employing 24 thousand people) and OJSC ‘Alchevsk Coke Plant’, and it has a number of plants producing construction materials and units, concrete products, and other industrial products. The volume of production in Alchevsk comprises over 25% of the industrial output of the entire Luhansk oblast. Among the main products produced by the two metallurgical giants are cast iron, steel, rolled metal, coke, and sulphuric-acid. While one of the more modern integrated steel works in Ukraine, AISW was fairly typical of the sector up to 2004 in terms of the vintage of technologies and physical plant used, and the characteristic high resultant energy intensity and poor general environmental performance relative to comparable facilities in OECD countries. When management of the AISW made the decision to proceed with an upgrade of the plant to increase the production capacity, the utilization of existing technology was viewed as a natural baseline. The existing technology was available, well known at the company and had lower initial investment costs than other more efficient technologies. In 2003, however, the company made a decision to explore the potential benefits of the Kyoto Protocol and in addition to production capacity increase introduce energy efficiency measures. The possibility of using the Kyoto mechanisms gave incentives for investigation into energy efficiency because it provides AISW with an opportunity to receive additional financial resources and to shorten the period of credit repayment. AISW’s main shareholder – Industrial Union of Donbas – owns a number of industrial enterprises in Ukraine. The group has also acquired steel plants in Hungary and Poland that facilitate access to EU export market.

2. Proposed objective(s)

The objectives of the project are to: i) generate and sell greenhouse gas (GHG) emission reductions (ERs) and transfer ERs as Emission Reduction Units (ERUs) to buyers under Joint Implementation (JI) mechanism by modernization of the steel making capacity in AISW, and ii) support investment in technology modernization that improves process and energy efficiency and environmental performance through significant reductions in local air emissions and wastewater discharges. Thus, the project will help towards achieving environmental sustainability, which is among the Ukraine’s CAS objectives. The World Bank assistance to Ukraine in profiting from the opportunities provided by the Kyoto Protocol is also highlighted in the CAS Progress Report 2004-2007. 3. Preliminary description

The proposed carbon finance project is an integral part of the extensive and comprehensive modernization program carried out by AISW since 2004 with the aim of applying more efficient technologies, improving environmental performance, process efficiency, increasing capacity and upgrading the quality and range of steel produced.

This comprehensive modernization program involves technology replacement or upgrade of all major components of the iron making and steel making and finishing processes. Its initial focus has been on steel production with the replacement of the old open hearth furnaces (OHF)1 with two modern basic oxygen furnaces (converters) integrated with continuous slab casters to replace the existing blooming mill. The first phase of this, involving installation of one converter, ladle furnace and continuous slab casting line, is at its final stage of completion along with upgrading of waste water treatment and recirculation infrastructure. In addition, one of four blast furnaces is currently under reconstruction. The second converter and continuous slab casting line is also currently under construction with addition of ladle furnace upgrades and vacuum degassing capability. Associated with the current work there are modernization and, specifically, installation of fugitive emission capture capability in ore handling, construction of two new lime kilns to replace existing facilities, all of which are due for completion in 2007. Downstream upgrading of rolling mill operations is also being undertaken. Planned but as yet uncommitted are other major upstream investments involving replacement of the existing sinter machines with new higher capacity machines and upgrading of the remaining three blast furnaces. The overall capacity of the plant expressed as steel production will increase from 3.6 million tons/year to 6.9 million tons/year, including 5.3 million ton within the boundaries of the proposed project.

The proposed carbon finance project will target only part of the above modernization program. Project boundaries include replacement of the current steelmaking system of open hearth furnaces (OHF) by modern LD converters, as well as the substitution of the current casting system, ingot casting and blooming mill, by a modern continuous slab caster. The proposed project comprises following measures:

• Elimination of existing old Open Hearth Furnace and Blooming Mill • Installation of two LD Converters • Installation of a twin ladle furnace (300 t / 50 MVA) • Installation of a Vacuum Tank Degassing Plant • Installation of 2 Continuous 2-strand Slab Casters • Reconstruction and installation of new oxygen blocks

The GHG reductions that are obtained from the steel making component investments are estimated to average 934 thousand tons CO2 eq./year over a five year crediting period, or 4.67

1 The 600 MT tandem OHF/bloom caster installed in 2005 which is equipped with modern air pollution control equipment is to be retained million tons in total (down from 8.6 million originally estimated in the PIN). Emissions reductions will result principally from: i) reduced use of natural gas in open heart furnaces in comparison with converters; ii) reduced use of blast furnace gas in blooming mill with saved gas being utilized in an existing on site combined heat and power plant to replace natural gas and grid electricity; and iii) reduced use of raw materials, energy and steel in converters and continuous casting.

Complex financing structure of currently committed components of the modernization program consists of several lending facilities and financial institutions, including IFC that extended a US$100 million direct loan and arranged a syndicated loan facility in the amount of US$250 million. A separate investment in a new combined cycle gas turbine plant to utilize recovered off gases for on site heat and power generation is also being developed with EBRD participation, and may be subject to separate JI carbon financing.

4. Safeguard policies that might apply

The safeguard policy, OP 4.01: Environmental Assessment, Category B, would be triggered by proposed project activities.

The net local environmental impact in terms of total mass of emissions of local air pollutants, discharges to water and waste generation per year will depend on whether the effect of doubling the overall production capacity will be offset by the improvements in emissions per unit of output due to replacing of old polluting technologies. This issue would apply both within the carbon finance boundary (steel making processes) and also to upstream and downstream processes/infrastructure that would require expansion and/or greater utilization to support increased steel production capacity. The concern relates primarily to air emissions recognizing the poor baseline local air quality in Alchevsk.

Based on a preliminary environmental safeguards review, it is anticipated that the overall modernization program being undertaken by IUD/AISW will provide significant improvement in the overall environmental performance of the beneficiary, including reduction of local pollution with potential public health benefits to the citizens of Alchevsk. Notwithstanding its significant global environmental benefits, the proposed carbon finance project itself in the absence of or prior to the planned upstream investments is essentially neutral in terms of local environmental impact. It is expected to bring a slight reduction in total air emission, net improvement in water consumption and quality, but an increase in solid waste generation (albeit non-hazardous). As a consequence, achievement of the expected long term positive impact on local environmental conditions despite the increased production is conditional upon the implementation of planned modernization investment upstream of the steel making processes and upon ensuring that the technology applied meets the World Bank Group environmental guidelines and approximates the EU guidelines for the best available techniques (BAT) prepared under the IPPC Directive. This includes modernization of the sinter plant as the major overall source of particulate emissions, as well as revamping of the blast furnace and the coke batteries at Alchevsk Coke. Consistent with the approach adopted by IFC, the project conditionality needs to reflect these requirements.

In assessing this impact for purposes of screening the project and determining the Category to be applied, the Project team will carefully review environmental audit of the company conducted for the IFC loan, IFC environmental review and environmental management plan (Environmental Corrective Action Plan) included in IFC loan agreement, as well as environmental assessments provided by the project sponsor and required under Ukrainian legislations. These sources will be verified and updated as necessary using site visits as well as interviews with AISW staff and project developers.

Neither the proposed carbon finance operation, nor the overall investment program will require any expansion on the new land area. All investments are being undertaken within the enterprises existing boundaries. As such it will not trigger any involuntary resettlement from adjacent residential areas. However, the Bank team takes note that the IFC assessment indicates that historical residential development exists in the pre-existing sanitary protection zone around AISW’s facilities. It originated in the soviet times where AISW was a state owned enterprise and was one of the “regulatory fictions” common in Soviet Union that were never intended to be enforced by authorities. Recognizing that although unlikely, theoretically re-settlement of this population could be required, the Environmental Corrective Action Plan adopted as a condition of the IFC loan seeks to have this zone reduced through agreement with authorities after completion of the overall investment program will improve environmental performance. This essentially aims to mitigate potential future resettlement. In any case, the project does not directly seek to strengthen enforcement capacities of the government for such action. During the safeguards review meeting the team was advised to track probability of enforcing relocation from the future smaller and cleaner sanitary zone. If it continue to be low, than the appraisal stage ISDS will indicate that the O.P 4.12 is not triggered.

5. Tentative financing

Source: (US$Million) Borrower, 944 including loans 661 including equity 283

The project, costing about $943.7 million, will be financed 30 percent with equity and 70 percent with borrowing. In recent years the company was able to raise impressive amount of investment credit by Ukrainian standards. In 2003, when the decision to implement the project was taken by the AISW, attracting large and long-term investment finance posed enormous challenge. Since that time the Euro 140M trade finance package was arranged to purchase new production equipment by the Swiss trading company and Euro 350 million 3-years finance facility was syndicated by Societe Generale. A year later IFC followed with the long term US$100 million direct loan and 250 million syndicated lending facility for the purpose of implementing capital expenditure program. Last year additional US$ 200 million was raised from the consortium of Ukrainian commercial banks and IUD increased its share capital in AISW by US$ 200 million and is now planning to issue Eurobonds for the next phase of CAPEX. Average cost of financing is estimated at 9% as majority of lines have floating rates arrangement and tied to LIBOR. Normally structured finance lines used offer 10 years tenor. The evolution of the debt structure raised se far reflects a growing confidence of financial institutions in AISW and its shareholder IUD.

Sale of ERUs is expected to generate a stream of payments during project operation averaging US$14 million per year, to be received by IUD from 2008 through 2012 (US$70 million total). The ERUs purchases and prices will be negotiated with the buyers. Of the total amount of ERUs, only 1 million ton (about 20%) will be sold to NECF (the Netherlands European Carbon Facility). The purchase price by NECF is indicatively set at a level below the expected average sale price as NECF absorbs project development and determination risks. Other buyers are expected to be willing to pay more for lower risk once the project is successfully determined and ERPA is signed with NECF through the World Bank.

Implementation of the project is financially attractive to AISW, but the rehabilitation of currently used dirty technologies (OHFs and ingot casters) is more financially attractive and less risky. As shown in the financial analysis, the FIRR in baseline scenario is higher, financing is easier, and therefore this scenario would have been chosen under common practice. Moreover, the identified barriers, discussed in financial analysis, would prevent project owner from carrying out the proposed project activity without considering carbon finance. IUD has chosen a long term perspective on investment that is still uncommon practice in a relatively risky business environment in Ukraine. Incremental early cash flow from carbon finance has been an important risk cushion making this investment feasible, and overall improvement of environmental performance another important motivating factor. In this context carbon finance has triggered the emission reductions that otherwise would not have taken place.

6. Contact Person: Grzegorz Peszko Senior Environmental Economist, ECSSD Europe and Central Asia Region The World Bank 1818 H Street N.W., Mail H5-503 Washington, DC 20433 USA [email protected] Phone: (1-202) 473-4767 ______Cleared by SM: Marjory-Anne Bromhead