Country Assistance Program Evaluation: Azerbaijan, 2011–2017

Country Assistance Program Evaluation Azerbaijan, 2011–2017

Independent Evaluation

Raising development impact through evaluation

Country Assistance Program Evaluation December 2018

Azerbaijan, 2011–2017

This document is being disclosed to the public in accordance with ADB’s Public Communications Policy 2011.

Independent Evaluation: CE-35

NOTES

(i) In this report, “$” refers to United States dollars. (ii) For an explanation of rating descriptions used in Asian Development Bank (ADB) evaluation reports, see ADB. 2015. 2015 Guidelines for the Preparation of Country Assistance Program Evaluations and Country Partnership Strategy Final Review Validations. Manila.

Director General Marvin Taylor-Dormond, Independent Evaluation Department (IED) Deputy Director Véronique Salze-Lozac'h, IED General Director Walter Kolkma, Thematic and Country Division, IED

Team leaders Joanne Asquith, Principal Evaluation Specialist, IED Kapil Thukral, Principal Evaluation Specialist, IED Marco Gatti, Principal Evaluation Specialist, IED (until July 2018) Team members Ed Alfred Abrahm Alvinez, Evaluation Assistant, IED Glennie Castillo, Evaluation Analyst, IED Lauren Hauck, Senior Evaluation Specialist, IED Alvin Morales, Senior Evaluation Officer, IED Tomoo Ueda, Principal Evaluation Specialist, IED Lucille Ocenar, Evaluation Officer, IED (until July 2018)

The guidelines formally adopted by the Independent Evaluation Department on avoiding conflict of interest in its independent evaluations were observed in the preparation of this report. To the knowledge of Independent Evaluation Department management, there were no conflicts of interest of the persons preparing, reviewing, or approving this report.

In preparing any evaluation report, or by making any designation of or reference to a particular territory or geographic area in this document, the Independent Evaluation Department does not intend to make any judgments as to the legal or other status of any territory or area.

Abbreviations

ADB – Asian Development Bank ADIF – Azerbaijan Deposit Insurance Fund AZN – Azerbaijani manat CAPE – country assistance program evaluation CAREC – Central Asia Regional Economic Cooperation COBP – country operations business plan CPS – country partnership strategy CPSFRV – country partnership strategy final review validation CSF – Countercyclical Support Facility CSPU – country strategy and program update ESG – environmentally sustainable growth FIMSA – Financial Market Supervisory Authority GDP – gross domestic product IDP – internally displaced persons IED – Independent Evaluation Department IEG – inclusive economic growth IFI – international finance institution IMF – International Monetary Fund km – kilometer kV – kilo-volt m3 – cubic meter MFF – multitranche financing facility MSMEs – micro, small, and medium-sized enterprises NAR – Nakhchivan Autonomous Region NSO – nonsovereign operations O&M – operations and maintenance OCR – ordinary capital resources PBL – policy-based lending PCG – partial credit guarantee PCR – project completion report PPP – public–private partnership PSM – public sector management RCI – regional cooperation and integration SAWMC – State Amelioration and Water Management Committee SGC – Southern Gas Corridor SMEs – small and medium-sized enterprises SOE – state owned enterprises SOFAZ – State Oil Fund of Azerbaijan SPPRSD – State Program on Poverty Reduction and Sustainable Development SRNEP – Strategic Roadmaps on National Economic Perspectives TA – technical assistance TFP – trade finance program WSS – water supply and sanitation WUS – water and other urban infrastructure and services WWTP – wastewater treatment plant

Contents

Page

Acknowledgments vii Evaluation in Brief ix Executive Summary xi Management Response xxi Chair’s Summary: Development Effectiveness Committee xxv

Chapter 1: Country Program and Evaluation Methodology 1 A. Country Program and Portfolio 2 B. Scope and Methodology of the Evaluation 5 C. Summary 7

Chapter 2: Country Context and Development Needs 9 A. Macroeconomic Developments 10 B. Poverty and Regional Inequality 14 C. Economic Diversification 17 D. Environmental Sustainability 19 E. Future Challenges 19 F. Summary 21

Chapter 3: Development Strategies and ADB Support 23 A. Government of Azerbaijan Development Strategies and Borrowing Policy 24 B. ADB’s Strategies in Azerbaijan and Responsiveness 26 C. Previous Country-Level Evaluations of ADB and Partner Experience in 29 Azerbaijan D. Summary 30

Chapter 4: Sector Program Performance 31 A. Energy Program 32 B. Transport Program 36 C. Water and Other Urban Infrastructure and Services Sector Program 39 D. Public Sector Management Operations 42 E. Nonsovereign Operations 45 F. Summary 48

Chapter 5: Strategic Agendas and Country Priorities 51 A. Inclusive Economic Growth 52 B. Regional Cooperation and Integration 55 C. Environmentally Sustainable Growth 56 D. Diversification and Capacity Development 58 E. Summary 60

Chapter 6: Summary, Lessons, and Recommendations 61 A. Summary of Assessments 62 B. Lessons 66 C. Recommendations 67

APPENDIX 69

1. List of Linked Documents

A. Azerbaijan Loans, Guarantees, and Technical Assistance Portfolio Covered by the Evaluation, 2011–2017 B. Energy Sector Program Assessment

C. Transport Sector Program Assessment D. Water and Other Urban Infrastructure and Services Sector Program Assessment E. Public Sector Management Program Assessment F. Nonsovereign Sector Program Assessment

Acknowledgments

This report was prepared by an independent evaluation team led by Marco Gatti (until July 2018) and thereafter by Joanne Asquith and Kapil Thukral. The evaluation team included Lauren Hauck (nonsovereign operations), Lucille Ocenar (public sector management), Tomoo Ueda (water and other urban infrastructure and services), Alvin Morales, Glennie Castillo, and Ed Alfred Abrahm Alvinez. Kapil Thukral also led the evaluation’s energy sector program performance assessment. Marvin Taylor-Dormond, Director General; Véronique Salze-Lozac’h, Deputy Director General; Walter Kolkma, Director, Thematic and Country Division provided overall guidance; and Nathan Subramaniam, Director, Sector and Project Division, also provided inputs.

International consultants included Jaime Jaramillo Vallejo (lead consultant), Charles Melhuish, and Robert Schenck. National consultants were Afsun Alakbar, Laura Bakhtizina, Tarana Jafarova, Farrukh Najafov, and Elshan Rustamov. Zulfiya Safarli provided translation and interpretation services for both missions.

Special thanks also go to Asian Development Bank staff for the time given to meet and discuss issues with the evaluation team, as well as staff of the Azerbaijan Resident Mission, Aziz Haydarov, and Nariman Mannapbekov for facilitating our missions and arranging meetings and field visits.

The Independent Evaluation Department retains full responsibility for this report.

Independent THE EVALUATION IN BRIEF Evaluation

Country Assistance Program Evaluation for Azerbaijan, 2011–2017

RECOMMENDATIONS This evaluation assesses Asian Development Bank (ADB) support to Azerbaijan during 2011-2017. The evaluation found that the program had strengths in project delivery and Strategic macroeconomic support but was weak in other areas. ADB 1. The ADB program should have a needs to use a more cohesive approach in providing support greater focus on building human with emphasis on building human and social capital relative and social capital in parallel with to infrastructure and policy reform development, and a developing and improving physical wider range of instruments and modalities in crafting a new infrastructure and supporting policy country strategy in the context of the government’s decision reform. to limit external borrowing. ADB also needs to increase due diligence and do better preparatory work to improve 2. ADB should use a broader range of its project implementation and expand its policy dialogue instruments and modalities as part of a across sectors to support economic diversiication including new strategy in Azerbaijan. greater proactive involvement in private sector operations. 3. ADB support for the diversiication A consultation mission with Azerbaijan authorities on a of the economy must include more draft of the evaluation in December 2018 conirmed the analytical work, a focus on the non- indings, assessments, and issues raised in the report. oil tradeable sectors, and a more proactive involvement in private PORTFOLIO sector operations in Azerbaijan beyond simple onlending operations. ADB’s lending portfolio was valued at $3.9 billion for sovereign operations and $1.2 billion for nonsovereign Operational operations. Of the total funding, 42% was provided to the energy sector to improve power transmission and 4. ADB should step up its due diligence distribution, as well as new power generation and gas and preparatory work for its operations ield expansion that will take Azerbaijan’s gas to European to handle expectations properly and markets; 27% was provided to the transport sector which avoid delays or failures, especially in included two multitranche inancing facilities for the road transport operations. sector, and a very recent railway sector development 5. ADB should expand its policy program comprising a policy-based loan and an investment dialogue, drawing on the iterative loan; 15% was provided for improvement of public sector and interpersonal approach that has management although it was added only at the end of the proved valuable in areas such as iscal evaluation period; 12% was for water supply, sanitation and and tarif reform. urban development; and 4% for the inance sector, mostly from nonsovereign operations. Multitranche inancing facilities, which used 47% ADB’s safeguarding of the environmentally of sovereign funding, initially were the modality of sustainable growth agenda in investment projects, choice in the three infrastructure sectors—energy, such as in energy distribution, led to lower transport, and water and sanitation. They helped emissions. ADB was also found to have explored signal ADB’s commitment to a sector but faced with the government options on renewable some problems. energy, an exercise that led to a dialogue on the tarif structure and the regulations needed to ADB activities and interventions over 2011–2017 make renewable energy attractive for private were guided by seven key strategic documents, all investors. Yet ADB did not pursue environmentally of which were found aligned with the country’s own sustainable growth as actively as it pursued other strategies: one country partnership strategy and six corporate agendas, such as inclusive economic country operations business plans. growth and regional cooperation and integration.

ADB’s main multilateral and bilateral development ADB was one of the few development partners partners in Azerbaijan regard ADB’s cooperation supporting the authorities’ structural reforms. during the country assistance program evaluation ADB’s support focused on the necessary period as constructive and helpful. conditions for economic diversiication, particularly the medium-term iscal framework. While much PERFORMANCE remains to be done for these reforms to bear fruit, ADB’s presence has helped the government stay All sovereign sector programs were assessed as the course. successful by the evaluation, with the energy and public sector management programs obtaining LESSONS good scores on all criteria used, while the transport program was successful despite being less than n ADB's greatest efectiveness is achieved efective and less than eicient, and the water when capacity building and infrastructure supply and sanitation program being successful but development or policy reform come together. less than eicient. The nonsovereign operations program was borderline less than successful, falling n When the government borrowing policy just below the cutof for a successful rating. changes (a near complete stop to external borrowing being enforced at present) and when RESULTS there is a consequent need for ADB to venture outside of the infrastructure sectors, then this The evaluation found that ADB’s contribution to generally requires applying a broader range of inclusive economic growth was relevant and had support instruments and modalities. satisfactory development impact, though very little statistical evidence was found to establish the n The pursuit of economic diversiication calls for extent to which ADB fostered inclusive growth by detailed analytical work and a sizable reliance reducing regional development disparities. on private sector operations.

ADB’s work on regional cooperation and integration n ADB’s experience with policy dialogue on tarifs in Azerbaijan was found relevant because of the and the iscal framework with Azerbaijan’s signiicant potential beneits accruing from further authorities shows that joint solutions can be integrating Central Asia, as well as the public goods found. issues in the region. The evaluation saw it as highly impactful.

Evaluation in Brief is a handy, two-page quick reference designed to feed findings Contact Us and recommendations from independent evaluations to a broader range of clients. [email protected] | www.adb.org/evaluation

Executive Summary

The Asian Development Bank (ADB) program in Azerbaijan over 2011–2017 consisted of 47 lending and nonlending operations totaling $5.1 billion: 21 sovereign loans and guarantees, 10 nonsovereign loans, and 16 technical assistance projects.

The evaluation finds the program successful, with strengths such as proactive engagement and support for macroeconomic policy reform outweighing weaknesses in some other areas. The main sector programs in energy, transport, water and other urban infrastructure and services, and public sector management were all found successful, although the large transport program was found successful on the borderline, on account of weaker effectiveness and efficiency especially in earlier years. ADB’s five special priorities for the Azerbaijan program in (i) inclusive economic growth and reduction of regional disparities, (ii) environmentally sustainable growth, (iii) regional cooperation and integration, (iv) economic diversification, and (v) capacity development were all relevant and impactful, with regional cooperation and capacity development work even rated as highly impactful.

Strategic recommendations. ADB should take a more integrated view of its support, with a greater focus on building human and social capital in parallel with developing and improving physical infrastructure and supporting policy reform. Where ADB has had its greater success, it has been where these elements have come together. Considering the limitations imposed by the government’s decision to refrain from new external borrowing for a period, ADB should use a broader range of its instruments and modalities as part of a new strategy in Azerbaijan. ADB support for the diversification of the economy must include more analytical work, a focus on the non-oil tradable sectors, and a more proactive involvement in private sector operations beyond simple onlending operations. For this to be successful, however, ADB will have to bolster its private sector operations presence in Baku.

Operational recommendations. ADB should step up its due diligence and preparatory work for its operations to handle expectations properly and avoid delays or failures, especially in transport operations. The experience from the evaluation period suggests that outcomes would have been much better if project delays in energy, transport, and water and other urban infrastructure and services had been avoided. In nonsovereign operations, detailed monitoring is imperative to adequately assess the systemic risks facing banks and other potential clients. ADB should expand its policy dialogue, drawing on the iterative and interpersonal approach that has proved valuable in areas such as fiscal and tariff reform.

A consultation mission with Azerbaijan authorities on a draft of the evaluation in December 2018 confirmed the findings, assessments, and issues raised in the report.

Overall Program through PSM operations (15% of the total portfolio), responded to Azerbaijan’s economic The Asian Development Bank (ADB) crisis. Nonsovereign operations (NSO) supported supported Azerbaijan during 2011–2017 with infrastructure and targeted diversification a sovereign lending portfolio valued at $3.9 initially and moved to onlending through banks billion, and a nonsovereign operations until the crisis hit the financial system. No new portfolio of $1.2 billion. The total portfolio NSO projects were approved in 2017. financed infrastructure in the energy, transport, and water and other urban infrastructure and Evaluation Methodology services (WUS) sectors, as well as public sector management (PSM) at the time of the recent The country assistance program evaluation economic crisis, and support to other sectors (CAPE) provides the Board of Directors and through the financial system. Energy was the Management with an independent largest sector supported, accounting for 42% of assessment of the ADB-supported program in financing and transport was the second largest Azerbaijan during 2011–2017. The evaluation with 27%. ADB support for economic reform follows the CAPE Guidelines of 2015 and uses a

xii Country Assistance Program Evaluation for Azerbaijan, 2011–2017

mixed-method approach with both qualitative The sharp drop in world oil prices, by almost and quantitative assessments. The evaluation 55% from June 2014 to October 2016 also takes a matrix assessment approach, by changed Azerbaijan’s macroeconomic assessing relevance and development impact of performance for the worse. The situation was the implementation of the three strategic amplified by the downturn in trading partners agendas of Strategy 2020—inclusive economic that were also oil-dependent. These growth (IEG), regional cooperation and developments resulted in lower or negative integration (RCI), and environmentally growth rates, fiscal imbalances, devaluations of sustainable growth (ESG), as well as two special the Azerbaijan manat, and finance sector priorities (drivers of change) relevant to the instability. Higher dollarization and a financial Azerbaijan program—economic diversification crisis led to a credit crunch. Also, public debt and capacity development. Sovereign sector rose on account of a bailing out of a major programs were assessed for their relevance, public bank, the government’s investments in effectiveness, efficiency, sustainability, and the Southern Gas Corridor (for the expansion of development impact; while NSO were assessed the Shah Deniz gas field), and the financial for their development results and ADB’s support given to state-owned enterprises investment profitability, additionality, and ADB (SOEs). The situation became more testing after work quality. major rating agencies downgraded Azerbaijan’s credit rating. The government reacted by The main evaluation questions are anchored dampening the downturn and initiating reforms on a theory of change underlying ADB’s needed to curb Dutch disease. These efforts strategies, results frameworks, and programs together with stronger fossil fuel prices in world for Azerbaijan in 2011–2017. The theory of markets stabilized the economy in 2017 and change is based on the objective of diversifying helped resume modest growth. the economy, which has been a central theme in the strategies of both the government and ADB Progress in poverty reduction has been throughout the evaluation period. The questions impressive, but large disparities persist explore whether (i) the choice of sector between sectors and regions. Rapid growth, programs helped diversify economic activity, (ii) high wage increases, growing employment, and the programs helped reduce regional heavy public spending on pensions and social development disparities, (iii) ADB was well protection programs contributed to a reduction positioned to support economic and policy in overall poverty from almost 50% in 2001 to reform, and (iv) multitranche financing facilities about 5% in 2013. However, most of the poor (MFFs) were the appropriate instrument to (61%) live in rural areas, and the poverty rate in support infrastructure development. rural areas was nearly twice that in urban areas in 2012 (8.0% versus 4.5%). At the same time, Country Context poverty varies widely across regions from more than 14% in the city of Lankaran to 2% or less in Azerbaijan’s economy is dominated by the Baku, the capital, and Nakhchivan. Internally hydrocarbons sector, with production displaced persons are a particularly vulnerable accounting for 75% of the growth of gross group, with a poverty rate of about 18%. domestic product (GDP) and 90% of exports. Fiscal policy is tied to hydrocarbon revenues, The policy environment has hampered leading to procyclical macroeconomic policies. economic diversification. Policies have led to Consequently, the economy grew at an average more rapid growth in non-tradable sectors than of 10.6% per year at the time of high oil prices in tradable sectors, except in the oil crisis years 2006–2014, boosting per capita gross domestic when the Azerbaijan manat depreciated product (GDP) from $663 in 2000 to $7,991 in markedly. Policies aimed at fostering the most 2014. Meanwhile, pent-up domestic spending of competitive non-oil tradable sectors have only oil revenues led to a significant appreciation of shown some degree of success in agriculture. All the Azerbaijan manat in real terms and a non-oil exports reacted favorably to the shrinking of the relative size of the non-oil devaluation of the national currency in 2015. tradable sector of the economy (Dutch disease). These developments show that Azerbaijan’s Executive Summary xiii economy has become increasingly dependent on The government’s borrowing policy has public spending associated with oil and gas changed with recent developments. With the revenues, which is the main source of demand increase in the debt-GDP ratio during the crisis, for the non-tradable sectors. Furthermore, the government’s borrowing policy changed. In diversification toward non-tradable sectors is April 2018, the President announced a new unlikely to absorb a large share of the growing policy, which was formalized on August 2018, labor force. targeting maintaining the debt-GDP ratio at 30% at most in 2018–2025, and 20% thereafter. Besides Dutch disease, Azerbaijan faces other The policy explicitly allows for some ADB challenges in diversifying its economy in a operations, including the second policy-based way that gives opportunities to young loan of the PSM programmatic series, and the people. These include a legacy of structural railway projects. Nevertheless, the government issues that hampers private enterprise remains interested in exploring greater private development, weaknesses and rigidities in labor sector participation in the provision of public markets, and low capacity and productivity in a services. Under these conditions, ADB’s large segment of the labor force. An additional engagement with Azerbaijan will have to be constraint stems from the frailty of capital creative and resort to a wider set of lending markets, and the constraints on financing instruments. imposed by the crisis in Azerbaijan’s finance sector. ADB Strategies

The government has made some progress in ADB activities and interventions during 2011– making growth environmentally sustainable, 2017 were guided by seven key strategic but challenges remain. The government has documents—one country partnership supported global and regional environmental strategy and six country operations business initiatives and worked on water supply, and solid plans—all of which were aligned with the waste management. Yet the legacy of the Soviet country’s own strategies. In addition, era weighs heavily, and challenges remain immediately before the evaluation period, the regarding desertification, endangerment of Azerbaijan country strategy and program some species, other threats to biodiversity, high update, 2006 provided strategic guidance for levels of air pollution, other industrial pollution, operations. In line with the country’s strategies, and water source contamination. ADB operations have remained anchored in the shared long-term objective of diversifying the Azerbaijan’s Strategies and Borrowing Policy economy by boosting the non-oil sectors. Both the focus areas and the primary sectors were Since the beginning of the oil boom in 2004, fully aligned with the government’s strategies, the government has defined its economic while ADB’s cross-cutting themes and drivers of and development strategy in several change have also been broadly in line with documents. These are the 2004 Long-Term government’s strategies. Strategy on the Management of Oil and Gas Revenues; the State Program on Poverty The main multilateral and bilateral Reduction and Sustainable Development 2008– development partners in Azerbaijan regard 2015; Azerbaijan 2020: Vision for the Future ADB cooperation during the evaluation (“Vision 2020”) in 2012; and, at the time of the period as constructive and helpful. The crisis, the Strategic Road Map on the National partners worked to exploit synergies where they Economy Perspective, 2016–2025. Two themes saw them. However, the 2011 advice from the that are repeated in these strategies are the need International Monetary Fund to delink fiscal to (i) diversify the economy and foster the non- policies from world prices to avoid procyclical oil economy, and (ii) develop infrastructure to macroeconomic policies was not heeded in time improve the quality of life and enable economic by the government or the development partners. diversification. Multitranche financing facility. MFFs, which accounted for 47% of the portfolio, initially were xiv Country Assistance Program Evaluation for Azerbaijan, 2011–2017

the instruments of choice in the three renewable energy projects, one using biomass infrastructure sectors—energy (one MFF), and the other floating solar panels. In transport (two MFFs), and WUS (one). They distribution, the scope was increased but the helped signal ADB’s commitment to a sector but projects were delayed. The PCG for the Janub sometimes did not get the ADB support needed power plant was never issued and lapsed 12 to be optimally useful. MFFs helped develop and months after approval. The TA on strengthening implement investment programs in stages, with the enabling environment for private sector the government incurring commitment charges participation in the power sector faced only for the loan taken to implement the certain significant delays. However, the TA to develop a stage of the investment program. Their use gave financial recovery plan for the energy sector has flexibility to ADB support, by enabling made significant progress, showing that ADB synchronized assistance to projects that built on can support policy reforms when it fosters previous ones, such as successive sections of a ownership. Stakeholders met considered that road. The instrument also made it easier to ADB staff were helpful and responsive to the accommodate needed design changes, such as needs of project beneficiaries. Moreover, in WUS. However, the management of the projects with Azerenergy and Azerishiq have facilities could have made greater use of ADB’s helped build the capacity of their staff. in-house technical skills to provide better oversight and improve the effectiveness and The ADB-supported transport program was efficiency of the support. Moreover, with the assessed successful on the borderline. The change in the government’s borrowing policy, program included two MFFs for the road sector ADB will not be able to use all available tranches and a recent railway sector development of the MFFs in energy and WUS. program comprising a policy-based loan and an investment loan While only the local roads were Sector Performance of Sovereign and operational in mid-2018, the expressway Nonsovereign Operations corridors that accounted for the bulk of ADB loans were opened to traffic in September 2018. The evaluation considered all sector Tolling is to begin by summer of 2019. Because programs, including the nonsovereign the full transport benefits are yet to be delivered, operations program, and the Independent it is early to definitively establish that the Evaluation Department noted both strong program is effective; and it is viewed as less than and weak results. Most structures and facilities effective at the time of the evaluation. The MFFs in the infrastructure sector were of good quality, provided seven loans financing mostly as were some ADB-supported policy reforms. contiguous sections of the North–South and However, there were issues that can be traced to East–West corridors, which in their entirety open weak preparatory work, and that led to delays, traffic from the Russian Federation to Iran, and cost overruns, and even losses. from Baku to Georgia. The loans were complemented by five TA projects, three of The evaluation finds the ADB-supported which helped prepare the railways operation. energy program successful overall. It Road projects faced many delays, cost overruns, addressed the sector’s priorities, and while and changes in scope that lessened their reach some investment and technical assistance into communities. Moreover, there were projects suffered significant delays, their unresolved issues related to road maintenance, outcomes were not significantly reduced. road safety, overloading, tolling, and vehicle ADB supported power network improvements, emissions. In addition, construction of the as well as new power generation and gas field border crossing with Iran had been awaiting the expansion that will deliver Azerbaijan’s gas to Iranian authorities’ decision on its geographical Europe. The support included one investment location until very recently. Despite the project and one MFF for power transmission and difficulties, the projects helped build capacity in distribution improvements, two partial credit Azerbaijan’s roads team. Moreover, the guarantees (PCGs) for power generation and gas government has decided to move that team to field expansion, and six technical assistance (TA) address the issues in railways now that the roads projects. The package included support for two are in better condition and the roads agency is Executive Summary xv more capable of upgrading and maintaining the The CSF was meant to support the government road network. in its expansionary policy designed to lessen the impact of the economic crisis on the most The ADB-supported program in water supply, vulnerable groups. The CSF also laid the sanitation and urban development was groundwork for the forthcoming structural successful based on the expanded water reforms needed to avoid procyclical services and improved access to 24-hour macroeconomic policies by delinking fiscal water supply in five towns, and well- policy from world prices for fossil fuels—a functioning wastewater operations in two of necessary condition to abate Dutch disease and the five towns. The program was aimed at allow economic diversification. The improving water supply in five towns—Agdash, programmatic approach built on those Aghjabedi, Beylagan, Goychay, and Nakhchivan. foundations, supporting efforts along three Support was structured through a stand-alone directions highlighted in the government’s project and an MFF with four tranches. The strategic road map of 2016. These called for (i) Azersu Open Joint Stock Company was a strengthening macroeconomic management by counterpart in the first four towns (all in establishing medium-term fiscal and debt mainland Azerbaijan), and the State management frameworks, (ii) buttressing Amelioration and Water Management efficiency and accountability by developing a Committee (SAWMC) was the counterpart in public investment framework and by Nakhchivan (in the Nakhichevan Autonomous restructuring and improving the governance of Republic exclave). While the project state-owned enterprises, and (iii) deepening implemented with Azersu faced delays and cost finance and increasing the scope of the private overruns, by the end of the evaluation period, all sector by developing securities and capital the projects’ key water supply components had markets while promoting the development of been completed. When the Independent small and medium-sized enterprises. The most Evaluation Department (IED) visited, a 24-hour vulnerable groups were protected to some service was running only in Goychay, but the extent, even if ADB support came late in the other three towns reportedly started to provide year. Progress is being made in all three 24-hour service since then. For sanitation, the directions of structural reform. wastewater treatment plants in the three towns are now expected to be financed by the The ADB nonsovereign operations program government. In Nakhchivan, the SAWMC started was less than successful on the borderline of the project without any delays and learned so successful. While NSO reflected the good much in the process that it is replicating it in quality of ADB's work and provided some other towns in the exclave. Any future additionality, their development results and investment in the sector calls for a serious profitability were less than successful. NSO dialogue on tariffs and their comprehensive provided direct support for the cement and gas reform to ensure full cost recovery. The fourth sectors, as well as other sectors through the MFF tranche was not implemented because of financial system. Support to the cement and gas the change in the government’s borrowing sectors was generally achieving satisfactory policy. development results and profitability. The operations were well prepared and made a The evaluation rated the ADB public sector significant difference by bringing additional management program successful overall, projects in the case of cement, and additional given that it achieved most of its outcomes financing in the case of gas. The only problem and outputs. While ADB support came only at observed is that one of the gas projects that was the end of the evaluation period, it helped the part of a One ADB approach was not being used country through a crisis period and built the by the beneficiary. ADB support to other sectors foundation for further reforms. ADB structured through the financial system had mixed results. its support through a countercyclical support The two initial onlending projects through facility (CSF) and programmatic policy-based commercial banks achieved satisfactory lending comprising two subprograms, including development results and were profitable the first ever policy-based loan for Azerbaijan. investments. ADB’s preparatory work was xvi Country Assistance Program Evaluation for Azerbaijan, 2011–2017

satisfactory, and the projects provided may be the case. More use of project outcome additionality by channeling resources to small indicators may have helped monitor progress in and medium-sized enterprises and this area more closely. agribusinesses. Another pre-crisis operation did not yield the expected results. The other three ADB support for regional cooperation and operations were channeled through two integration. ADB’s work on RCI in Azerbaijan is commercial banks that were impacted by the relevant because of the significant potential crisis. These do not include an intended benefits that will accrue from further integrating transaction in which the counterpart commercial Central Asia, as well as the public goods issues bank opted for not doing business in Azerbaijan in the region. For that reason, the evaluation because of the crisis. One of the commercial saw it as highly impactful. ADB supported banks is being liquidated because the Financial integration through Central Asia Regional Market Supervisory Authority did not accept the Economic Cooperation (CAREC), as well as proposed financial restructuring; the other is in through cross-border projects in transport and a restructuring process under negotiation. energy. The most salient project in this regard is Weaker results during the latter part of the the Southern Gas Corridor which will convey evaluation period reflected effort to support the Azerbaijan’s gas to Europe. financial sector during difficult times alongside other development partners but provided with ADB support for environmentally sustainable inadequate monitoring of the finance sector and growth. ADB safeguarded ESG in the insufficient understanding of systemic risks investment projects. In some cases, such as in facing banks. The lack of ADB in-country energy distribution, this led to lower emissions. expertise may also have been a constraint. ADB and the government also explored options for renewable energy, an exercise that led to a ADB’s Strategic Agendas dialogue on the tariff structure and the regulations needed to make renewable energy ADB support for inclusive economic growth. attractive for private investors. Of two pilot Most of ADB’s infrastructure work was focused projects on renewable energy—biomass and outside the Baku–Absheron area to attend to the floating solar panels—only the solar panel needs of the less wealthy parts of the country project is under implementation. Yet ADB and reduce regional disparities. It also pursued ESG less actively than the other incorporated inclusive elements into project corporate agendas—IEG and RCI. designs and involved projects in sectors with high inclusion impact. Water and sanitation ADB Special Priorities coverage indicators in Nakhchivan and feedback received from users during IED’s field visits in ADB work on economic diversification. This energy and road projects attest to the inclusive was assessed as relevant but with less than way in which beneficiaries' needs were satisfactory development impacts. ADB focused addressed. The CSF and the programmatic on the necessary conditions for economic approach in support of PSM, on the other hand, diversification only in the last 2 years of the were designed to help the poorer segments of evaluation period, when the crisis hit (2016– the population weather the crisis and fend off 2017). In the earlier years of the evaluation future crises. period, ADB focused on infrastructure development, following the government’s lead, The evaluation finds that ADB’s contribution to and did not bring to its attention the damaging IEG was relevant and had a satisfactory impact of the real appreciation of the Azerbaijan development impact. However, there is very little manat. Any cost reductions stemming from statistical evidence to establish the extent to infrastructure investment were not enough to which ADB fostered inclusive growth by overcome the negative impact of the real reducing regional development disparities. appreciation. Not surprisingly, despite these Intuitively, the fact that most ADB-financed investments, Azerbaijan was unable to diversify infrastructure investments were located outside its economy toward the tradable sectors capable the Baku–Absheron region suggests that this of a sustained growth path and continued Executive Summary xvii employment performance that could absorb the are likely to do so when complementary growing labor force. Even so, ADB was one of investments take place. Highlights of the the key drivers of change when the government program were the development impacts in the opened up for policy dialogue and was a main areas of RCI and capacity development. development partner to engage the government Nevertheless, ADB’s preparatory work was in constructive policy dialogue that led to critical sometimes inadequate or failed to include policy changes and an improved critical factors such as the need for land macroeconomic framework. More consultations acquisition or the depth of the banking crisis. with the civil society representatives of some of These weaknesses led to delays, cost overruns, the beneficiaries and key actors could have and/or losses. In addition, at least one operation helped guide ADB in this endeavor, especially in and one PCG did not yield any outcomes. the earlier period of the evaluation. Factoring in all of these considerations, IED rates ADB’s Azerbaijan 2011–2017 program ADB work on capacity development. ADB successful. support addressed the need for qualified teams and technicians that could run the infrastructure Lessons sectors in a responsible manner. Although TA was relatively limited and unsuccessful, ADB • ADB's greatest effectiveness is achieved when used project implementation to build local capacity building and infrastructure capacity and this made the capacity development or policy reform come together. development work overall relevant and even highly impactful. IED received positive feedback • When the government borrowing policy from all implementing agencies, and, more changes (a near complete stop to external importantly, witnessed the demonstrated ability borrowing being enforced at present) and of some of them to replicate the ADB projects at when there is a consequent need for ADB to a different location and scale. Examples of venture outside of the infrastructure sectors, replication are WUS projects by the SAWMC in then this generally requires applying a Nakhchivan and the government’s decision to broader range of support instruments and move the roads team that had learned with ADB modalities. to take care of and refurbish the railways. • The pursuit of economic diversification calls Overall Assessment for detailed analytical work and a sizable reliance on private sector operations. The evaluation finds that the ADB-supported program was successful overall. ADB was one • ADB experience with policy dialogue on of the few development partners supporting the tariffs and the fiscal framework with authorities’ structural reforms. ADB’s support Azerbaijan’s authorities shows that joint focused on the necessary conditions for solutions can be found. economic diversification, particularly the medium-term fiscal framework. While much Strategic Recommendations remains to be done for these reforms to bear fruit, ADB’s presence has helped the government The ADB program should have a greater focus persist with the reforms. ADB also engaged with on building human and social capital in the authorities and all sector teams parallel with developing and improving constructively, and IED received positive physical infrastructure and supporting policy feedback from all of them highlighting ADB reform. ADB has had greater success where support as critical, timely, and flexible. A these elements have come together, as was the consultation mission with Azerbaijan authorities case with the WUS support in Nakhchivan on a draft of the evaluation in December 2018 Autonomous Republic and in the ongoing work confirmed the findings, assessments, and issues on a medium-term fiscal framework. Capacity raised in the report. The work on infrastructure development calls for both supplying the provided completed structures and facilities that capacity and aligning the right incentives and are providing valuable services to the people or accountability framework to effectively lead to xviii Country Assistance Program Evaluation for Azerbaijan, 2011–2017

sustained progress in institution building and in presence in Baku, ADB’s private sector implementation. Indeed, well-motivated operations are limited. This suggests the need recipients of capacity development have for a more visible and connected presence of the advanced with reforms more steadily and ADB Private Sector Operations Department in effectively, as was the case with the reform of Baku. Greater presence in this area should be the roads system and now the railways. A useful attuned to the needs of the client and it should complement of this integrated view is to consult entail cooperation with other development with the civil society representatives of some of partners rather than competition so that the the beneficiaries and key actors to help fine-tune combined efforts lead to a stronger private some measures to make them more effective. sector. Moreover, this move would be in line Civil society is an integral part of the informal with Strategy 2030, which foresees a greater institutions that make up social capital, and it role for the private sector in upper middle- deserves as much attention as formal income countries. From this perspective, these institutions. Furthermore, ADB could contribute efforts should be complemented with support to building human capital through support for for policy reform to foster private sector education, health, and/or social protection. development.

ADB should use a broader range of its Operational Recommendations instruments and modalities as part of a new strategy in Azerbaijan. A broader range of ADB should step up its due diligence and instruments and modalities is warranted in light preparatory work for its operations to handle of the evolving demands for ADB support and expectations properly and avoid delays or the limitations imposed by the government’s failures, especially in transport operations. decision to keep its external borrowing in check. The experience from the evaluation period While continued support for the structural suggests that outcomes would have been much reforms and their implementation will be best better if project delays in energy, transport, and served by additional policy-based lending WUS operations had been avoided by being coupled with TA, ADB may wish to consider mindful of some essential requirements, such as other options, such as results-based lending, the need to acquire land, understand the domestic currency financing, stand-alone TA, enabling legal environment, consult affected private participation in transaction advisory and communities, and/or adhere to ADB’s safeguard project financing of some projects, and more policy. In NSO, detailed monitoring is imperative active cofinancing with other development to adequately assess the systemic risks facing partners. banks and other potential clients.

ADB support for the diversification of the ADB should expand its policy dialogue, economy must include more analytical work, drawing on the iterative and interpersonal a focus on the non-oil tradable sectors, and a approach that has proved valuable in areas more proactive involvement in private sector such as fiscal and tariff reform. ADB operations in Azerbaijan beyond simple experience in policy dialogue with Azerbaijan’s onlending operations. The analytical work can authorities in these two areas has demonstrated be oriented toward more sharply defining the the virtues of listening, taking their concerns activities, milestones and targets of some of the into account, and working with them to find 11 strategic sector roadmaps, as well as solutions to move forward. In this regard, the improving their evaluability. ADB will also have Headquarters staff has led the policy dialogue to bolster its private sector operations presence and has been ably supported by the current in Baku and develop a deeper understanding of Resident Mission in Baku. This process should be (i) the macroeconomic framework in which it is expanded to all sectors, even though it may be operating, (ii) Azerbaijan’s advantages in the construed as slow and a cause of delays. non-oil tradable sectors, and (iii) the impact of Fostering ownership and developing the policies on the different sectors and existing government’s capacity has proved to lead to market realities. Compared with other success in dealing with difficult tasks. development partners that have a greater Executive Summary xix

Link Between Findings and Recommendations Findings Recommendations ADB's greatest effectiveness is achieved when capacity building and The ADB program should have a greater focus infrastructure development or policy reform come together. This needs on building human and social capital in parallel the right alignment of incentives and an accountability framework that with developing and improving physical lead to sustained progress in institution building and in infrastructure and supporting policy reform. implementation. A useful complement is to consult with beneficiaries or key actors. The government’s borrowing policy has changed and venturing outside ADB should use a broader range of its the infrastructure sectors requires a broader range of support instruments and modalities as part of a new instruments. strategy in Azerbaijan. Diversification and the government's borrowing policy call for more ADB support for the diversification of the analytical work, as well as more private sector operations, which at economy must include more analytical work, a present are limited and sparse. focus on the non-oil tradable sectors, and a more proactive involvement in private sector operations in Azerbaijan beyond simple onlending operations. Stronger preparatory work would have led to better outcomes in ADB should step up its due diligence and energy and transport operations by preventing project delays and cost preparatory work for its operations to handle overruns. Nonsovereign operations would have had more success if expectations properly and avoid delays or preparatory work had been informed by a sound understanding of failures, especially in transport operations. macroeconomic and financial conditions. ADB experience in policy dialogue with Azerbaijan’s authorities on ADB should expand its policy dialogue, drawing tariffs and the fiscal framework has demonstrated the virtues of on the iterative and interpersonal approach that listening to them, taking their concerns into account, and working with has proved valuable in areas such as fiscal and them to find solutions to move forward. tariff reform.

Management Response

On 14 January 2019, the Director General, Independent Evaluation Department (IED) received the following response from the Special Senior Advisor to the President, on behalf of Management:

I. General Comment

Management acknowledges that the Country Assistance Program Evaluation (CAPE) for Azerbaijan, 2011–2017 has rated ADB’s strategy and program for the country as overall successful. The CAPE provides important inputs to the preparation of the next Country Partnership Strategy (CPS) for Azerbaijan, 2019– 2023, which will focus on supporting economic diversification and inclusive growth. We appreciate and agree with the CAPE’s strategic and operational recommendations. In fact, most of the recommendations of the CAPE are already under implementation.

II. Management Response

Strategic Recommendation 1: The ADB program should have a greater focus on building human and social capital in parallel with developing and improving physical infrastructure and supporting policy reform.

Management agrees. During the evaluation period, ADB’s and other IFI’s work in Azerbaijan focused on physical infrastructure reflecting the government’s priorities on the use of external financing to support major transport and energy projects. At the same time, however, and even during the current CPS, ADB has maintained policy dialogue with the government on selected aspects of the education sector. For example, in 2016–2017, ADB developed policy briefs for the Ministry of Education on moving to K+12 system and rationalizing expenditure in the technical and vocational education and training (TVET) sector. Also, ADB prepared a scoping study for delivery of student accommodation through public-private partnerships (PPPs). This engagement laid the platform for a transaction technical assistance (TA), financed from the Asia-Pacific Project Preparation Facility and approved in January 2018, to support the preparation and transaction of the country’s first-ever two PPP projects.

The next CPS—through its third strategic pillar—envisages support to strengthening the education sector, including TVET, through building links between education, science, and the private sector; promotion of private delivery of public education services and infrastructure; and raising private provision of education through innovative demand-based instruments.1 However, given the government’s conservative stance on public borrowing in the initial years of the CPS, ADB’s support will focus on policy advice and institutional strengthening. For example, at the request of the Ministry of Labor and Social Protection, ADB will continue to provide policy advice on the: (i) development of legal framework for alternative (private) pension schemes; and (ii) rationalization of the country’s extensive social allowances and targeted social assistance systems. Under the TA on PPPs for student accommodation, institutional capacity of the Ministry of Education in managing PPPs will be strengthened. This upstream work will lay a platform for a more tangible engagement in the human capital area (including the development of skills for economic diversification) in the outer years of the CPS, if—as expected—the public borrowing stance eases.

1 The overall objective of next CPS is to support diversified and inclusive growth in Azerbaijan per the government’s Strategic Roadmaps. This objective will be achieved through implementation of ADB’s operations under three strategic pillars: (i) acceleration of economic diversification, (ii) raising public sector efficiency, and (iii) enhancement of infrastructure and human capital.

xxii Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Strategic Recommendation 2: ADB should use a broader range of its instruments and modalities as part of a new strategy in Azerbaijan.

Management agrees. Prior to 2015, the portfolio comprised solely of investment loans—majority through the Multitranche Financing Facility (MFF)—reflecting the government’s vision on the use of external financing for infrastructure development. Since 2015 and in response to the changing country environment and the government’s needs, ADB has applied a more diverse range of financing modalities, such as the countercyclical support facility, programmatic policy-based lending, partial credit guarantee, and a sector development program.

Considering Azerbaijan’s evolving challenges, the tight external borrowing space, and the country’s upper-middle income status, the next CPS envisages provision of smart and integrated financing solutions drawing on the full spectrum of ADB’s instruments and modalities. Given the government’s interest in ADB’s further support to structural reforms, the next CPS will continue programmatic policy-based financing for the next phase of public sector reforms. Through the project readiness financing modality, ADB will support preparation of smart and innovative projects (including PPPs) via engagement of high- quality advisors. ADB will also seek to support microentrepreneurs and small- and medium-sized enterprises (SMEs) through a financial intermediation loan to eligible nonbank financial institutions. ADB will seek to provide such financing in local currency, subject to obtaining government approvals for issuance of debt instruments in the domestic capital market.

Strategic Recommendation 3: ADB support for the diversification of the economy must include more analytical work, a focus on the non-oil tradeable sectors, and a more proactive involvement in private sector operations in Azerbaijan beyond simple onlending operations.

Management agrees. In response to the government’s new development policy framework, which is explicitly focused on economic diversification, ADB has stepped-up its diversification-related analytical and advisory work in Azerbaijan. For example, in 2017 ADB conducted the first-ever Country Diagnostic Study to define the most binding constraints to sustained economic growth in Azerbaijan and hence inform the government’s policy reform prioritization effort. In parallel and given the economic importance of state-owned enterprises (SOEs), ADB undertook an SOE Sector Review for Azerbaijan to inform the reforms on raising efficiency and reduce fiscal cost of the SOE sector. Both studies provided valuable inputs to the next CPS and are at the final stages of completion. To enable provision of just-in- time policy advice to priority reforms on economic diversification, in 2017 ADB approved a TA on rapid response to strategic reforms that supports such priority reforms as the development of a strategy on introduction of regulatory impact assessments on SMEs and operationalization of the country’s PPP Development Center. The next CPS envisages a scaling-up of ADB’s knowledge work in Azerbaijan to commensurate with its upper middle-income country status. ADB will offer knowledge products and services in the most suitable type and modality driven by demand and in conformity with the three strategic pillars of the next CPS.

Support to the non-oil tradable sectors will be included in the focus of the next CPS’s first strategic pillar on acceleration of economic diversification to effectively raise the share of non-oil private sector in the economy. This will be done through, for example, strengthening the legal, regulatory, institutional, and funding frameworks of nonbank financial institutions to support microenterprises, farmers, and SMEs with a special focus on regions and agriculture, tourism, Information and Communications Technology, and manufacturing sectors. The next CPS also envisages raising ADB’s private sector operations in Azerbaijan that, subject to suitable market conditions and viable opportunities, may also entail direct engagement with eligible SMEs and support PPP projects through equity or debt finance. To strengthen the on-the-ground engagement with the private sector, ADB has already initiated strengthening of AZRM’s capacity in facilitating financial solutions via a proactive and coordinated response to market needs from different departments and offices in ADB.

Management Response xxiii

Operational Recommendation 1: ADB should step-up its due diligence and preparatory work for its operations to handle expectations properly and avoid delays or failures, especially in transport operations.

Management agrees. We appreciate the importance of an in-depth and comprehensive due diligence (including on environment and social safeguards, gender equality, and financial sustainability) during project preparation to mitigate the risk of delays during project implementation that may adversely affect the scope or timeliness of the attainment of the intended development results. At the same time, we would like to note that in some cases, ADB had to fast-track project preparation due diligence because of the expectation of the government for an expeditious provision of financing. For example, this was the case during the processing of the first MFF for the road sector. The pace of implementation of road projects has also been affected by two exogenous factors: (i) the rise of construction input prices way beyond the expectations, and (ii) a sharp devaluation of the local currency against the US dollar in the aftermath of the oil price plunge in 2014. To raise quality-at-entry and subject to the government’s request for ADB’s project financing, the next CPS envisages the use of a PRF operation to enable the conduct of detailed due diligence, assessments, and designs to ensure the projects are “shovel ready” at approval. AZRM’s stepped-up project administration and portfolio management capacities will also help proactively mitigate implementation delays and raise development effectiveness.

Operational Recommendation 2: ADB should expand its policy dialogue, drawing on the iterative and interpersonal approach that has proven valuable in areas such as fiscal and tariff reform.

Management agrees. Increased demand for ADB’s policy advice, including in fiscal and electricity tariff reform, reflects the evolving nature of ADB’s operations in the country in response to the government’s new development policy framework as well as the trusted partnership established between the authorities and ADB. A critical factor to ADB’s growing policy advisory role has been the strong support, close involvement, and excellent facilitation by leadership and staff of the Ministry of Finance, the government agency responsible for ADB’s operations in Azerbaijan. With several new government institutions set up to drive the government’s policy agenda,2 the next CPS envisages expansion of policy advice, institutional strengthening, and capacity building assistance drawing from various support options, including regional technical assistance of CWRD and knowledge departments of ADB. During the next CPS and given their importance for project and sector sustainability, ADB will continue supporting utility tariff reforms and improving governance of state-owned enterprises (public utilities). To ensure synergy and relevance, AZRM’s capacity will be strengthened to be the single-window through which the requests for and outputs of policy advice and knowledge products will be channeled.

2 Among the new institutions are the Center on Analysis of Economic Reforms and Communication, Financial Market Supervisory Authority, Energy Regulatory Agency, Small and Medium Business Development Agency, Food Safety Agency, and the State Tourism Agency.

Chair’s Summary: Development Effectiveness Committee

The Development Effectiveness Committee (DEC) considered the Independent Evaluation Department (IED) report, Country Assistance Program Evaluation: Azerbaijan, 2011–2017, on 24 January 2019. The following is the Chair’s Summary of the Committee discussion:

IED Findings and Recommendations. Despite reporting effectiveness issues in ADB interventions related to transport, diversification and non-sovereign operations (NSO), IED rated successful ADB’s overall support for Azerbaijan from 2011-2017 (the evaluation period) totaling $5.1 billion, representing 21 sovereign loans and guarantees (valued at $ 3.9 billion), 10 non-sovereign loans (valued at $1.2 billion), and 16 technical assistance (TA) projects. During the evaluation period, the report found that Azerbaijan’s oil-dependent economy was adversely affected by the oil price drop that began in 2014, which has led to a rapid increase in its debt-to-GDP ratio to over 30%. Azerbaijan sought to restore macroeconomic stability and control external debt by temporarily adopting a borrowing freeze policy and diversify its economy with ADB’s help by focusing on infrastructure (energy, roads, water) and SME development, and later seeking ADB support for social protection and structural reform.

Consistent with the CAPE’s lessons, IED recommended that ADB: (i) put greater focus on building human and social capital along with infrastructure development and policy reform; (ii) use a broader range of instruments and modalities to respond to changing government policies and extend the bank’s support to sectors beyond infrastructure; (iii) support more analytical work and more proactively involve private sector operations to achieve economic diversification; (iv) enhance due diligence and preparatory work to avoid delays or failures; and (v) expand the policy dialogue, drawing on iterative and interpersonal approaches, to further difficult reforms (such as fiscal and tariff reforms).

Management Response. Management agrees with the CAPE’s strategic and operational recommendations, noting that most of them were under implementation. (See Management Response for details of its ongoing initiatives.) It also noted the good internal collaboration with IED in preparing the CAPE, and the country’s positive reception to the findings and recommendations.

On the borrowing freeze, Management views that Azerbaijan will resume its borrowing in the next two to three years since the policy response had already reduced the debt-to-GDP ratio to 19%. In the interim period, Management is setting up a project preparation facility for the resumption of project lending, focusing on projects with high-technology or innovation elements. It will also provide TA in TVET for example to improve job creation, competitiveness, and further develop the private sector.

DEC Discussion and Comments. DEC underscored the importance of CAPEs that it enables board members to see how ADB has been operating in member countries. It commended IED for the well- written, fair report, and the collaborative engagement with Management and government interlocutors in undertaking the evaluation. DEC agrees with the CAPE’s findings and recommendations, encouraging Management to seriously consider them.

xxvi Country Assistance Program Evaluation for Azerbaijan, 2011–2017

While DEC agreed that the CAPE presented sensible recommendations that were well-linked to its findings, some members pointed that deeper recommendations with specific suggestions to Management could have been offered, and linkages between the CAPE and Strategy 2030 directions (e.g. upper middle-income countries or UMICs, non-diversified economies and large state-owned sectors) could have been more explicit. IED explained its role as evaluator that it identifies issues and concerns based on the findings, and what ADB needs to do, without being too prescriptive in the manner how the same could be achieved (as this was within Management’s remit). IED accepted DEC’s suggestion to present future evaluations in the wider context of Strategy 2030, while clarifying that the country program evaluated was developed under Strategy 2020 and that the CAPE’s recommendations are forward-looking and inspired by some of Strategy 2030’s priorities.

Recommendation 2. Taking into account that Azerbaijan has achieved UMIC status and that it has in place a borrowing freeze policy, DEC supports the CAPE’s recommendation to deploy a wider range of instruments and modalities, including the use of policy-based loans (PBLs), which are particularly useful to support countries undertaking reforms. DEC encouraged Management to view the current situation of Azerbaijan as an opportunity to focus its support on areas where it could share experience, best practice and innovation, and in areas where it could add most value and expand private sector operations. Management has started to use PBLs in 2017 and plans to support skills education in Azerbaijan through results-based loans (RBLs) and establish a project readiness facility (as mentioned above).

Linking the CAPE, Strategy 2030 and UMICs, DEC and Board members encouraged Management to continue its engagement with Azerbaijan (and other UMICs or members that have achieved new levels of development), noting that adjustments have to made in the type of engagement it will pursue to be responsive and country-specific, such as focus on analytical and knowledge work, use other products/modalities like PBLs, support private sector development.

Multi-tranche financing facilities (MFF). DEC noted that ADB heavily relied on MFFs to support Azerbaijan during the evaluation period as a way to signal to Azerbaijan its long-term commitment and flexibility. The overuse of MFFs however presented specific risks and challenges relating to committing financing far into the future that made them susceptible to modifications or cancellations when circumstances change, as what happened in the case of Azerbaijan (access to or availability of cheaper financing). DEC noted IED’s ongoing evaluation of MFFs and encouraged it to undertake a thorough analysis of MFF operations to provide useful insights to Board and Management.

Recommendation 3. DEC noted that the goal of economic diversification has always been part of Azerbaijan’s and ADB’s strategy, but with limited impact. Management explained that economic diversification is a challenge faced by many Central West Asian countries, with very little success due to incentives, i.e. when oil prices are high, oil-rich countries experience overvalued exchange rates, making their tradeable sectors (e.g. agriculture) less competitive, thus providing no incentive to pursue reforms. Conversely, when oil prices are low, oil-rich countries have no resources to spend since many oil-rich economies follow procyclical, instead of countercyclical policies. Further, economic diversification is anchored on a thriving private sector, which in Azerbaijan is hindered by the dominance of government and state-owned enterprises (SOEs).

DEC noted that ADB could support economic diversification in member countries (including Azerbaijan) by undertaking more in-depth analysis and discussion of the topic, gathering more evidence from ADB’s support in the area, focusing on non-oil related sectors, and proactive involvement of the private sector. 11 potential non-oil-related sectors were identified to be supported to facilitate diversification, including information and communications technology, agriculture, tourism, education and manufacturing. However, caution was given that picking winners might not really work to diversify an economy.

Private Sector Development. DEC recognized that the less than successful performance of ADB’s NSO during the evaluation period was due to challenging operating environment in the country, including Chair’s Summary: Development Effectiveness Committee xxvii high country risks (resulting in higher margins in NSO projects), overvalued currency, and dominant public sector and SOEs.

DEC noted that economic diversification could be promoted by creating the enabling environment for greater private sector participation, which include putting in place the necessary policies and regulations, bringing down the cost of doing business, and developing technology and skills.

For example, private sector investment in Azerbaijan’s power sector has been low due to the country’s tariff regime, which is below the cost of service of electricity. Management is supporting reforms in the energy sector aimed at establishing a cost-recovery tariff regime and creating a regulatory environment to promote competition and attract private sector participation. To help increase tariffs to cost-recovery levels, Management is currently helping electric companies to prepare a four-to-six-year financial recovery plan.

Technical Assistance. DEC pointed to the inadequacy of TA provided to Azerbaijan (amounting to $15.7 million during the evaluation period, or $2 million per year, which were mostly transaction-specific project preparation TA) compared to the country’s reform challenges and its scale of borrowing. Taking the point that there is significant underfunding of TA (particularly knowledge TA) for Azerbaijan, Management agreed to revisit TA support for analytical work while the new CPS is being finalized.

Staffing. DEC noted that the analysis of inputs (staffing) are conducted separately from discussions about results and pointed to the need to include an analysis of human resources allocated to tasks or operations in the evaluation (evaluation frameworks, in general) to understand how a program was managed at headquarters and at the resident mission. The resident mission’s capacity to implement Recommendation 1 (integrating human and social development with infrastructure development), i was raised owing to the small resident mission. For UMIC members, DEC pointed that ADB’s engagement will transition to analytical and knowledge work and thus requires different staffing profile.

IED clarified that analysis of staffing allocation to tasks would normally be contained in a section on Organization for Delivery, which is not normally included in CAPEs, but normal for thematic evaluations. IED agreed to be more consistent in discussing such analysis across its evaluation products. Management explained that decisions relating to staff allocation are guided by an overall human resources framework. However, Management admitted that it was supply constrained (particularly for non-sovereign operations), and that staff allocation or movement from headquarters to resident mission could be a zero-sum exercise.

Gender. DEC noted that there was scant discussion of gender issues in both the CAPE and the Management’s Response and sought views how performance on gender equality could be improved. IED agreed that the main text of the CAPE contained little on the issue of gender and committed to give more systematic attention to gender issues in future CAPEs. Management clarified that gender equality was an issue for the region, not just for Azerbaijan, and it will address the issue (usually done at project level) by identifying gender elements in all operations such as budgeting, public sector reform, education skills development, etc.

Country Program and Evaluation Methodology 1 2 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Highlights: • The Asian Development Bank (ADB) had a succession of strategies for Azerbaijan, among which the major documents are the country partnership strategy, 2014–2018 and the country operations business plans. • The ADB strategies were aligned with the government’s development strategies. • The Independent Evaluation Department evaluated the Azerbaijan program in 2012. • The main evaluation questions are anchored on a theory of change derived from ADB strategies, results frameworks, and programs for Azerbaijan in 2011–2017. The ADB program has been consistently anchored in the objective of diversifying the economy. • The main evaluation questions are whether (i) the choice of sector programs helped diversify economic activity, (ii) the programs helped reduce regional development disparities, (iii) ADB was well positioned to support economic and policy reform, and (iv) multitranche financing facilities were the appropriate instrument to support infrastructure development.

A. Country Program and Portfolio

1. The Asian Development Bank (ADB) activities and interventions over the 2011–2017 evaluation period were guided by seven key strategic documents. Following the country’s strategies, ADB remained anchored in the shared long-term objective of diversifying the economy by boosting the non-oil sectors.3 To do so, ADB chose to support infrastructure in the energy, transport, and water and other urban infrastructure and services (WUS) sectors, as well as public sector management (PSM) at the time of the recent economic crisis. Nonsovereign operations (NSO) aimed to support diversification in the earlier part of the evaluation period, and onlending through banks until the crisis hit the financial system. The focus areas and primary sectors were aligned with the government’s strategies, while ADB’s cross-cutting themes and drivers of change have also been broadly in line with government’s strategies.

2. The portfolio of lending operations taken into account was valued at $5.1 billion, dedicated 80% to the infrastructure sectors, with a sustained focus on transport and energy, and a gradual reduction in focus on water and other urban infrastructure and services (WUS). This included $4.5 billion approved during the evaluation period and $0.6 billion of projects approved prior to 2011 but completed during the evaluation period. Energy was the largest sector, accounting for 42% ($2.1 billion), and transport was the second largest with 27% ($1.4 billion) (Figure 1). In late 2016, ADB responded to Azerbaijan’s economic crisis and gradually reallocated its resources to support economic reform. Accordingly, PSM grew in importance, reaching 15% of the portfolio with the approval of two policy-based loans in 2016 and 2017. NSO accounted for 24% of the studied portfolio and included energy and finance sector projects; no new NSO were approved in 2017.4 The studied portfolio, 2011–2017, is in Linked Document A.

3. Funding sources and cofinancing. Of the $3.9 billion studied portfolio of sovereign lending operations over the evaluation period, only two loans, amounting to $30 million, were funded by the concessional resources (Asian Development Fund [ADF]).5 ADB approved these two loans before 2013 when Azerbaijan was classified as a Group B (ordinary capital resources [OCR]

3 The seven strategic documents are the country partnership strategy (CPS), 2014–2018 and six country operations business plans (COBPs), three of which were particularly relevant—the COBP, 2011–2013; COBP, 2014–2016; and COBP, 2018–2020 (ADB. 2014. Country Partnership Strategy: Azerbaijan, 2014–2018. Manila; ADB. 2011. Country Operations Business Plan: Azerbaijan, 2011–2013. Manila; ADB. 2014. Country Operations Business Plan: Azerbaijan, 2014–2016. Manila; and ADB. 2017. Country Operations Business Plan: Azerbaijan, 2018–2020. Manila). In addition, immediately before the evaluation period, the Azerbaijan country strategy and program update (CSPU), 2006 provided strategic guidance for operations. 4 The stagnation of private sector operations may also reflect the lack of presence of ADB specialized staff in Baku. 5 ADB. 2007. Report and Recommendation of the President to the Board of Directors: Road Network Development Program (Tranche 1). Manila; and ADB. 2004. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Urban Water Supply and Sanitation Project. Manila.

Country Program and Evaluation Methodology 3

blend) country, and had access to the ADF.6 Four development partners cofinanced projects in Azerbaijan during the evaluation period, contributing a total of $176.9 million or 31% of the external funding 7 for five projects (four technical assistance [TA] projects 8 and a sector development program9). Of these projects, two transport sector operations received 99% of the entire cofinanced amount. Agence Française de Développement (AFD) was the largest of the four cofinanciers, accounting for almost 99% of the total amount cofinanced during the review period and providing 30% of the loan project’s external funding.10 Three of the five cofinanced projects are still active. In addition, the Trade Finance Facilitation Program (TFP) supported more than $4.3 million in trade through four transactions during 2011–2012. There were no TFP transactions during 2013–2017.

Figure 1: Evaluated Portfolio of ADB Support to Azerbaijan by Sector, 2011–2017

Sovereign Loans and Guarantees and Nonsovereign Loans ($ million)a

2000 WUS, FIN, 1500 630 , 220 , 4% 12% 1000 ENE, PSM, 2,144 , 500 750 , 42% 15% TRA, 0 1,400 , 27%

ENE FIN PSM TRA WUS

Technical Assistance ($ million)

6 WUS, 5 PSM, 1.3, 8% 1.4, 9% 4 3 FIN, 1.4, ENE, 2 9% 5.9, 38% 1 TRA, 0 5.7, 37%

ENE FIN PSM TRA WUS

Note: Percentages may not total 100% because of rounding off.

ADB = Asian Development Bank, ENE = energy, FIN = finance, PSM = public sector management, TRA = transport, WUS = water and other urban infrastructure and services. a Two partial credit guarantees, with sovereign guarantee, are included; one was not issued. Source: Asian Development Bank.

6 ADB. 2013. Azerbaijan: Review of Classification under ADB’s Graduation Policy. Manila. Ordinary capital resources blend countries were formerly called blend countries. 7 External funding excludes funding from the government. 8 ADB. 2013. Technical Assistance to Azerbaijan for Renewable Energy Development (Biomass Cogeneration). Manila; ADB. 2014. Technical Assistance to Azerbaijan for Microfinance Sector Development. Manila; ADB. 2014. Technical Assistance to Azerbaijan for Solid Waste Management Project for Intermediary Cities. Manila; and ADB. 2014. Technical Assistance to Azerbaijan for Baku Sustainable Urban Transport Investment Program. Manila. 9 ADB. 2017. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Railway Sector Development Program. Manila. 10 As of 28 May 2018, the $175 million cofinancing with AFD had not been signed. 4 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

4. ADB broadened the mix of financing modalities over the evaluation period. While ADB initially used multitranche financing facilities (MFFs) and a few project loans for sovereign operations, after 2016, the range of instruments increased as ADB resorted to other modalities (Figure 2). These included policy-based lending (PBL) for PSM, a sector development program for railways with a mix of an investment loan and PBL, and a partial credit guarantee (PCG) with the sovereign guarantee blended with a nonsovereign loan for energy. ADB also funded TA projects. Most of these were for project preparation and some were for policy advisory and capacity development. However, four of nine approved project preparatory TA projects did not materialize into infrastructure projects because government priorities changed. NSO primarily used loans.

5. Technical assistance. TA projects approved and/or completed during 2011–2017 amounted to $15.7 million, which funded 16 projects including project preparatory TA and a nonsovereign TA project. The TA portfolio generally tracked the lending portfolio’s sector distribution, with about 84% going to infrastructure sectors About 62% of the committed amount was for project preparation. There was only one nonsovereign capacity development TA. 11 Azerbaijan also benefited from 13 regional TA projects during the evaluation period, amounting to $22.8 million. These TA projects addressed issues such as environmental protection, low-carbon growth, and safeguards implementation.12

6. At 71%, the average success rate of completed lending operations was similar to that of ADB as a whole, but the TA program performed more poorly.13 The success rate of sovereign lending operations was 67% and that of NSO was 75%.14 All three TA projects with completion reports were self-assessed as less than successful, and 35% of the total TA portfolio did not materialize into infrastructure projects.

Figure 2. ADB Sovereign Operations by Lending Modality, 2011–2017 ($ million)

Project, 340.0, 9%

Partial credit guarantee, 732.3, 19% MFF (Tranches), 1850.4, 47%

Program, 1000.0, 25%

ADB = Asian Development Bank, MFF = multitranche financing facility. Note: Two partial credit guarantees are covered by the evaluation, one of which was not issued. An MFF was terminated in August 2017. Programs are policy-based loans. Source: Asian Development Bank.

11 ADB. 2013. Technical Assistance to Azerbaijan for Capacity Building for Rural Financial Inclusion. Manila. 12 Other regional TA topics included food safety, gender mainstreaming, technical and vocational education and training, information technology in education, customs and cross-border regional trade facilitation, water sector strategy development, and institutional strengthening. 13 Of the 18 public sector projects and programs (supported by 19 loans and 2 guarantees), 7 (supported by 7 loans and 1 guarantee) have closed, and 3 (supported by 4 loans) have project completion reports (PCRs). 14 These ratings are the self-evaluation ratings validated by the Independent Evaluation Department (IED). Country Program and Evaluation Methodology 5

B. Scope and Methodology of the Evaluation

7. The country assistance program evaluation (CAPE) provides the ADB Board of Directors and Management with an independent assessment of the performance of the program in Azerbaijan during 2011–2017. It includes a description of the portfolio, as well as two assessments that, in keeping with the CAPE Guidelines of the Independent Evaluation Department (IED), examine the extent to which ADB support met the objectives of its strategies and their results frameworks.15 One assessment rates ADB programs and projects in energy, transport, WUS, PSM, and NSO. The other, using a matrix assessment approach, gauges the relevance and development impact of ADB’s three strategic agendas and two special priorities. Throughout these assessments, the CAPE delves into the evaluation questions laid out in the approach paper for this evaluation. 16

8. Evaluation period. The evaluation covers ADB operations from January 2011 to December 2017, which corresponds to the coverage period of three recent Azerbaijan country planning documents: the country operations business plan (COBP), 2011–2013; the country partnership strategy (CPS), 2014–2018; and the COBP, 2016–2017. 17 The CAPE assesses all projects, policy-based loans, grants, and TA projects approved over this period, as well as those that were approved before the period but were active during all or part of the period.

9. The CAPE’s main evaluation questions are anchored on a theory of change derived from ADB strategies, results frameworks, and programs for Azerbaijan in 2011–2017. The theory of change is anchored in the objective of diversifying the economy, which has been a central theme in the strategies of both the government and ADB throughout the evaluation period (Figure 3). The questions explore whether (i) the choice of sector programs helped diversify economic activity, (ii) the programs helped reduce regional development disparities, (iii) ADB was well positioned to support economic and policy reform, and (iv) MFFs were the appropriate instrument to support infrastructure development.

10. Mixed-methods approach. In making the assessments and looking into the evaluation questions, the CAPE uses a mixed-methods approach with both qualitative and quantitative assessments, including (i) a study of documents and files; (ii) analysis of portfolio data; (iii) interviews with ADB staff, government counterparts, beneficiaries, and other stakeholders; and (iv) field observations. Information studied includes project completion reports (PCRs) and their validation reports, and the findings of project performance evaluation reports for projects that closed during the evaluation period. Additional details on the approach and methodology of the CAPE are set out in the approach paper for this evaluation.

11. Background documents. Before developing the CAPE main report, the evaluation team prepared four sovereign sector program assessments for energy, transport, WUS, and PSM operations, as well as an assessment of NSO (accessible through links provided in the List of Linked Documents in the Appendix).

12. CAPE Guidelines of 2015. The evaluation follows the assessment approach set out in the CAPE guidelines of 2015. The assessment scale includes the ratings highly successful, successful, less than successful, and unsuccessful. There are five evaluation criteria for sovereign programs, each weighted at 20% of the overall success rating: relevance, effectiveness, efficiency,

15 IED. 2015. Guidelines for the Preparation of Country Assistance Program Evaluations and Country Partnership Strategy Final Review Validations. Manila: ADB. 16 IED. 2018. Country Assistance Program Evaluation: Azerbaijan–Evaluation Approach Paper. Manila: ADB. 17 ADB. 2011. Country Operations Business Plan: Azerbaijan, 2011–2013. Manila; ADB. 2014. Country Partnership Strategy: Azerbaijan, 2014–2018. Manila; and ADB. 2015. Country Operations Business Plan: Azerbaijan, 2016–2018. Manila. 6 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

sustainability, and development impact. The ratings for the four public sector programs (the sovereign program) were weighted depending on each sector’s financial girth. The private sector operations program or nonsovereign program was assessed based on four evaluation criteria: development results, investment profitability, ADB additionality, and ADB work quality. Its weight in the overall assessment was also determined by its approved financial size.

Figure 3: Theory of Change: ADB Support to Azerbaijan, 2011–2017 CPS/COBP Country Development Goals

Strategic Objectives

• Help restore macroeconomic and financial • Inclusive growth through infrastructure development stability • Economic diversification through infrastructure development • Foster economic diversification • Improved and expanded access to social services • Support for economic policy reforms

2011–2013 2014–2017, (CPS) (2011 COBP) 2014–2015, (2014 CPS) 2016–2017, (2017 COBPb)

Outcomes that ADB Contributes to Outcomes that ADB Contributes to Outcomes that ADB Contributes to

Transport Transport Transport Adequate, efficient, safe, and low- More efficient, reliable, and safer More efficient, reliable, and safe carbon sustainable transport movement of people and goods to movement of people and goods to infrastructure network and services domestic and international markets domestic and international markets

Energy Public sector management c Increased affordable, and reliable Energy Improved allocative efficiency of power supply Increased and more efficient use of state budget resources, enhanced energy resources, including performance of state-owned Expanded power transmission and renewable energy enterprises, and reduced cost of distribution system; Increased financial intermediation in the public efficiency of delivery

and private sectors Independent Evaluation Government Sector Objectives Government Sector Objectives Water Supply and Sanitation Water and Other Urban Improved coverage, hygiene safety, Infrastructure and Services continuity, and quality of water Increased use of water supply, supplies and wastewater disposal sanitation, and municipal services b In 2017 COBP (2018–2020), energy was de- by urban residents emphasized; water and urban infrastructure and in selected towns services was dropped; and PSM was added. a a Finance Finance c The PSM policy-based loan approved in Increased private investment Improved private sector December 2017 has a finance sector opportunities participation development component. a Focusing on private sector operations Crosscutting themes and drivers change of Private sector operations, private sector development, environmental sustainability and climate change, regional cooperation and integration, governance and capacity development, gender equity Programs and projects supported by loans and technical assistance that are approved, active, and closed during 2011–2017

ADB = Asian Development Bank, COBP = country operations business plan, CPS = country partnership strategy, PSM = public sector management. Source: Asian Development Bank Independent Evaluation Department.

13. Matrix assessment approach. The evaluation takes a matrix assessment approach by assessing the relevance and development impact of the implementation of the three strategic agendas of Strategy 2020 and two special priorities (drivers of change) and integrating this with the sector program assessment.18 The three strategic agendas are inclusive economic growth (IEG), environmentally sustainable growth (ESG), and regional cooperation and integration (RCI). The two special priorities identified as constants in the CPSs are economic diversification and capacity development.

14. Structure of the report. The remainder of the report is structured as follows. Chapter 2 provides an overview of the context in which the program was developed, highlighting Azerbaijan’s development needs and the dominant themes of the evaluation period. Chapter 3 summarizes Azerbaijan’s development strategies through the evaluation period, and ADB’s strategies in support of the country. Chapter 4 assesses the performance of ADB sovereign operations by sector program, and that of NSO. This chapter pays special attention to the results of MFFs, which are a prominent feature of the program. Chapter 5 assesses results in terms of support for the strategic agendas and special priorities. Chapter 6 ties together the various assessments, summarizes key findings, and provides recommendations.

18 ADB. 2008. Strategy 2020: The Long-Term Strategic Framework of the Asian Development Bank, 2008–2020. Manila. Country Program and Evaluation Methodology 7

C. Summary

15. The ADB program centered on the shared long-term objective of diversifying the economy by boosting the non-oil sectors. To do so, ADB supported infrastructure in the energy, transport, and WUS sectors, as well as PSM at the time of the recent economic crisis. NSO supported diversification in the earlier stages but turned to onlending through banks until the crisis hit the financial system. ADB dedicated about 80% of the $3.9 billion sovereign lending portfolio to the infrastructure sectors, with a sustained focus on energy and transport, and a gradual reduction in WUS. Energy was the largest sector, accounting for 42% ($2.1 billion) and transport was the second largest, with 27% ($1.4 billion). In late 2016, ADB responded to Azerbaijan’s economic crisis by supporting economic reform. Accordingly, PSM grew in importance, reaching 15% of the portfolio. Meanwhile, NSO stagnated mostly due to the crisis, no new NSO were approved in 2017.

16. The CAPE includes a description of the portfolio and details, two assessments that, in keeping with the evaluation guidelines, examine the extent to which ADB support met the objectives of its strategies and their results frameworks. The CAPE’s main evaluation questions explore whether (i) the choice of sector programs helped diversify economic activity, (ii) the programs helped reduce regional development disparities, (iii) ADB was well positioned to support economic and policy reform, and (iv) MFFs were the appropriate instrument to support infrastructure development.

Country Context and Development Needs 2 10 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Highlights: • The Azerbaijan economy is dominated by the hydrocarbon sector and has suffered from the negative impact of Dutch disease. • Azerbaijan’s economic crisis during 2014–2017 was brought about by the decline in the world price of hydrocarbons. • Azerbaijan’s policy response to the crisis was to undertake structural reforms to delink government revenues from the world price of oil. • Azerbaijan still faces significant challenges regarding infrastructure, abating Dutch disease, and diversifying away from the oil economy.

A. Macroeconomic Developments

1. Economy

17. Azerbaijan's economy is dominated by the hydrocarbon sector. The economy grew at an average rate of 10.6% per year while riding the wave of high oil prices in world markets in 2006–2014. With oil-related production accounting for three-fourths of the growth of gross domestic product (GDP) and 90% of exports, the oil boom helped Azerbaijan transition to middle- income status, with per capita GDP rising from $663 in 2000 to $7,991 in 2014. The boom also allowed Azerbaijan to accumulate large foreign exchange reserves, some of them in its sovereign wealth fund, the State Oil Fund of Azerbaijan (SOFAZ). It also allowed the country to reduce its external debt burden, a significant share of which is from multilateral and bilateral sources, to just 8% of GDP in 2014. The boom in hydrocarbon revenues was further supported by the initial burst of foreign direct investment, mostly in the oil sector.19 The authorities’ focus at the time was to invest a large share of oil revenues in developing the country’s infrastructure. ADB supported that effort by focusing its strategy on large projects in energy, roads, and water and sanitation.

18. The creation of SOFAZ did not arrest the ensuing Dutch disease. In 1999, Azerbaijan created SOFAZ as a sovereign wealth fund for hydrocarbon revenues. Although it backed this effort with institutional changes that transformed the country into a market-based economy, these measures did little to shield the economy from the ensuing Dutch disease brought about by the surge in hydrocarbon-related domestic spending.20 This may be because SOFAZ was set up as a savings fund with domestic spending capacity, and not as a stabilization fund.21 Indeed, the 2005–2016 period provided SOFAZ with $128 billion in revenue, but by the end of 2016 only $33.1 billion, or 26% of the revenues, had been saved; the rest had been injected into the economy. Not surprisingly, with the pent-up demand for productive resources and non-tradable goods,22 Azerbaijan’s real effective non-oil exchange rate appreciated by about 35% between the

19 Most foreign direct investment into Azerbaijan went to the fossil fuels sector (83%). The main sources were the Czech Republic, France, Japan, Norway, the Russian Federation, Turkey, the United Kingdom, and the United States. 20 In economics, Dutch disease is the apparent causal relationship between the increase in the economic development of a specific sector and a decline in other sectors. In Azerbaijan, this manifested as pent-up domestic spending of oil revenues leading to a significant appreciation of the manat in real terms and a shrinking of the relative size of the non- oil tradable sector of the economy. 21 A stabilization fund would have saved all excess oil revenues beyond a long-term metric during the boom years and then used the savings to finance expenditures at a level consistent with the long-term metric. See R. Ossowski and H. Halland. 2016. Fiscal Management in Resource-Rich Countries: Essentials for Economists, Public Finance Professionals, and Policy Makers. World Bank Studies. Washington, DC.: World Bank p. 71. 22 For the purposes of this evaluation economic sectors have been divided into three groups: tradables, non-tradables, and basic services. Tradables include agriculture, forestry, fishing, manufacturing, transportation and storage, and information and communication. Non-tradables include construction; wholesale and retail trade; accommodation and food services; financial and insurance activities; real estate activities; professional, scientific and technical activities;

Country Context and Development Needs 11 end of 2010 and January 2015 (Figure 4). Meanwhile the share of the non-oil economy shrank from 60.9% in 2002 to 50.3% in 2010, with the share of non-tradables further increasing from 21.3% in 2010 to 38.6% in 2017 (Figure 5).

Figure 4: Azerbaijan: Real and Effective Exchange Rates, 2001–2017 150 140 130 120 110 100 90 80 70 60 50

Total Economy Non-oil Economy

Sources: Central Bank of Azerbaijan and study team estimates.

Figure 5: Azerbaijan Gross Domestic Product by Sector, 2010–2016 100%

80%

60%

40%

20%

0% 2010 2011 2012 2013 2014 2015 2016

Oil & Gas Tradable Nontradable Basic Serv, Edu, Health, Gov Sources: State Statistical Committee of Azerbaijan and study team estimates.

19. The strong spending pressure on the non-tradable sector including government services, absorbed about half of the labor force and did not open space for the tradable sector. During 2011–2016, the share of the labor force employed in the non-oil tradable sector of the economy slightly declined from 48.2% to 46.9%, instead of increasing, as would have been expected from a diversifying economy (Figure 6). As early as 2011, the International Monetary Fund (IMF) had called for Azerbaijan to delink its fiscal policy from the global oil price cycle to reduce procyclicality and protect the non-oil economy.23 At the time, the government did not pick up on these calls.

administrative and support service activities; the arts; entertainment and recreation; and other service activities. The third group includes basic services−energy and water and sanitation, education, health, and government services. Existing data do not allow for a more precise differentiation. 23 IMF. 2012. Republic of Azerbaijan: 2011 Article IV Consultation. IMF Country Report 12/5. Washington, D.C. 12 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Figure 6: Azerbaijan Employment by Sectors, 2011–2016 100%

80%

60%

40%

20%

0% 2011 2012 2013 2014 2015 2016

Tradable Nontradable Basic Services, Edu, Health & Gov Oil & Gas

Sources: State Statistical Committee of Azerbaijan and study team estimates.

2. The Crisis

20. The sharp drop in world oil prices, by almost 55% from June 2014 to October 2016, changed Azerbaijan’s macroeconomic performance for the worse. The drop resulted in lower or negative growth rates, fiscal imbalances, devaluations of the Azerbaijan manat, and finance sector instability. Azerbaijan’s economic growth rate dropped by almost 6-percentage points from 2.8% in 2014 to -3.1% in 2016. However, the recession bottomed out in 2017 as oil prices started to recover, and GDP growth resumed. Nevertheless, with lower oil-related revenues, the external current account swung from a surplus of 13.6% of GDP in 2014 to deficits of 0.4% in 2015 and 3.6% in 2016.24 Meanwhile the government’s balance of payments went from a surplus of 2.9% of GDP in 2014 to a deficit of 3.6% of GDP in 2016. Public expenditure fell and public investment declined, slowing construction and overall economic activity. The decline in activity was hastened by SOFAZ’s asset loss during 2014−2016, which resulted in smaller transfers to the budget in dollar and real terms, though not in Azerbaijan manat terms.

21. The ripples of the fall in world prices also hit oil-rich neighboring trading partners, further worsening the crisis in Azerbaijan. Hard-hit neighbors allowed their currencies to depreciate, and exports to and remittances from these economies declined. Remittances, most of which support the rural population, declined by 31% to $1.2 billion per year. In addition, the depreciation of neighboring countries’ currencies coupled with an initial expansionary credit stance by the Central Bank of Azerbaijan put further pressure on the manat, and Central Bank of Azerbaijan was forced to allow the currency to depreciate by more than 49.4% in 2015. The exchange rate has since been stabilized. The average rate of inflation rose to almost 12.9% in 2017, from 1.4% in 2014 with the high pass-through of the devaluation of the Azerbaijan manat. . 22. The weakening of the Azerbaijan manat increased dollarization and led to a credit crunch. The people’s perception of the Azerbaijan manat as a poor store of value led to an increase in the share of dollar-denominated deposits in the banking system from 38.5% in 2014 to 85.0% in 2016.25 In addition, many banks were faced with a sharp deterioration in their assets

24 According to the World Bank, the external deficit is estimated to have turned into a surplus of 4.1% in 2017. 25 Part of the increase in the share of dollar-denominated deposits stems from the valuation of those deposits at a more depreciated exchange rate, which increases their values in Azerbaijan manat terms even if their dollar value has not increased by much. It may also reflect depositors exchanging their Azerbaijan manat deposits for dollar-denominated deposits by buying the foreign exchange with their Azerbaijan manats. IED did not have access to the dollar value equivalent of these deposits. Country Context and Development Needs 13 as debtors were unable to service their foreign exchange-denominated debts at a more depreciated exchange rate and as the economy slowed. The impact on Azerbaijan’s banking system was significant. Twelve banks had to close. Overall, these monetary developments resulted in a credit crunch, especially in Azerbaijan manat and for small and medium-sized enterprises (SMEs) and the rural sector.

23. External debt increased significantly. The external debt increase was most due to the bailing out of a major public bank, as well as the government’s investments in the Southern Gas Corridor (for the expansion of the Shah Deniz gas field), and financial support given to state- owned enterprises (SOEs). These increases, coupled with the impact of the devaluation on the debt-GDP ratio, led to the jump in the ratio from a low 8% of GDP in 2014 to between 20% and 30% of GDP in 2016 and 2017. The situation became more testing after major credit rating agencies downgraded Azerbaijan, thereby increasing the cost of sovereign and nonsovereign borrowing abroad.

24. Taking a long view, the fossil fuel boom that had led to a 15-fold increase in the size of Azerbaijan’s economy in 2000–2014, was followed by a halving of GDP in dollar terms at the time of the bust in 2014–2017. Azerbaijan’s GDP increased from $5.3 billion in 2000 to a peak of $75.2 billion in 2014, before falling to $37.9 billion in 2016 and an estimated $40.8 billion in 2017. Per capita GDP, which had risen from $663 in 2000 to a peak of $7,991 in 2014, fell to an estimated $4,186 in 2017.26

3. Policy Response and Recovery

25. The government reacted by dampening the downturn and addressing needed reforms to curb Dutch disease. The government’s active response together with stronger fossil fuel prices in world markets allowed the economy to stabilize in 2017 and resume modest growth. The non-oil economy is being propelled by the pick-up in tourism and the agricultural sector, which have benefited from the more depreciated Azerbaijan manat and government spending in the social sectors. The government confronted the oil price shock by initially carrying out countercyclical policies, followed by a needed tightening. In addition, the government allowed exchange rate flexibility at the most testing times and started to address the crisis in the banking sector.

26. Needed structural reforms were at the core of the government’s policy response. The authorities are moving to create a medium-term fiscal policy framework that, if properly implemented, should moderate the impact on the economy of fluctuations in world oil prices. The government’s efforts to confront the crisis also led to improvements in social protection and labor markets, including the introduction of a new unemployment insurance fund, the implementation of pension reform, and a shift from passive to active labor market programs. The government is also working on improving the administration and transparency of SOEs, to lessen their burden on the budget and to prepare some of them for eventual privatization. Nevertheless, several challenges remain. Monetary and exchange rate policies must work with the fiscal framework and be geared toward protecting the economy from further occurrences of Dutch disease. In addition, the government should continue work on the recovery of the banking system, so that credit flows may resume, especially to small producers in the non-oil economy. More generally, the implementation of all these welcome structural reforms must be sustained to yield the desired results.

26 Ministry of Economy, Government of Azerbaijan. 14 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

B. Poverty and Regional Inequality

1. Poverty

27. The oil boom was accompanied by significant reductions in poverty, with the poverty headcount ratio declining from 49.6% of the population in 2001 to 5.3% in 2013. Extreme poverty fell below 3%, measured using the international poverty line of $1.25 per day (at purchasing power parity). Rapid growth, heavy public spending on pensions and social protection programs, high wage increases, and growing employment contributed to the impressive progress in poverty reduction.27 During 2007–2012, the consumption of the bottom 40% of the income distribution grew by more than 2% per year, which was twice as fast as the consumption growth of the top 60% of the income distribution. The positive trend in shared prosperity has led to an expansion of the middle class, from 4.3% of the population in 2007 to 28.9% in 2012. During 2000−2013, the minimum wage increased by a factor of 20 and real wages rose by 11% per year. While considerable progress has been made in reducing poverty, many low-income groups are vulnerable to falling back into poverty. Among the who are most vulnerable are the 597,000 internally displaced persons (IDPs) from the Nagorno-Karabakh conflict in the early 1990s.

28. After rising at the fastest pace among ADB member countries, GDP per capita plummeted at the time of the crisis. Real GDP per capita (in 2005 purchasing power parity [PPP] terms) grew by 12.5% in 2000–2005, and by a further 18.1% in 2005–2009, the highest combined growth rate among ADB member countries during those years.28 When world market prices for fossil fuel declined markedly, the boom of the earlier years of the evaluation turned into a bust. This had a major impact on per capita GDP (Figure 7). By 2016, real GDP per capita had dropped to $5,862 (in 2010 United States dollars), which is about the same as the level in 2010.

Figure 7: Azerbaijan: Gross Domestic Product per Capita (constant 2010 United States Dollars)

6200

6100

6000 5900

5800

5700

5600

5500 2010 2011 2012 2013 2014 2015 2016

Sources: World Bank Sustainable Development Goals database and study team estimates.

27 ADB. 2010–2017. Asian Development Outlook (various issues). Manila. 28 ADB. 2011. Framework of Inclusive Growth Indicators: Key Indicators for Asia and the Pacific 2011. Manila.

Country Context and Development Needs 15

29. Beyond GDP growth, the two main forces behind the decline in poverty were the increase in social transfers, and in wages and employment. Both factors reflected domestic spending of a large share of the hydrocarbon revenues. According to World Bank estimates the poverty rate could have been almost 60% higher in the absence of these higher social transfers.29 The largest contributions to poverty reduction came from the increase in pensions and general social insurance. Although government spending on social transfers remained just under 5% of GDP in 2000–2008, the amount of resources increased markedly in real terms because of the fast pace of GDP growth; about 81% of the poor received some kind of social transfer during this period. The World Bank 2008 household survey found that about two-thirds of Azerbaijan’s population lived in households that were receiving at least one social transfer.

30. Real wage increases, rather than an increase in employment, explain most of the reduction in poverty attributable to employment. Average real wages grew by nearly 13% per year during 2000−2010. However, the observed increases were not even across sectors. While nominal wages in agriculture rose at an average yearly rate of 27.3% during the same period, the figure was 13.1% for trade and commerce, and 14.6% for tourism and accommodations. In the transport sector and wholesale and retail trade, wage increases were backed by productivity increases; in agriculture and construction the correlation is unclear. Despite the sizeable differences in wage dynamics, the absorption of labor by the different sectors has been stable, denoting a rigid and imperfect labor market. While the oil and gas sector absorbed about 0.9% of those employed, the share of agriculture−the largest employer−only showed a slight decline from 39.1% in 2000 to 37.9% in 2011 (Figure 8). Another noticeable feature of the absorption of labor by the different sectors is that the non-oil tradable sector only employs about one-third of the labor force.30 These labor market features work against the inclusiveness of growth, to the extent that the labor force seems unable to move to the sectors where productivity and rewards are greatest.

Figure 8: Azerbaijan: Employment by Sector 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 00 01 02 03 04 05 06 06 08 09 10 11 12 13 14 15 16 17

Agriculture Manufacturing Services

Sources: World Bank Sustainable Development Goals database and study team estimates.

2. Regional Inequality

29 World Bank. 2010. Azerbaijan Living Conditions Assessment Report. Washington, D.C.; and World Bank. 2011. Azerbaijan: Inclusive Growth in a Resource-Rich Economy. Washington, D.C. 30 Non-oil tradable sectors include agriculture, forestry, fishing, manufacturing, transportation, and information and communications. The latter three sectors serve the oil and gas sector, and thus the size of the non-oil economy is overstated by including these sectors. However, given the available statistical information, there is no way to fine-tune this definition.

16 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

31. National averages mask important welfare disparities between rural and urban areas and across regions and social groups. Although poverty declined in both rural (by 10.8%) and urban areas (by 8.5%) during 2007−2012, 61% of the poor live in rural areas. In 2012, the poverty rate in rural areas was nearly twice that in urban areas (8.0% versus 4.5%). At the same time, poverty varies widely across regions, from more than 14.0% in Lankaran to 2.0% or less in Baku and Nakhchivan.31 IDPs are another vulnerable group, with a poverty rate of about 18%.

32. Further regional disparities arise from the heavy concentration of population and economic activity in the capital, Baku, and the surrounding region of Absheron, where about 25% of the population live and where economic activity has hastened regional disparities. Baku metropolitan area with a quarter of the population, accounted for 78% of the goods produced in 2009.32 Indeed, while rural poverty declined from 42.5% in 2001 to 18.5% in 2008, poverty in Baku fell more sharply from 49.2% to 9.3% in the same period. When looking at the regions, however, statistical information is scant making it difficult to draw clear conclusions. A comparison of the share in total production of Baku and the Absheron region and the rest of the country shows that the share of production by the rest of the country has gradually increased suggesting that growth has been inclusive despite the oil crisis (Figure 9). However, on a per capita basis, the production of the seven poorest regions (those with a higher concentration of the two lower quintiles of income), has not kept pace with the increase in the more affluent ones—Absheron, Baku, Ganja, and Nakhchivan (Figure 10).33

Figure 9: Production of Goods: Baku and Absheron versus the Rest of Azerbaijan 85% 24% 22% 80% 20% 75% 18% 70% 16% 14% 65% 12% 60% 10%

Baku Baku & Absheron Rest of Country

Sources: State Statistical Committee of Azerbaijan and study team estimates.

31 Although Nakhchivan and Ganja are still poor regions, together with Absheron and Baku they are relatively better off because the rest of the regions have a higher accumulation of the two lower quintiles of income. See footnote 7 in World Bank. 2015. Country Partnership Framework for Azerbaijan for the Period FY16-FY20. Washington, D.C. 32 European Commission. 2011. Social Protection and Social Inclusion in Azerbaijan. Brussels. 33 World Bank. 2015. Country Partnership Framework for Azerbaijan for the Period FY16-FY20. Washington, D.C. Country Context and Development Needs 17

Figure 10: Azerbaijan Gross Domestic Product per Capita by Region 5.20 10,000 5.10 5.00 8,000 4.90

6,000 4.80

manats 4.70 4,000 4.60 4.50 2,000 4.40 0 4.30 2011 2012 2013 2014 2015 2016 2017

Wealthiest 4 Poorest 7 Ratio Wealthy/Poor

Sources: State Statistical Committee of Azerbaijan and study team estimates.

C. Economic Diversification

33. As a resource-rich country, Azerbaijan faces the challenge of managing its economic policies to ensure that a single commodity that dominates GDP and exports but employs less than 1% of its labor force, does not cause the rest of the population to live on social benefits dispensed from government oil and gas revenues. As mentioned in the country partnership strategy final review validation (CPSFRV), the Asian Development Outlook, and documents of other development partners,34 in the long-run, Azerbaijan must become less reliant on hydrocarbons to reduce its vulnerability to global shocks, maintain social transfers at a sustainable level, and keep growth and development on a smooth path. Accordingly, diversification should take place in the sectors in which Azerbaijan has a comparative advantage in export markets, and those that are less dependent on oil-financed government spending, especially given the rapid growth of the labor force by 56% between 1991 and 2016.35

34. Diversifying economic activity in Azerbaijan is challenging for several reasons. These include (i) Dutch disease, (ii) a legacy of structural issues that hampers private enterprise development, (iii) weaknesses and rigidities in labor markets, and (iv) low capacity and productivity in a large segment of the labor force. An additional constraint stems from the frailty of capital markets, and the constraints on financing imposed by the crisis of Azerbaijan’s finance sector: even if entrepreneurs manage to overcome relative prices, distortions, rigidities, and weak capacity, they may not be able to get together the financing for their investments and working capital.

34 World Bank. 2017. Azerbaijan Snapshot. Washington, D.C.; World Bank. 2015. Country Partnership Framework for Azerbaijan. Washington, D.C.; European Bank for Reconstruction Development. 2014. Strategy for Azerbaijan. London; IMF. 2016. Republic of Azerbaijan: Staff Report for the 2016 Article VI Consultation. Washington, D.C.; and ADB. 2016 and 2017. Asian Development Outlook. Manila. 35 Republic of Azerbaijan and International Labor Organization. 2016. Decent Work Country Programme of the Republic of Azerbaijan for 2016–2020. Baku. 18 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

35. Macroeconomic management has resulted in faster growth in the non-tradable sectors than in the tradable sectors, except in the oil crisis years when the Azerbaijan manat depreciated markedly. Figure 11 illustrates this pattern. Moreover, policies and infrastructure investments aimed at diversifying the Azerbaijan economy toward its most competitive non-oil tradable sectors have met with scant success, except in the agriculture and food staples sector (Figure 12). None of the non-oil exports except food staples have been able to increase their share in total exports beyond 2% in dollar terms, and the only time they all increased notably coincided with the 2015 real depreciation of the Azerbaijan manat. Agriculture and food staples, which make up about 5% of total exports, have benefited from special development efforts, such as agricultural parks and special trade agreements, which have resulted in sustained development of products such as tomatoes, nuts, and other fruits. These developments show that Azerbaijan’s economy has become increasingly dependent on public spending associated with oil and gas revenues, which is the main demand source for the non-tradable sector. Hence, while some diversification has taken place, the economy has developed into sectors that heighten its vulnerability to the cycles in the world markets for fossil fuels. Moreover, Azerbaijan’s comparative advantages outside fossil fuels have been ignored for the most part, despite their potential to absorb a large share of the growing labor force.

Figure 11: Azerbaijan Gross Domestic Product Factor Cost Nominal Growth, by Sectors 70% 200

180 60% 160

50% 140 120 40% 100 30% 80 ominal growth rate

n 20% 60 40 10%

20 Indexfor real effective exchange rate 0% 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Tradables Nontradables Real Effective Exchange Rate

Sources: Central Bank of Azerbaijan, State Statistical Committee of Azerbaijan, and study team estimates.

Figure 12 Azerbaijan: Share of Non-Oil Exports Country Context and Development Needs 19

7.0

6.0

5.0

4.0

3.0 Percent

2.0

1.0

0.0 2011 2012 2013 2014 2015 2016 2017

Food Staples Chemicals & Plastics Textiles Jewelry Metals Machinery

Sources: State Statistical Office of Azerbaijan and study team estimates. D. Environmental Sustainability

36. Like other countries of the former Soviet Union, Azerbaijan was left with a legacy of environmental challenges after the collapse of the Soviet Union. At the time of the CPS, 2014–2018, ADB identified several environmental areas where action was warranted. These included petroleum and industrial pollution, which was concentrated mainly on the Absheron Peninsula; continued pollution of the principal surface water bodies; inadequate management of household and hazardous waste and a legacy of unsafe disposal of hazardous waste; degradation of agricultural lands and pastures and of the ecology of the Caspian Sea coast; air pollution and greenhouse gas emissions by stationary and mobile sources; and pressure on the country’s biodiversity.36

37. Some progress has been made in many environmental fronts in recent years. The government has worked on improving legislation and supporting global and regional initiatives. The work has included rehabilitating contaminated soils, improving water supply and treatment, and upgrading solid waste management. Such efforts have resulted in successes, such as tapering in the rate of deterioration of air pollutant emissions since 2013 (Figure 13). Nevertheless, the environmental picture is still challenging, and includes issues related to desertification, endangerment of species, other threats to biodiversity, high levels of air pollution, other industrial pollution, and water source contamination.

Figure 13: Azerbaijan Air Pollutants by Source (in ‘000 tons)

36 ADB. 2014. Azerbaijan: Country Environment Note. Manila. 20 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

1400 1200 1000 800 600 400 200 0 2010 2011 2012 2013 2014 2015 2016 2017

Stationary Mobile Total

Sources: State Statistical Committee of Azerbaijan and study team estimates.

E. Future Challenges

38. Restoring macroeconomic stability. Following the crisis, a key government objective has been to safeguard macroeconomic stability to restore confidence and stimulate economic recovery. Government revenue needs to be delinked from volatile hydrocarbon revenues, through a combination of a medium-term fiscal rules and revenue mobilization from other sources. Public expenditures must be managed under clear rules governing transfers from SOFAZ to the budget for countercyclical spending, while maintaining clear program delivery targets in a sustainable medium-term fiscal framework. The government must also adopt best practices to gradually make its budget planning and implementation more effective, including improving the governance in SOEs and making greater use of private participation in public service delivery and infrastructure development.37 Moreover, SOEs need to stop being a burden on the budget and the economy.

39. Need for economic diversification. As mentioned in IED’s CPSFRV, the Asian Development Outlook, and documents of other development partners, in the long-run, Azerbaijan needs to become less reliant on hydrocarbons to reduce its vulnerability to global shocks and to restore more sustainable rates of economic growth and socio-economic development.38 That diversification is also essential to absorb the growth in the labor force, which has increased by 56% between 1991 and 2016, and to open economic opportunities in poorer regions and reduce disparities. Diversifying economic activity is challenging because it can only happen once Dutch disease is tackled. Additional challenges stem from (i) a legacy of monopolies and SOEs dominating activity in key sectors, (ii) the government’s traditional role of absorbing labor surpluses and of providing rather than facilitating privately-provided services,39 and (iii) the weaknesses in public service delivery and governance. A frail investment climate, a shallow and bank-centric financial market, and a skills mismatch in the labor market have also impeded economic diversification. Azerbaijan’s comparative advantages beyond fossil fuels are not being fostered, and any attempts to do so will face the burden of an appreciated Azerbaijan manat in real effective terms. However, diversification toward tradable non-oil sectors has the

37 ADB. 2017. Report and Recommendation of the President to the Board of Directors: Proposed Programmatic Approach and Policy-Based Loan for Subprogram 1 Republic of Azerbaijan: Improving Governance and Public Sector Efficiency Program. Sector Assessment Public Sector Management and Finance (accessible from the list of linked documents in the Appendix). Manila; and Center for Analysis of Economic Reforms and Communications. 2017. Strategic Road Map on National Economy and Key Sectors of The Economy of Azerbaijan. Baku. 38 IED. 2012. Azerbaijan: Validation of the Final Review of Country Operations: 2000–2011. Manila: ADB. 39 While the share of the labor force employed by the government declined from 56% in 1995 to 25% in 2015, the government absorbed a large portion of those that became unemployed because of the oil shock and ensuing recession. Country Context and Development Needs 21 added benefit of contributing to environmental sustainability, as sustainability approaches can now be introduced toward managing renewable resources.

40. Regional disparity, environmental sustainability, and infrastructure. While large infrastructure investments are ongoing, the infrastructure gap is still huge, and the challenges of regional disparity and environmental sustainability remain. The degree to which large infrastructure investments are able to catalyze sustainable non-hydrocarbon economic growth depends very much on how these investments are planned, delivered, operated, and maintained. Special efforts will be required to ensure that the road and rail corridors link all regions and are properly managed and maintained, and that rural roads, power lines, and other economic infrastructure are extended to secondary towns and cities to spread the benefits of transport corridor development, including reducing regional disparities. Likewise, reforms in the railway sector will need to be continued to improve its competitiveness, financial sustainability, and operational and cost efficiency. The sustainability of the significant public investment in construction and rehabilitation of infrastructure, particularly in the transport and energy sectors, would bring important environmental benefits, but is undermined by low tariffs and ineffective maintenance systems. Particularly in the power sector, tariffs will need to be set so that costs can be recovered, and investors have incentives to exploit the country’s considerable renewable energy potential. More generally, environmental concerns should weigh in the risks posed by climate change and the importance of managing disaster risks and building resilience to natural hazards.

F. Summary

41. Azerbaijan’s economy is dominated by the hydrocarbons sector. Fiscal policy is tied to hydrocarbon revenues, leading to procyclical macroeconomic policies. The economy grew at an average rate of 10.6% per year at the time of high oil prices in 2006–2014. The sharp drop in world oil prices, by almost 55% from June 2014 to October 2016, changed Azerbaijan’s macroeconomic performance for the worse. The government reacted by dampening the downturn and addressing needed reforms to curb Dutch disease. These efforts together with stronger fossil fuel prices in world markets stabilized the economy in 2017 and helped resume modest growth.

42. Progress in poverty reduction has been impressive, and some progress has been made on environmental sustainability, but challenges remain especially in economic diversification. Large disparities persist between sectors and regions; 61% of the poor live in rural areas, and poverty varies widely across regions. Economic diversification toward sectors in which Azerbaijan has comparative advantage has met with little success, and the economy’s dependence on fossil fuels has increased. In addition, the pollution legacy of the Soviet era weighs heavily; and challenges remain regarding desertification, endangerment of species, other threats to biodiversity, high levels of air pollution, other industrial pollution, and water source contamination.

D OF R 2)

Development Strategies and ADB Support 3 24 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Highlights: • The government has updated its development strategies on a regular basis and the Asian Development Bank (ADB) has closely aligned its strategic priorities and support with them. • The most recent government strategy, developed in December 2016, focuses on accelerating economic diversification in light of the socio-economic impact of the oil price shock, and responding to the fossil fuel crisis. • ADB’s strategic priorities during 2011–2017 can be split into two phases. Before 2016, ADB focused on inclusive growth and economic diversification through infrastructure development and improved and expanded access to social services. From 2016, ADB added fostering economic diversification by restoring macroeconomic and financial stability and supporting needed economic policy reforms. • Transport operations were a priority throughout the period, while support for the energy sector was provided on a standby basis (subject to government request). Public sector management (PSM) operations replaced water supply and sanitation operations in the second phase. • In April 2018, the government announced a new policy on foreign financing from all sources, including international finance institutions. Formalized on 28 August 2018, the policy set a clear target to hold the public debt-gross domestic product to 30% at most in 2018–2025, and 20% thereafter. The policy explicitly allows for some ADB operations, including the second policy-based loan of the PSM programmatic series, and railways projects.

A. Government of Azerbaijan Development Strategies and Borrowing Policy

43. The government’s development strategies. The government has regularly updated its development strategies, maintaining a focus on what it sees as Azerbaijan’s most relevant objectives. ADB has aligned its support closely with the government strategies, including the 2004 Long-Term Strategy on the Management of Oil and Gas Revenues,40 the State Program on Poverty Reduction and Sustainable Development 2008–2015 (SPPRSD),41 Azerbaijan 2020: Vision for the Future (Vision 2020),42 and the Strategic Road Map on the National Economy Perspectives (SRMNEP), 2016–2025.43

44. Azerbaijan's Long-Term Strategy on the Management of Oil and Gas Revenues. This was Azerbaijan's first strategy clearly designed to chart a course that would lead to optimizing the use of the country's revenues from fossil fuels, while promoting a more diverse economy. Clear on objectives but short on numbers, this strategy laid out the following objectives for the use of the windfall revenues from fossil fuels: (i) developing the non-oil sector, poorer regions, and small and medium-sized enterprises (SMEs); (ii) undertaking large-scale development of infrastructure; (iii) fulfilling poverty reduction measures and solving other social problems; (iv) stimulating the improvement of “the intellectual, material, and technical base of the economy”; (v) developing human capital, including training highly qualified specialists even abroad, and improving the professional capacity of employees; and (vi) addressing some of the issues raised by the Nagorno-Karabakh conflict.

45. The State Program on Poverty Reduction and Sustainable Development, 2008–2015. This program was fully aligned with Azerbaijan’s Millennium Development Goals commitments

40 Government of Azerbaijan. 2004. Long-Term Strategy on the Management of Oil and Gas Revenues. Baku; and Decree of the President of the Republic of Azerbaijan No. 128, dated 27 September 2004. Baku. 41 Government of Azerbaijan. 2008. State Program on Poverty Reduction and Sustainable Development, Republic of Azerbaijan. 2008–2015. Decree of the President of the Republic of Azerbaijan No. 3043, dated 15 September 2008. Baku. 42 Government of Azerbaijan. 2012. Development Concept Azerbaijan—2020: The Vision of the Future. Baku. 43 Decree of the President of the Republic of Azerbaijan on approval of the Road Map on National Economy and Main Sectors of the Economy, dated 9 December 2016. Baku; and Center for Analysis of Economic Reforms and Communication. 2017. Strategic Road Map on National Economy and Key Sectors of the Economy of Azerbaijan. Baku. Development Strategies and ADB Support 25

and was designed to tackle poverty through major public spending in infrastructure, social services, social protection, information and communications technology, and by modernizing industries and agriculture aimed to double real GDP between 2008 and 2015, contain inflation in the single digits, and maintain the rate of non-oil GDP growth within the range of 7%–8% per year. Several infrastructure megaprojects, including the Baku-Tbilisi-Erzurum gas pipeline and the Baku-Tbilisi-Kars railway, were key drivers of inclusive economic growth under the program.

46. Vision 2020. In 2012, the government felt the need to affirm its development strategy and issued Vision 2020. This strategy aimed at preserving macroeconomic stability, improving the business environment and ensuring free competition, creating favorable conditions for local and foreign investments, taking measures to upgrade the structure of the economy, implementing investment and other large-scale projects, and organizing effective social security for all. These policies were meant to develop the non-oil sector, speed up the emergence of knowledge-intensive products (works and services), balance the development of the regions, develop human capital, and improve the social safety net, while developing institutional capacity. These objectives were to be achieved while protecting Azerbaijan’s cultural heritage, and its environment. The clear objectives were to raise per capita GDP to $13,000 by 2020, based on a diversified economy that would make Azerbaijan a regional commercial center, and distribute service delivery evenly so that all regions in the country could benefit from the best services. Vision 2020 was the government’s first focused and detailed policy on economic diversification. After the presidential elections of October 2013, the government continued to pursue the same approach and accelerated the reforms in selected areas, such as education, social services, agriculture, and e-government.

47. The strategic road maps. The Strategic Road Map on National Economy and Main Sectors of the Economy of Azerbaijan, approved on 6 December 2016, addressed national economic development and included specific strategies for the development of 11 economic sectors. It embodied the government’s policy response to the fossil fuel crisis, while continuing many of the initiatives of older strategies and calling for a shift from a growth trajectory based on investment to one based more on efficiency and productivity. Key elements of the 2016 economic development strategy include: (i) strengthening fiscal sustainability and ensuring a robust monetary policy; (ii) coordinating the overall approach to improve the efficiency of the public sector’s role in the economy, particularly regarding the governance of SOEs; (iii) attracting the most appropriate investors for privatization and foreign direct investment; (iv) improving the quality at all stages of education while bolstering human capital to increase labor productivity; and (v) developing a suitable business environment. Restoring macroeconomic stability, broadening the scope for private initiative and enhancing the investment climate were accorded high priorities for the first years of the strategic road maps. This road map targets a growth in real per capita incomes of 5% per year with three-quarters of growth originating in the non- hydrocarbon sectors. Beyond 2025, it envisions Azerbaijan becoming a high-income economy that is more inclusive, diverse, regionally integrated, technologically-sophisticated, and knowledge-based. However, the quality of the sector road maps is not uniform; there are varying levels of details on action plans, activities, milestones and targets, and specific ministries and agencies have been identified for implementing the action plans and achieving the stated targets. A monitoring and evaluation system has also been established, though it needs strengthening.

48. The government’s borrowing policy. During the early years of the CPS, the government had a clear policy of optimizing its external borrowing over the medium-term as part of the ongoing effort to maintain fiscal sustainability. This policy led the government to refocus its foreign-currency denominated borrowing, including loans from international finance institutions (IFIs), to support projects with a high economic rate of return where international expertise and technical assistance (TA) would justify potential exchange rate risks. Projects in this category include investments in highways and other transport, water supply and sanitation (WSS) systems, 26 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

and energy distribution. The government chose to fund investments in social sectors, such as health, education, and social protection, using its own resources, given the high domestic component in these programs and their typically slow and long-term returns.

49. The government’s policy shifted dramatically after the crisis. In his inauguration speech in April 2018, the President announced a policy of limiting foreign financing to the public sector from all sources, including IFIs.44 The policy was formalized on 28 August 2018, setting a clear target to hold the public debt to GDP ratio to 30% at most in 2018–2025, and 20% thereafter. The policy explicitly allows for some ADB operations, including the second policy- based loan of the PSM programmatic series, and railways projects. The freeze reflects the government’s concerns with the rising external debt to GDP ratio, which now exceeds 30% of GDP. The sharp increase was due in part to the devaluation of the Azerbaijan manat which reduced the denominator in the ratio in dollar terms. More important were the increases due to the government’s investments in the Southern Gas Corridor, the bailing out of the International Bank of Azerbaijan, and SOE contingent liabilities, guarantees, and other government support.

50. The government remains interested in exploring greater private sector participation in the provision of public services. The move, however, is seen as a gradual process where opportunities for private sector investments will be opened as soon as some structural barriers are removed. For instance, private participation in energy distribution will only be viable once the government makes significant progress in using cost-recovery tariffs. At that point, the government will consider creating the necessary legal framework for private participation to take place.

B. ADB’s Strategies in Azerbaijan and Responsiveness

1. ADB Strategies in Azerbaijan

51. The studied portfolio of interventions was guided by seven key strategic documents. One CPS and six COBPs guided ABD’s activities (footnote 3). In addition, immediately before the evaluation period, the 2006 country strategy and program update (CSPU) provided strategic guidance for operations.45

52. 2006 CSPU. In the absence of a formal country strategy, the 2006 CSPU guided ADB operations during 2006–2010. 46 The CSPU shifted ADB’s focus from poverty reduction to infrastructure and private sector development. After a decade of rapid economic growth and poverty reduction, the government’s focus had changed to strengthen infrastructure links with neighboring countries and improving competitiveness. The CSPU identified education, energy, transport, urban development, and WSS as possible focus areas. It highlighted that an assessment of Azerbaijan’s repayment capacity in light of the oil-led economic growth rates showed that the country could prudently increase its level of non-concessional borrowing. It argued that the shift toward less concessional financing would necessitate a readjustment in the emphasis of ADB’s country program. It added that the government had indicated its willingness to use OCR financing for projects in transport, energy, and WSS. It identified a larger pipeline of

44 IED understands the policy covers public and publicly guaranteed debt. 45 Before the CAPE period, the first strategy document to guide ADB’s operations in Azerbaijan was the Interim Operational Strategy approved in December 2000 (ADB. 2000. Economic Report and Interim Operational Strategy for Azerbaijan. Manila). This was intended to guide operations during 2001–2003 until a full-scale country strategy could be prepared. However, the full strategy was only prepared in 2014. Thus, ADB operated without a formal country strategy for 10 years from 2004 until 2013. A partnership strategy was to have been belatedly prepared in 2007, but it did not go forward because of uncertainty regarding government interest in borrowing from IFIs and a lack of clarity in the forward lending program. Indeed, the increasing abundance of hydrocarbon revenues changed the government’s borrowing strategy repeatedly from 2004 to 2011. 46 ADB. 2006. Country Strategy and Program Update: Azerbaijan. Manila. Development Strategies and ADB Support 27

road and WSS projects than in previous CSPUs. It indicated that ADB would also address areas of the energy sector, such as renewable energy and gas supply in underdeveloped areas, to bring power and heating to the poor. The CSPU also signaled ADB’s intention to deploy private sector operations in support of privatization or to assist private entities in key sectors. Support for regional towns was to be expanded, in line with government’s decentralization efforts, with funds earmarked to assist IDPs. Basic education was to be an emerging area of support, while ADB was to exit from support for agriculture and rural development.

53. 2011 COBP. ADB’s COBP, 2011−2013 was an interim step in the preparation of a new CPS in 2013.47 While the primary objective of ADB operations in Azerbaijan remained unchanged from 2006, the focus of ADB support was narrowed to supporting physical infrastructure. Sector priorities were identified as transport, energy, and WSS. In transport, ADB’s focus was on reconstruction and rehabilitation of highways, and sector-wide management and reforms. In energy, support was to be provided for rehabilitation and upgrading of transmission and distribution lines, and sector-wide institutional and capacity building. In WSS, the emphasis was to be given to WSS services, wastewater treatment, and sector-wide institutional development and capacity building. ADB’s proposed indicative pipeline would average $315 million per year for 2011–2013 and be delivered entirely in the form of a series of MFFs. These were to cover road network development, WSS, power distribution, border highway investment, and urban transport investment. The COBP indicated that ADB would continue to support private sector operations in trade finance and finance sector development, while exploring private sector investment opportunities in energy, logistics, agribusiness, and shipping.

54. 2014 CPS. ADB’s first CPS for Azerbaijan was issued in 2014 and covered 2014–2018.48 The CPS supported Azerbaijan’s transition to a diversified, knowledge-based economy, bolstering sustainable, non-oil economic growth. ADB’s support prioritized transport, water and other urban infrastructure and services (WUS), and energy. In transport, the priorities were to help the government finish the East-West and North-South transport corridors, and to support institutional reforms that would strengthen road management and maintenance. In the urban sector, the CPS envisioned a comprehensive approach encompassing WSS, urban transport, and solid waste management to improve service coverage and environmental management in secondary towns, including in the central and northern regions and the Nakhchivan Autonomous Republic (NAR). In energy, the focus was on renewable energy development and upgrading the power distribution network. Policy dialogue on tariff and utility management was to continue, while support would also be provided to develop the legal framework to allow greater private participation in power generation. ADB support was to contribute to inclusive growth by upgrading infrastructure outside the Absheron Peninsula, stimulating new economic activities outside the capital, and lowering household costs for water and electricity. Private sector support was to continue to promote rural financial inclusion by providing lending to rural micro, small, and medium enterprises (MSMEs) and farmers, expanding the housing mortgage market, and deepening leasing and insurance. Trade finance would help fill market gaps, and nonsovereign projects were to be initiated in the downstream petrochemicals industry. ADB would provide advice to the Central Bank of Azerbaijan to help develop the policy and regulatory framework for microfinance. ADB was also to help prepare an enabling environment for PPPs and develop PPP projects. To achieve these goals, the CPS targeted OCR funding of $752 million for infrastructure projects during 2014–2017.

55. 2017 COBP. ADB’s strategic priorities were adapted in 2016 in response to the sharp fall in global fossil fuel prices with the approval of a $500 million Countercyclical Support Facility

47 ADB. 2011. Country Operations Business Plan: Azerbaijan, 2011–2013. Manila. The CAPE considers the COBP as a country planning document in the absence of a full CPS for 2011–2013. 48 ADB. 2014. Country Partnership Strategy: Azerbaijan, 2014–2018. Manila.

28 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

(CSF) in December 2016 to support the government’s fiscal stimulus program. Along these lines, the COBP, 2018−2020 approved in September 2017 signaled ADB’s strategic intention to focus on programmatic PBL.49 This shift responded to a less favorable economic environment, and targeted PSM, and railway sector reform and development. ADB’s PSM operations were to strengthen the country’s public expenditure framework, the governance of SOEs, and the deepening of the finance sector. Public sector support was also to be used for improving railway infrastructure to help Azerbaijan capitalize on its crossroads location. The COBP also included a $500 million direct nonsovereign loan and a $500 million PCG with a sovereign guarantee to help the government continue to develop the Shah Deniz gas field, one of the world’s largest gas fields. The Shah Deniz project also supported the energy sector by (i) encouraging foreign operators to develop similar gas fields, (ii) opening the European market to Azerbaijan gas exports with a new pipeline, and (iii) increasing foreign direct investment in the country. Private sector operations would continue to support infrastructure finance, while engaging with commercial banks to onlend to SMEs. The COBP foresaw $450 million in lending programmed for 2017 on a standby basis, and $250 million programmed for 2018–2020.

56. ADB’s strategic priorities during 2011–2017. The strategic objectives, cross-cutting themes and drivers of change, and focus areas and/or primary sectors set out in the country strategy and planning documents are summarized in Table 1. The first and second phases (2011– 2013 and 2014–2015) focused on inclusive growth and economic diversification through infrastructure development and improved and expanded access to social services. ADB refined the strategic objectives in the third phase (2016–2017), shifting the focus to fostering economic diversification by restoring macroeconomic and financial stability and supporting needed economic policy reforms. The cross-cutting themes and drivers of change showed continuity, with private sector operations, private sector development, environmental sustainability and climate change, RCI, and capacity development present throughout all three phases. Gender equity was emphasized in the first two phases, governance in the second and third phases, while partnerships and knowledge solutions were present in the second phase. Transport operations continued to have priority throughout the period, while support for the energy sector was on a standby basis (subject to government request) and WSS operations were replaced by PSM operations in the third phase.

2. ADB’s Responsiveness to Government Strategies

57. ADB’s strategic objectives were broadly consistent with the government’s strategies and Azerbaijan’s long-term needs. Throughout the evaluation period, ADB adjusted its strategies to the government’s changing priorities, remaining anchored in the shared long- term objective of diversifying the economy by boosting the non-oil sectors. This anchor reflected the country’s long-term need to develop non-oil sectors capable of absorbing a growing labor force. At the government’s request, ADB focused on developing the necessary infrastructure identified in the 2004 Long-Term Strategy on the Management of Oil and Gas Revenues. One significant adaptation of ADB’s strategy came with the COBP, 2014−2016, which brought in the broader concept of the non-oil economy, including increased competitiveness and expanded export opportunities, introduced by the government’s Vision 2020 Strategy. A second major adaptation by ADB came with the COBP, 2018−2020, which acknowledged the strategic road maps’ targets of improving macroeconomic management, reforming SOEs, boosting human capital, and improving the business environment.

58. ADB’s cross-cutting themes and drivers were also broadly in line with government’s strategies. However, some cross-cutting themes or drivers of change were not always in ADB’s strategies throughout the CAPE period. In particular, partnerships, knowledge solutions, and

49 ADB. 2017. Country Operations Business Plan: Azerbaijan, 2018–2020. Manila. Development Strategies and ADB Support 29

gender equity appeared in the 2014 CPS, were barely addressed in the subsequent business plans. Only the COBP, 2018−2020 lists knowledge products for education, transport and urban assessments, and financial inclusion. There are no clear reasons why these documents did not highlight a topic such as gender equity.50 Nevertheless, many of ADB’s interventions could be construed as contributing to gender equity, such as the improvements in WUS, which gave women a better quality of life, and the CSF, which sought to help some sectors where women benefit the most, such as social housing. However, no special emphasis was given to these topics. ADB interventions were also limited in some other areas, such as environmental sustainability, where only two projects explicitly addressed environmental concerns.

Table 1: ADB Strategic Priorities in Azerbaijan, 2011–2017 2014–2017 (country partnership strategy, 2014–2018b) 2011–2013 2014–2015 2016–2017 Priorities (COBP, 2011–2013a) (COBP,2018–2020c) Strategic • Inclusive growth through infrastructure development • Help restore macroeconomic and objectives • Economic diversification through infrastructure development financial stability • Improved and expanded access to social services • Foster economic diversification • Support for economic policy reform Cross-cutting • Private sector operations • Private sector operations • Private sector operations themes and • Private sector development • Private sector development • Private sector development drivers of • Environmental sustainability and • Environmental sustainability and • Environmental sustainability and change climate change climate change climate change • Regional cooperation and • Regional cooperation and • Regional cooperation and integration integration integration • Governance and capacity • Capacity development • Governance and capacity development • Gender equity development • Gender equity • Partnerships • Knowledge solutions Focus areas • Transport • Transport • Transport (including railway) and/or primary • Energy • Energy (including gas) • Public sector management (public sectors • Water supply and sanitation • Urban infrastructure and services expenditure and fiscal management, (water supply and sanitation, state enterprise reform, public debt urban transport, and solid waste management) management) • Power (standby, subject to government request) ADB = Asian Development Bank, COBP = country operations business plan. a The COBP, 2011–2013 was updated by the COBP, 2012–2014 without any change in strategic direction. b The country partnership strategy (CPS), 2014–2018 was accompanied by four COBPs: the COBP, 2014–2016; the COBP, 2015–2017; the COBP, 2016–2018; and the COBP, 2018–2020. The first three COBPs did not have any change in strategic direction and primary sectors. c During 2016–2017, the strategic direction of the CPS, 2014–2018 was refined to include public sector management operations but this was acknowledged later in the COBP, 2018–2020. Sources: Azerbaijan CPS, 2014–2018; COBP, 2011–2013; and COBP, 2018–2020.

C. Previous Country-Level Evaluations of ADB and Partner Experience in Azerbaijan

59. The 2012 CPSFRV was the first independent country-level assessment. The first and only country program assessment prepared by IED was a CPSFRV in 2012, which covered ADB support during 2000–2011.51 Overall, the validation rated ADB-supported activities during the period successful and noted the country’s need for a diversified economy, increased competitiveness, and strengthened social services. It also made three recommendations: (i) ADB should always have a valid country strategy under which to operate, (ii) ADB needs to support

50 The CWRD provided comments on a draft of this report that the MFF had put a premium on involving women in the design, monitoring, evaluation, and management of the WSS systems. IED could not verify or observe notable evidence, or outcomes coming from special consideration to women during the field visits to target towns. The CWRD expects to receive the remaining data from the last PCR mission in December 2018, after the intended issuance of this report. 51 IED. 2012. Azerbaijan: Validation of the Final Review of Country Operations: 2000–2011. Manila: ADB. 30 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

the continuation of inclusive growth in the long run by channeling infrastructure investments and private sector initiatives directly toward secondary towns and rural populations, and (iii) ADB needs to prioritize public and private sector operations that help diversify the economy given that fossil fuel resources are finite.

60. Experience of other multilateral development partners. ADB’s main multilateral development partners in Azerbaijan are the Black Sea Trade and Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the International Finance Corporation, the International Monetary Fund (IMF), the Islamic Development Bank, the United Nations Development Programme, and the World Bank. In general, ADB cooperation with these partners during the CAPE period was constructive and helpful for Azerbaijan and the development partners. The institutions often worked together in different areas of the same sectors, finding useful synergies, as was the case with energy, water and sanitation, or roads. However, cooperation was not always uniform and productive. For instance, the IMF warned of the need to delink fiscal policy from world oil prices to curb Dutch disease as early as 2011, but this was not followed up by the government and other development partners, including ADB (apart from in discussions on this theme in its Annual Development Outlook). Nevertheless, it was ADB that began the dialogue on the necessary structural changes to macroeconomic policies, and ADB was the only multilateral institution that was able to work with the government in support of these reforms.

61. Experience of bilateral development partners. ADB’s main bilateral development partners in Azerbaijan are the Agence Française de Développement (AFD), German development cooperation through KfW, the Japan International Cooperation Agency (JICA), the Swiss Cooperation for the South Caucasus (SECO), and the United States Agency for International Development (USAID). In general, the experiences of these partners during the CAPE period has been positive, with a level of cooperation positively acknowledged by both the government and the bilateral partners. For instance, SECO, appreciated ADB efforts to improve macroeconomic policies, as they perceived those reforms as necessary to provide a stable macroeconomic background for their efforts to improve Azerbaijan’s finance sector. Similarly, USAID noted recent ADB work to support civil society organizations that face a challenging regulatory environment. These efforts helped a range of such organizations including think-tanks and organizations working on gender equity.

D. Summary

62. Since the beginning of the oil boom in 2004, the government and ADB have defined their economic and development strategies in several strategy documents. Two themes that are repeated in all these documents are the need to diversify the economy by fostering the non- oil economy, and to develop the necessary infrastructure to improve the quality of life, and enable economic diversification. However, the government’s borrowing policy changed in April 2018, when the President announced a policy of zero net increases in public sector exposures to the different creditors. The government remains interested in exploring greater private sector participation in public services provision.

IED produced the first and only independent country program assessment in 2012, covering ADB support during 2000–2011. The CPSFRV noted the country’s need for a diversified economy, increased competitiveness, and strengthened social services. It also made three recommendations: (i) ADB should always have a valid country strategy under which to operate, (ii) ADB needs to support the continuation of inclusive growth in the long run by channeling infrastructure investments and private sector initiatives directly toward secondary towns and rural populations, and (iii) ADB needs to prioritize public and private sector operations that help diversify the economy given that fossil fuel resources are finite. Sector Program Performance 4 32 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Highlights: • Infrastructure accounted for 80% of the Asian Development Bank program. Support for economic reforms made up the rest. • Energy tariffs are not sufficient to cover the sector’s cash outflows, which need continuing government support. The sector is expected to return to full profitability by 2025. • Transport suffered from implementation challenges leading to delays and cost overruns. Once all roads are in use, they are expected to contribute to Azerbaijan’s development as planned. • Any future investment in water supply and sanitation calls for a serious dialogue on tariffs and their comprehensive reform to ensure long-term sustainability. • Nonsovereign operations were to assist with economic diversification and help the private sector play a greater role in industry, trade, small and medium-sized enterprises, and infrastructure development. The performance of ADB nonsovereign operations was satisfactory overall but they faced major challenges.

63. ADB support to Azerbaijan focused mostly on sovereign operations in energy, transport, WUS, and PSM. Support for NSO stagnated toward the end of the evaluation period. Most (80%) of ADB support was through sovereign lending in the infrastructure sectors, with support for PSM coming only in the last 2 years. Although they accounted for more than 20% of the portfolio in 2011−2017, support for NSO stagnated following the economic crisis, and no new NSO were approved in 2017.

64. This chapter looks at the performance of the ADB program in each sector. The assessment considers the relevance, effectiveness, and efficiency of ADB support. It also looks at the development impact and the likelihood that the outcomes of ADB support will be sustainable.

A. Energy Program

1. ADB Program

65. ADB support to the energy sector focused mostly on improving the distribution system, facilitating exports of Azerbaijan’s energy, and buttressing policies and institutions. Addressing the critical gaps in and constraints on the distribution system implied rehabilitating the power transmission and distribution networks to improve power supply reliability and efficiency. Promoting exports of energy entailed facilitating regional power and gas trade and cooperation through cross-border gas and power transmission connectivity and trade with neighboring countries through the Central Asia Regional Economic Cooperation (CAREC), as well as by supporting the development of the Southern Gas Corridor (SGC) to deliver Azerbaijan’s gas to European markets. Buttressing policies and institutions entailed teaming up with other development partners to help establish a tariff regime and creating a sound regulatory environment to promote competition and attract private sector investment. ADB also intended to explore ways to bring in private sector participation to the development of clean energy sources.

66. The studied energy sector portfolio totaled $1.14 billion, 29% of sovereign portfolio. The loans aimed to rehabilitate the transmission and distribution sectors, and the PCGs aimed to provide financial support for new generation and the expansion of the Shah Deniz gas field. The two PCGs which were meant to reduce the funding costs of the major projects they Sector Program Performance 33 supported, constituted 64% of all energy sector lending to Azerbaijan.52 The first energy loan in 2008 was for a single project that had no planned follow-up action and accounted for 14% of total lending.53 The MFF for the Power Distribution Enhancement Investment Program was to assist with a multitranche portfolio of expansion projects.54 Its first tranche accounted for 22% of the total energy sector portfolio.

67. ADB approved six energy-related TA projects for a total of $5.9 million which constituted 38% of total ADB TA for the evaluation period. Two of four project preparatory TA projects were converted into loans. Through one of these (Shah Deniz Stage II Investment Plan), ADB is supporting the strengthening of country systems for extractive industry transparency, in particular with respect to the implementation of the Roadmap for Beneficial Ownership Disclosure. Two policy and advisory TA projects are assisting the restructuring of the financial management in the energy sector and strengthening the enabling environment for private sector participation in the power sector.

2. Assessment

68. Energy plays a prominent role in the government’s Vision 2020, and in the strategic road map, particularly in relation to the development of utility services. ADB loans and TA projects supported the government’s strategy to increase generation capacity, develop a strong national grid to ensure a reliable supply of power to all, reduce aggregate technical and commercial losses, and create and strengthen institutions that support the energy sector, and carry out and promote energy efficiency and conservation. Two loans addressed the rehabilitation of severely deteriorated key transmission and distribution lines.55 The government did not use the PCG for the Janub power plant.56 However, it used almost the entire PCG amount for the Shah Deniz Stage II Gas Field Expansion Project.57 TA projects have either led to loan operations, or have addressed critical issues, such as renewable energy or the regulatory framework.

69. Progress is being made but outcome indicators are weak. Only one project was completed during the CAPE period. The transmission project met its major objectives and was assessed effective. The distribution capacity of 220 kilovolt (kV) substations was increased by 1,010 mega-volt ampere (MVA) and transmission line losses were reduced by 95 gigawatt hours (GWh) per year and from 6.0% in 2007 to 2.7% in 2014. Another project, Tranche 1 of an MFF investment program, was expected to be completed in June 2019; and more than 95% of all subprojects had been completed by the end of March 2018.58 By June 2018, all distribution subprojects of Tranche 1 had been completed. It is expected to deliver all the expected outcomes

52 ADB. 2010. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Janub Gas-Fired Power Plant Project. Manila; and ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Shah Deniz Gas Field Expansion Project. Manila. 53 ADB. 2008. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Power Transmission Enhancement Project. Manila. 54 ADB. 2016. Proposed Multitranche Financing Facility for Azerishiq Open Joint Stock Company Power Distribution Enhancement Investment Program. Manila. 55 ADB. 2008. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Power Transmission Enhancement Project. Manila; and ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Power Distribution Enhancement Investment Program Tranche 1. Manila. 56 ADB. 2010. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Janub Gas-Fired Power Plant Project. Manila. 57 ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Shah Deniz Gas Field Expansion Project. Manila. The PCG and the underlying commercial loan were signed in December 2017, and financial close occurred in April 2018. As of October 2018, ADB has received several cash calls and all have been paid in. 58 ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Power Distribution Enhancement Investment Program Tranche 1. Manila. 34 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

for the portion of the projects assigned to Tranche 1. The subprojects’ outputs and impacts are already visible, and the impacts on the communities that benefit from the rehabilitation of the distribution system are positive but cannot be quantified because no baseline indicators were established. The loan was initially classified as category C for social resettlement purposes but, because of unanticipated land acquisition and affected persons compensation requirements, it was reclassified as category B without any delay to project implementation. The CAPE mission conducted construction site visits to Ganja and Goranboy and held discussions with beneficiaries. It was ascertained that at two subprojects with new 110 kV/35 kV/10kV, and 6 kV substations, the number of forced outages decreased to zero from 20 per month in one subproject area and from 150 per month in the other, while losses in the 10 kV and 6 kV line were reduced from 20% to 4% in both project areas. Beneficiaries stated that the supply of power which had previously been available at very low voltage levels for only 4–6 hours a day was now reliably available 24 hours a day. The Shah Deniz project is ongoing and is meeting all construction schedules. The first phase was 99% complete at the end of March 2018 and production commenced in July 2018. Both projects are deemed to be likely effective. However, the PCG for the Janub power plant, although approved by the ADB Board of Directors, was never issued due to procurement- related integrity issues, and ADB approval lapsed. For the completed biomass TA, outputs were achieved as envisaged and all capacity development objectives were met.59

70. The ongoing TA to strengthen the enabling environment for private sector participation in the power sector has suffered significant delays. It is unlikely to be effective. The TA to develop a financial recovery plan for the energy sector has made significant progress, is supported by all stakeholders and is likely to be effective. However, some of the design and monitoring frameworks for energy sector projects can be improved. Impact indicators are sometimes too broad or not measurable, and thus are difficult to evaluate. Some of the targets were not readily measurable, and these issues are compounded by a lack of baseline data.

71. There have been delays. The PCG for a new gas-fired plant was not utilized, and although the plant was built without ADB funding assistance, the objectives of dismantling of the Shirvan plant, resettling the redundant staff, and reducing energy use were not met. However, Azerenergy began dismantling the Shirvan plant in 2018, and it is expected to be decommissioned by mid-2019. During the implementation of the Power Transmission Enhancement Project, loan savings detected early on were used to finance additional components that increased the scope of the project without significantly changing its outputs, outcome, and impact. However, the project was delayed by 2 years, which was unavoidable from an implementation perspective. The PCR and its validation both concluded that the project exceeded the economic internal rate of return (EIRR) threshold. Tranche 1 of the Power Distribution Enhancement Investment Program is complete and has suffered no major delays or changes in scope. The Shah Deniz Stage II Gas Field Expansion Project began production in July 2018, having suffered no delays in any of the building activities. The demonstrated experience of the contractors, lack of political risks associated with the Trans-Anatolian Natural Gas Pipeline and Trans-Adriatic Pipeline, and availability of funding for the final works suggest that all components of Stage II will be completed on schedule and all outputs anticipated in the Report and Recommendation of the President (RRP) will be realized within the specified time frame. The project preparatory TA for two biomass plants did not lead to a loan for the expected projects but it did deliver all the outputs set out by the TA. Although the TA completion report (TCR) rated the TA less than successful, its outputs will continue to be highly relevant beyond the TA completion date. Other ongoing TA projects cannot be assessed because their outputs are incomplete. Stakeholders met during the CAPE mission considered that ADB staff were helpful and responsive to the needs of project beneficiaries.

59 ADB. 2013. Technical Assistance to Azerbaijan for Renewable Energy Development (Biomass Cogeneration). Manila. Sector Program Performance 35

72. Tariffs remain an issue. Current electricity tariffs are sufficient to cover accounting costs but are not sufficient to cover the sector’s cash outflows, which needs continuing government support. Given the government’s strong commitment to resolving the sector’s finance gap, the strong support given to the proposed tariff structure through the ADB-funded TA for the financial recovery of the electricity sector, and the appointment of an independent regulator, the sector is now poised to turn its financial performance around and become profitable by 2025. At that point, the sector will be ready for private sector participation, so the authorities are starting to consider alternatives, including with ADB support. The Power Transmission Enhancement Project PCRs indicated the financial internal rate of return threshold had been exceeded, but the project was deemed unsustainable due to the high financial losses incurred up to 2015. However, given the proposed and widely supported tariff increases, the transmission and the current distribution projects are likely to have the financial resources to operate, maintain, and invest in new infrastructure. Further, the project strengthened staff capacity by providing on-the-job training in transmission and substation operation and maintenance (O&M), environmental management, social safeguards implementation, procurement, and financial management. Both Azerenergy and Azershiq have enough qualified staff to perform O&M and operate the assets in a reliable manner, hence the achievements of the program components are likely to be sustainable. In the gas sector, the Shah Deniz Stage II Gas Field Expansion Project is governed by commercial operating criteria, has long-term operational and offtake agreements, and has sufficient funding to complete the remainder of the project.

73. Energy infrastructure contributes significantly to inclusive growth and diversification by creating and expanding economic opportunities and improving access to economic opportunities. Reliable electricity enables working hours and productivity to increase and creates jobs. ADB support for expanding and improving generation, transmission, and distribution systems increases electricity supply and access, including in rural areas. The ADB- supported rehabilitation of rural networks, which is now providing continuous electricity supply to a section of rural customers, is likely to have similar impacts on expanding economic opportunities. These projects have already measurably decreased line losses and reduced carbon dioxide emissions. The current support for private sector participation has targeted two projects, one using waste heat from power generation, thereby increasing the energy produced from existing supplies, and the other involving a solar project demonstrating an ongoing commitment to mitigating climate change. The Ministry of Energy, the Ministry of Finance, and the newly appointed Energy Regulator strongly support the tariff reform being undertaken through ADB TA and acknowledge the need for tariffs, system operations, and legislation to support an increase in renewable energy.

74. ADB continues to support cross-border gas and power transmission connectivity and trade with neighboring countries through CAREC and other regional forums. ADB has also been supporting the Southern Gas Corridor project initiated by the government with the aim of delivering Azerbaijani gas to European markets. ADB collaborates with other development partners and supports policy and institutional reforms with the aim of establishing a tariff regime for the energy sector and creating an enabling regulatory environment to promote competition and attract private investment. The impacts from the capacity building components of loans and TA have transferred significant operational and management skills to the energy companies, which will enable them to better manage their systems into the future. The ADB energy sector portfolio is likely to provide significant development impacts by supporting inclusive growth, ESG, and facilitating regional power and gas trade, cooperation, policy reforms and capacity building. The evaluation considers the ADB energy program relevant, effective, efficient, likely sustainable, and with satisfactory development impacts. See Linked Document B for details (accessible from the list of linked documents in the Appendix).

36 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

B. Transport Program

1. ADB Program

75. Within the national framework, ADB aimed to support the primary economic corridors, particularly the East-West and North-South corridors. These were not only the core transport arteries in the country but were important international trade links because they formed part of designated CAREC corridors. Improving and expanding these routes was expected to increase opportunities for rural communities by providing them with better access to markets, educational facilities, and health and social centers. The overall strategy envisaged that the lending program would also address several key sector issues that would result in better performance of the sector in the medium to long term.

76. Transport has been one of the largest sectors in the ADB portfolio in terms of support, with a total of $1.4 billion in sovereign loans approved during 2007–2017.60 This includes two MFFs for roads, each for $500 million61, and a railway sector development program comprising a policy-based loan of $250 million and an investment loan of $150 million62. The loans for railway development were only approved in December 2017 and thus limited disbursement had taken place.63 The MFF operations provided seven loans, five of which were applied to the construction of contiguous sections of the M3 expressway linking Shorsulu town to the city of Astara on the southern border with Iran (a distance of 121.1 kilometers [km]). When completed, it will be a tolled four-lane grade separated expressway. Under the first MFF, tranches 1 and 3 were used to construct the southernmost sections between the cities of Masalli and Astara (58.1 km), while the second MFF funded the two northern sections between the Masalli city and Jalilabad district (30.0 km), and Jalilabad and Shorsulu (33.0 km). Under the first MFF, two additional tranches were provided to cover the Ganja bypass (37.5 km) (tranche 2) and a package of five local roads (41.2 km) and four bridges in the Gazakh region (tranche 4). A recent major change in scope used funding from loan savings to construct two additional national roads under the second MFF. All construction under the first MFF is complete, but only tranche 2 has a PCR. Under the second MFF, construction of the expressway sections is complete, but the additional roads using loan savings will only be completed in December 2020.

77. Technical assistance complemented the loan portfolio. This comprises two grants for preparing road investments and three grants for the railway sector, two of which were used to prepare the Railway Sector Development Program, and the other to support capacity development and reform measures. Three TA grants funded the preparation of the Baku Sustainable Urban Transport program, but they did not result in a planned loan for city transport. The TCR rated the TA less than successful. See Linked Document A, Table A2 for details.

2. Assessment

78. ADB support for the transport sector is in line with government priorities for the

60 Although the CAPE period is defined as 2011−2017, the first MFF for the road sector was approved in 2007 and the first tranche loan was implemented over 2007−2018. The transport sector assessment therefore covers the longer period of 2007−2018. 61 ADB. 2007, 2008, 2011, and 2014. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Road Network Development Program (Tranches 1–4). Manila.; and ADB. 2012 and 2014. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Second Road Network Development Investment Program (Tranches 1 and 2). Manila; and 62 ADB. 2017. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Railway Sector Development Program. Manila 63 Because implementation had just started, these loans were only rated for relevance. Sector Program Performance 37 sector, including those for road and railway development. In the road sector the assistance was designed to support the government’s 10-year road network development plan, which originally covered 2006−2015 but was subsequently extended to 2022 in light of the negative macroeconomic conditions. Within the plan, the components selected for ADB support were high-priority core national roads that were also sections of important international trade corridors. In the railway sector, the program supports the twin objectives of addressing urgently needed reforms and investment. The reforms tackle issues impeding railway performance and are expected to halt the sector’s decline. The investment is on track and structures of the Sumgayit to Yalama rail line are in place, a key stretch of the North-South railway corridor.

79. In general, safeguard documents were prepared and disclosed in accordance with the requirements of the Safeguard Policy Statement (2009). Nevertheless, occasionally the safeguard documents prepared during project preparation were not fully satisfactory. The primary reasons for this were (i) the recruitment of safeguard specialists with limited experience and skills; (ii) poor cooperation between the TA consultant and the executing agency or implementing agency; and (iii) a lack of coordination between the relevant government and nongovernment organizations (e.g., Ministry of Ecology and Natural Resources, the State Committee on Property Issues, the Land Acquisition Inspectorate, and environmental and social- related nongovernment organizations). Closer supervision of consultants by ADB project officers in the selection of safeguard consultants and continuous supervision could have helped improve the quality of documentation and avoid last-minute changes and adjustments. Some changes in design (e.g., new underpasses) were added in both transport MFFs, and the locations of access roads and bridges were changed in the second MFF. This occurred because local people had not been consulted sufficiently to properly understand their requirements, especially for locating underpasses. Land acquisition was also delayed because landowners were out of the country or could not be located, and heirs were missing or disputed. In these cases, the executing agency could have deposited compensation to an escrow account and obtain the court's decision, as required by the Land Acquisition Law (2010), to gain access to these land plots without delaying the project. Civil works contractors were mandated to replant trees to be cut by the project. In this respect the site-specific environmental management plans (for all sections) specify that "After completion of the road, indigenous trees will be planted along the carriage way on both sides where suitable." However, no information is available to assess the situation and interpret whether the remedial actions are adequate. These activities could be better monitored and reported in semi-annual monitoring reports and final environmental audits. In other cases, appropriate actions were taken, such as a turtle action plan to protect turtles crossing the road (para. 135).

80. Delays, cost overruns and cost savings. At the time of the evaluation mission all construction under the first MFF was complete. However, only roads under Tranches 2 and 4 were open to traffic. The expressway between Masalli and Astara, which was funded by Tranches 1 and 3, is yet to open to traffic. Tranche1 faced lengthy delays attributable to significant increases in material costs and inexperienced contractors. The scope originally included 120 km of local roads to extend the benefits of the expressway to the surrounding towns and villages but these roads were excluded from the scope after the bidding because the road agency deemed the construction costs to be excessive. The CWRD reports that about 40 km of local roads were eventually implemented under the MFF in another location but that the remainder were excluded from the project and it was agreed they would be implemented under the government’s budget. The adjoining stretches of expressway included in the second MFF linking Masalli to Shorsulu were completed on schedule but were yet to open for public use. Tranches 1 and 2 of the second MFF achieved substantial cost savings ($238 million, equivalent to 48% of the loan amount) due to the devaluation of the Azerbaijan manat in 2015. The loan savings were eventually reallocated to improve two additional stretches of national roads (Road R32 and M5/R57) and procure and install tolling equipment for all expressway sections under both MFFs. While the use of the 38 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

savings is appropriate, the time taken to reach this decision was excessive. The decision to impose tolls also took time. Discussions started during the appraisal of the first MFF in 2007 but were concluded only during the discussions for the major change in scope more than 10 years later. As it will take an additional 2 years to procure and install tolling equipment, a decision needs to be taken on whether the completed expressways are to be used toll-free in the interim. Meanwhile, in September 2018, the north south road stretches were opened officially without tolls.

81. Additional challenges. The Ganja bypass road was constructed with resources provided by Tranche 2 of the second MFF. The project was successfully completed, although there were serious start-up delays attributable to poor coordination between contractors, subcontractors, and local authorities; unfavorable weather; and poor contractor performance. During implementation the government decided to expand the road from 2 lanes to 4, using funding from another development partner to cover the additional costs. A design deficiency, however, stems from not having any animal crossing points along the alignment. The CAPE mission observed many herds of livestock crossing the roads, causing safety hazards and traffic disruptions. Sections of the central crash barrier had been removed to allow livestock and herders to cross the road. While this also has to do with traffic management enforcement of regulations, this is a major traffic hazard and the road agency must take urgent steps to rectify the situation – the road agency plans to look into this in 2019. Tranche 4 of the second MFF funded four bridges and five sections of local roads in the Ganja–Gazakh region. There was an initial delay of 2 years, which reduced the time available to complete implementation within the 10-year limit of the MFF. This constraint subsequently resulted in the exclusion of the component for materials testing and laboratory equipment. The roads and bridges, nevertheless, were completed on schedule.

82. Issues with the loans. Tranche 1 of the first MFF experienced significant delays attributable to land acquisition and procurement issues and increases in prices of construction materials. Because of the higher prices of materials, two sections totaling 36.0 km of the 58.1 km overall length were removed from the scope. They were subsequently funded under Tranche 3. Tranche 1 was eventually closed 7.5 years after the date originally scheduled. Tranche 2 experienced a delay of 1 year. The PCR re-estimated the EIRRs at or above 12% which was confirmed by validation estimates. Tranche 3 experienced delays in signing and effectiveness, and further delays in land acquisition and design adjustments, all of which led to a 3-year delay in completion. Tranche 4 was physically completed on time and appears to provide accessibility to the villages along the routes. However, use of the same MFF monitoring framework is not appropriate for local roads that have a limited connection to the main investment under the MFF. The second MFF experienced a significant delay in loan effectivity due to concerns regarding the impact of currency devaluations. The authorities took more than 2 years to decide what to do with the large loan savings. Of the two grants to prepare possible policy-based loans, one was cancelled, and the CWRD rated the three TA projects allocated for the Baku Sustainable Urban Transport Project less than successful. Those allocated for the railway sector provide the basis for preparing a policy loan and an investment loan, and as such appear to be fully satisfactory. Despite this success, the delays in implementation under both MFFs show that efficiency has been an issue in ADB support for the transport sector.

83. The resources of the road fund have increased, institutional capacity has improved, and the incidence of overloading has declined. These findings are based on limited discussions and knowledge of road transport investments in the region, as PCRs have yet to be prepared. Separate limited liability companies are responsible for expressway maintenance, and there is a need to continue improving road maintenance practices. Five vehicle weighing stations were set up as of mid-2018, and there is a need to continue analyzing weighbridge data to verify whether overloading is declining, while identifying the reasons. Both MFFs indicate that road safety was Sector Program Performance 39 an important sector issue, but limited resources were allocated for this purpose under the MFFs. A road safety audit was included in some tranches, but not all, and the expressway sections were subjected to audits. A pre-opening road safety audit has begun to be conducted of the total expressway length prior to opening; any recommendations made through these audits should be implemented prior to public use. It is also recommended that forthcoming PCR missions undertake an in-depth assessment of road safety, which should include organizations outside the road agency. Although a significant number of sector issues were identified under both road sector MFFs, including in relation to road maintenance, road safety, overloading, tolling, vehicle emissions, and policy dialogue, there was limited progress in resolving these issues during the 10-year implementation period, despite the inclusion of covenants in the loan agreements. Given the importance of these issues to the long-term sustainability of the road sector, this evaluation recommends that the forthcoming PCR missions make a detailed assessment of each of the sector issues and discuss any further recommendations and suggestions with the government. Even so, the ADB transport program is expected to be sustainable given progress with the road fund, institutional capacity, and overloading.

84. The benefits of road investment only occur once the infrastructure is complete and road transport services become available. Only a small proportion of roads was open to traffic at the time of the evaluation mission (May 2018), but in September 2018, the ADB supported expressway corridors were opened to traffic. It is expected that tolling will begin by the summer of 2019. Although it is clear that the roads are of good quality, it is early to definitively establish that the investment is effective, and ADB program is viewed as less than effective at the time of the evaluation. Based on the experience of similar transport sector operations in other countries the expressway is anticipated to facilitate better transport services. It will provide a shorter and faster route between origins and destinations. Designed for high traffic volumes, it is anticipated that it will divert a high proportion of traffic from existing roads and it is also likely to generate additional traffic due to time savings and removal of capacity constraints. While the expressway is planned to facilitate international trade, further action is required in the last section leading to the border.64 It is anticipated that towns and villages on the existing routes will benefit from reduced traffic, particularly of heavy-goods vehicles and long-distance bus services. This will help decongest town centers and improve urban livability. However, some local traders will forfeit passing trade and business. Overall, the evaluation considers the ADB transport program relevant, likely sustainable, and with satisfactory development impacts overall; but it was less than effective at the time of the evaluation, and less than efficient especially in early years (recent MFF tranches have showed a relatively higher efficiency). See Linked Document C for details (accessible from the list of linked documents in the Appendix).

C. Water and Other Urban Infrastructure and Services Sector Program

1. ADB Program

85. ADB and other development partners, including EBRD and JICA, based their programs on the World Bank-funded WSS Sector Review and Strategy of 2000. The World Bank estimated that more than $1.5 billion would be required to provide water and basic sanitation services for all of Azerbaijan and supported the government in preparing sector development plans for 22 of the 59 towns in the country.65 The World Bank originally intended

64 It is reported that this 2.4 km stretch will be financed by the government from the state budget; Recently the Government of Iran seems to have agreed to provide a linkage road to the originally planned border crossing, which will also lead to the construction of the final stretch of 2.4 km of expressway to the border on the Azerbaijan side. 65 World Bank. 2000. Azerbaijan Water Supply and Sanitation, Sector Review and Strategy. Washington, D.C.

40 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

to support 20 towns but reduced it to 8. ADB took five towns for its stand-alone project and the subsequent MFF .66 The study found that household water supply was intermittent and quality was low. Many households opted to buy water from private vendors to ensure sufficient water for daily use. Sewerage systems were also unreliable as they were poorly maintained and pipes were often clogged. Sewage flooded the streets during the rainy season. ADB support took a medium-term perspective and aimed at supporting the WSS sector in (i) ensuring service sustainability, (ii) improving efficiency through strengthened management and clustering local governments operations where possible, (iii) improving system accountability, and (iv) improving financial management. Besides the infrastructure work, these objectives called for institutional improvements and capacity development that would allow cost recovery and higher efficiency.

86. ADB support for WUS included one conventional stand-alone project, and one MFF originally planned with four tranches.67 The MFF was expected to be completed by May 2018. While Tranche 1 was financially closed in November 2017 and Tranche 2 in May 2018, Tranche 3 is financially active.68 The last tranche was “lapsed for effectiveness” due to the government’s decision to change Azerbaijan’s borrowing policy.69 While the original coverage of the MFF was more ambitious, its focus was narrowed to five towns—Agdash, Aghjabedi, Beylagan, Goychay, and Nakhchivan.70 Azersu was the implementing agency for the first four towns and the one State Amelioration and Water Management Committee (SAWMC) was the executing agency for Nakhchivan, the exclave.71

2. Assessment

87. ADB support was in line with its strategies and those of the government and was adapted to the conditions in the country. The initial loan was a learning experience that helped adapt that operation and the subsequent MFF to the particular challenges of Azerbaijan. Both the PCR and its validation for the initial stand-alone project rated it less than successful. As noted in these evaluations, the project was not well-conceived and would have been unsuccessful had it not been revised and redesigned. Due diligence helped assess the institutional capacity of the executing and implementing agencies, the readiness and willingness of the borrower and its agencies to adopt innovative project concepts, and the conditions and status of the sector. Revising the project design and recasting it as an initial phase of a multi-phased project provided a realistic and more attainable approach to development of the WUS sector in Azerbaijan. It helped ensure that investments, institutional capacity, financial resources, and O&M capability developed in parallel over time, in a consistent and sustainable manner. Furthermore, the many changes from the original design enabled the program to benefit from the flexibility of the MFF modality.

88. Azersu components. In the town of Goychay, almost all components had been

66 ADB. 2004. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Urban Water Supply and Sanitation Project. Manila. 67 ADB. 2009. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Water Supply and Sanitation Investment Program Tranche 1. Manila; ADB. 2011. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Water Supply and Sanitation Investment Program Tranche 2. Manila; ADB. 2013. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Water Supply and Sanitation Investment Program Tranche 3. Manila; and ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Water Supply and Sanitation Investment Program Tranche 4. Manila. 68 The loan was physically closed on 31 May 2018 but continues to be open for the remaining civil works. 69 ADB approved Tranche 4 but the government did not sign the loan agreement because of its tight public borrowing stance. As the loan agreement remained unsigned for 12 months, the validity of ADB approval financing lapsed. 70 As of IED’s CAPE mission in May 2018. 71 Since January 2017, the Nakhchivan Water and Sewerage Enterprise is fully in charge of the WSS operations in Nakhchivan city and surrounding villages.

Sector Program Performance 41 completed and were in operation, including the wastewater treatment plant (WWTP) and other infrastructure.72 Construction of the WWTP started in 2016 under Tranche 2, and operations commenced in March 2018. In the three other towns (Agdash, Aghjabedi, and Beylagan), there were changes in scope during implementation of the MFF due to the slow start, design changes from the original feasibility study, and changes in the physical requirement needed to comply with the liter per capita per day requirements in 2015. Each town had its own additional reasons for delays and changes. For the water supply component, only Goychay had a 24-hour supply at the time of IED mission. The IED team was informed that water supply was running for 18–20 hours in Beylagan. According to information received in October 2018, CWRD, Azersu officials, and SuKanal directors reported that water supply in all four towns was running for 24 hours a day. For wastewater, domestic used water is discharged to septic tanks, and wastewater bills are added to water bills, with different units per amount of water consumed. There have been some incidents of illegal connection to the newly constructed collector that have not been put into operation. There is no legal provision to penalize these acts and it is not clear how often they occur.

89. SAWMC component. The project constructed WSS facilities in the NAR.73 In addition, Tranche 2 included the WSS network for the villages of Shikhmahmud and Khalili and Tranche 3 included the WSS network for five peri-urban areas and the village of Shakarabad. The three towns all serve as satellite towns of Nakhchivan. Construction of the WWTP started in June 2014 and the facility was commissioned in October 2017. It was officially opened by Azerbaijan’s President on 17 May 2018. The WWTP was constructed by a joint venture of Azerbaijani, Dutch, and German companies. The current capacity of the WWTP is 32,000 cubic meters (m3). The WWTP is fully automated and treats the wastewater in three stages—mechanical, biological, and membrane treatment. The treated water is stored in clean water ponds and used for irrigation in the surrounding villages. According to the site manager, treated water can even be used for drinking, so ADB support has been effective in delivering its objectives.

90. Both the initial stand-alone project and the MFF faced implementation delays, particularly the Azersu components. Tranche 1 closed more than 4 years later than expected, Tranche 2 encountered shorter delays, and there were unresolved technical operation issues at the time of writing.74 The government-financed WWTPs in three of four Azersu towns have not been constructed. Thus, the economic benefit of the Azersu projects cannot be calculated. Even Goychay’s WWTP had only been commissioned a few weeks before the IED visit. Accordingly, the four towns will only begin to see the full economic benefits once the government-financed WWTPs are built.

91. The sustainability of WUS projects depends on the building of the WWTPs and on tariff reform. Most of the water supply facilities had just been completed or were about to be completed at the time of the IED mission, so it was too early to firmly assess the sustainability of ADB-supported investments in WUS. The government’s commitment to finance the WWTPs on its own is a positive sign for the physical sustainability of ADB-financed WUS investment. In terms of the financial sustainability, the original RRP for the MFF assumed that the water supply operating entity would be able to increase tariffs every 2 years. However, Azersu is not authorized to set the tariff on its own; this authority lies with the Tariff Council. During the MFF period, both Azersu and the SAWMC increased the unit tariff rate in 2011 and 2016. Azersu officials

72 This included the construction of the Azersu administration branch office, water wells, water reservoirs, chlorination chamber and pumping station, and water supply and wastewater treatment networks, and the installation of water meters for connected households. 73 The facilities include the water treatment plant, the WWTP, the administration office building, the water intake (infiltration gallery), the water reservoir, the water supply and wastewater treatment networks, and the installation of water meters for connected households. 74 The Azerbaijan Resident Mission informed the CAPE team that the issue was resolved at the end of June 2018, after the CAPE missions. 42 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

acknowledge that the company’s water tariff should be increased threefold to cover costs. Currently, the government subsidizes water using resources from its budget. The SAWMC also uses the prescribed tariff unit charge of AZN0.30/m3 for water and AZN0.15/m3 for wastewater. Nakhchivan, which has the largest population among the five towns, has sufficient economies of scale to keep household tariffs affordable. The rest of the towns (all served by Azersu) however, will have to rely on substantial government subsidies. The financial analysis had predicted that even with the optimum biennial tariff increase (which did not happen), the total annual cumulative tariff subsidies or viability gap funding would amount to $24 million for both Goychay and Nakhchivan to ensure full cost recovery. Any future investment in the sector calls for a serious dialogue on tariffs and their comprehensive reform to ensure long-term sustainability.

92. ADB was able to transfer skills both to Azersu and, especially, SAWMC. IED saw some project implementation skill transfer from ADB to Azersu, which now has an in-house design institute that can prepare projects. Azersu is also able to procure and manage major civil works. At one point, AzerSu had 40 consultants from Turkey to support its operations. These have been reduced to just a few at headquarters and at the newly commissioned WTPs during the initial liability period. Azersu gained valuable project design and implementation capacity through the MFF. The SAWMC developed enough in-house capacity to replicate the ADB-financed project in other exclave towns, showing how scaling up projects can enhance development effectiveness. IED also observed that development effectiveness is present throughout the water supply projects. Moreover, when the WWTPs are in operation in three towns, the improved sanitation conditions will lead to better living standards. The evaluation considers the ADB WUS program relevant, effective, likely sustainable, and with satisfactory development impacts, but less than efficient. See Linked Document D for details (accessible from the list of linked documents in the Appendix).

D. Public Sector Management Operations

1. ADB Program

93. ADB support for governance and PSM responded to the country’s needs in the midst of the 2014 crisis. Before the crisis, ADB had no strategic inputs on macroeconomic and governance issues beyond some analytical work.75 Although the CPS addressed diversification of the economy, it did not link it to macroeconomic policies or acknowledge their relevance for this purpose. However, ADB regularly adapted its strategy in the successive COBPs, while remaining anchored in the government’s long-term purpose of boosting the non-oil sectors and diversifying the economy (para. 57). These adaptations reflected adjustments in the government’s development strategy, while also factoring in significant changes in the economy. A major adaptation came in the COBP, 2015−2017 which was anchored in the strategic road maps with its four targets of improving macroeconomic management, reforming SOEs, human capital, and improving the business environment. This adaptation set the stage for the ADB work and operations in PSM.

94. ADB had two lending operations with PSM elements, totaling $750 million, and two TA projects for $1.4 million. The first lending operation was the CSF for $500 million approved by the Board of Directors in December 2016.76 This operation is closed but has not been reported on or evaluated by IED. It was accompanied by TA for improving public sector

75 ADB does not seem to have discussed with the government ahead of the crisis the link between world fossil fuel prices and fiscal revenues or the smoothing of expenditures over the medium-term. 76 ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Countercyclical Support Facility Program. Manila.

Sector Program Performance 43 efficiency.77 The second lending operation was the first policy-based loan for $250 million, of two such loans that are part of the Improving Governance and Public-Sector Efficiency Program (programmatic approach), which the Board of Directors approved on 6 December 2017. 78 Azerbaijan signed the loan agreement on 8 June 2018, and loan funds were fully disbursed on 6 July 2018. The second loan is foreseen for 2018 and 2019. ADB approved TA for rapid response support for strategic reforms to support the implementation of the priority policy reforms under the strategic road map.79

95. The CSF supported Azerbaijan through the crisis. Although ADB approved the operation late in the year, the CSF supported a countercyclical fiscal expansion aimed at protecting the most vulnerable groups, while laying some of the groundwork for the needed structural reforms. Protection of vulnerable groups included increases in salaries and employment, pensions, and social and health benefits, as well as support for low-income groups through housing and tax benefits. The structural components included mostly initial efforts along three broad directions: (i) strengthening macroeconomic management by laying the basis to establish medium-term fiscal and debt management frameworks; (ii) buttressing efficiency and accountability by developing a public investment framework, and restructuring and improving the governance of SOEs; and (iii) deepening finance and increasing the scope of the private sector by developing securities and capital markets, while promoting the development of SMEs.

96. The programmatic approach supported the main structural reforms foreseen in the government’s strategic road maps. Prior actions of the first policy-based loan focused on a medium-term fiscal framework, fostering private sector participation and SOE governance, and deepening finance while promoting SME development. Central to the medium-term fiscal framework was the introduction of rules-based planning of fiscal policy so that it is countercyclical and isolates the economy from the impact of fluctuations in the world markets for fossil fuels. The loan also supported an amendment of the Pensions Law, and the development of ceilings on the government’s debt, the use of the State Guarantee Fund, and borrowings by SOEs. A single treasury account at the Central Bank of Azerbaijan would become the repository of all residual funds. The loan supported private sector participation and SOE governance with an action plan on SOE transparency and efficiency, the development of the Governance Standards and Rules Framework for SOEs, and the establishment of a commission to monitor 20 large SOEs..80 The loan also supported the approval of strategic road maps for key sectors, and an institutional framework for build-operate-transfer projects. Within access to finance, the prior actions included the establishment of the Credit Guarantee Fund for SMEs,81 the recapitalization of and the use of risk-based contributions to the Azerbaijan Deposit Insurance Fund (ADIF),82 and the approval of the Law on Credit Bureaus. The loan expected at least one reform along the lines of the World Bank’s ease of doing business index, and budget

77 ADB. 2016. Technical Assistance to Azerbaijan for Improving Public Sector Efficiency. Manila. 78 ADB. 2017. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Improving Governance and Public Sector Efficiency Program (Subprogram 1). Manila. 79 ADB. 2017. Technical Assistance to Azerbaijan for Rapid Response Support for Strategic Reforms. Manila. 80 The list of 20 SOEs includes several that have been or are ADB counterparts. These include Azerenergy, Azerbaijan Railways, Azersu, and Azersiq. The program did not foresee the privatization of any of the 1,034 SOEs. It is expected that privatization will be possible once the governance of SOEs has been revamped. 81 The Credit Guarantee Fund for SMEs was created and merged with the mortgage fund in a new entity called the Azerbaijan Mortgage and Credit Guarantee Fund established in December 2017. While mortgage guarantees were operational before, the Azerbaijan Mortgage and Credit Guarantee Fund is developing new schemes for SME credit guarantees. 82 The ADIF was established in August of 2007. The ADIF had to face the banking crisis of 2015–2016 and ended up paying bank depositors with its own resources, and with credits from the Central Bank of Azerbaijan. Recapitalizing the ADIF was essential for financial stability. The ADIF was also entrusted with the administration of the assets of the banks that are being liquidated. However, it does not have the power to sell good assets, either individually or as part of a package, to viable banks that may be interested.

44 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

funding of the National Fund for Entrepreneurship Support.83

2. Assessment

97. With the onset of the economic crisis, the government understood that its procyclical macroeconomic policies had amplified the impact of the oil slump on the economy. This realization shaped the government’s strategic road maps, and the determination to move forward with a set of structural reforms aimed at, among other things, making macroeconomic policies countercyclical. ADB was relatively timely in moving in with its PSM operations. The first one supported efforts to protect the most vulnerable groups through a CSF, while the succeeding programmatic approach sought to support many of the necessary structural reforms foreseen in the strategic road maps. Nevertheless, while ADB response was relevant, it could have been timelier had the earlier calls of the IMF been heeded and had the CSF been approved earlier in 2016. The instruments ADB chose were appropriate and facilitated a constructive policy dialogue on the issues at the core of economic diversification and employment generation through a sustainable private sector. Moreover, the two operations and the succeeding one, which is expected to be approved at the end of 2018, are logically linked and properly sequenced, building up support for the needed reforms.

98. This assessment is based on the observed outputs of the CSF, and the likely achievement of the outputs foreseen in the first policy-based loan of the programmatic approach. The CSF foresaw outputs that included providing a social safety net, facilitating social housing, creating additional jobs, and identifying and initiating reforms for economic diversification. Subsequently, the first policy-based loan of the programmatic approach included outputs introducing rules-based fiscal planning, a restructuring of SOEs, the strengthening of private sector participation, and enhancing access to finance while improving the business environment. Each operation had outcome indicators. The CSF’s outcome indicator was for the government to have spent $1.40 billion in fiscal stimulus by February 2017. In that period, SOFAZ transferred $1.44 billion to the budget to support macroeconomic stability. However, the Ministry of Finance reported that the fiscal stimulus amounted to AZN 1.4 billion, or about $857 million, which is less than the expected outcome. The outcome indicators for the programmatic approach are for (i) local currency bank credit in Azerbaijan manat to have increased by 20% during 2016−2019, and (ii) fiscal outlays related to SOEs to have declined by 0.2 percentage points of GDP in the same period. Given the lack of information on financial progress with SOEs, it is not possible to come to a view on the likelihood of the achievement of this outcome indicator.

99. Although the reform program is firmly anchored in Azerbaijan’s strategic road maps and has a high degree of government ownership, three areas of concern are—the fiscal rules, the improvement in the governance of SOEs, and the regulation and supervision of the finance sector. The fiscal rules are certain to test the authorities’ resolve soon, especially in regard to smoothing fossil fuel revenues and capping expenditure growth in an environment where world markets have crept up to high levels. In early 2018, the government revised the budget upward to use the higher revenues stemming from higher fossil fuel prices. In addition, the fiscal rules will limit the supply of foreign exchange going into the market and may put pressure on the Azerbaijan manat to depreciate more in real terms. While this is an intended outcome of these rules and necessary to protect the non-oil economy, consumers and sectors of the oil economy may find it challenging. On the governance of SOEs, increasing the coverage gradually, while keeping the 20 large SOEs in check will require strong and sustained support from the highest political levels. Concerns about the finance sector’s ability to restore

83 The National Fund for Entrepreneurship Support (ANFES) was established in 1993 to provide subsidies to private entrepreneurs. At times, ANFES has also lent through commercial banks. The purpose of this action was to restart the fund’s credit flows to the mentioned sectors. The funding is over longer terms and at subsidized interest rates. Sector Program Performance 45 credit to the non-oil economy are grounded in the sector’s regulation and supervision. In particular, (i) some development partners have complained about political interreference by some banks, (ii) the authorities face challenges stemming from the complexity and sequencing of the reforms, and (iii) the banking system remains frail. These concerns point to the need for a very strong political commitment to the reform package. Azerbaijan took an important step in August 2018, when its President approved proposed reforms on a fiscal rule and oil revenue use, implementing a medium-term expenditure framework, and the policy on public debt management. These reforms have also been recently approved by the National Assembly.

100. The authorities perceive ADB support for the reform agenda as opportune and constructive. While the success of the effort in expanding the non-oil economy hinges on the government’s adherence to the fiscal rules, the reform program has many elements that contribute to the diversification goal. Besides the support to the fiscal rules, diversification is well served by bringing more transparency and better governance to SOEs, helping to set an example that private firms can follow. In addition, the elements that contribute to easing the access to finance and doing business also help the diversification objective. These include a strong ADIF, an established credit bureau, an operating guarantee fund, a working entrepreneurship support fund, and the lifting of some of the constraints to doing business, making it easier to start a business and access finance.84 The PSM program also contributes to several of the cross-cutting themes of the ADB country’s strategy, as articulated in CPS and in the different COBPs, by fostering private sector development while improving governance and developing capacity. The program also goes a long way in promoting knowledge solutions, given the complexity and diversity of the reform agenda. The evaluation considers the ADB PSM operations relevant, effective, efficient, likely sustainable, and with satisfactory development impacts. See Linked Document E for details (accessible from the list of linked documents in the Appendix).

E. Nonsovereign Operations

1. ADB Program

101. ADB’s NSO strategy was to assist with economic diversification and help the private sector play a greater role in industry, trade, SMEs, and infrastructure development. Besides the non-oil sector, the strategy considered financing projects in the downstream petrochemicals processing sector. Leveraging of ADB financing through third-party funding would be sought wherever possible. In the finance sector, support for individual banks and non-bank institutions would be targeted to promote rural financial inclusion by providing onlending to MSMEs and farmers outside of the capital region, establish credit facilities for MSMEs, expand the housing mortgage market and deepen leasing and insurance. ADB’s TFP would support selected banks to fill market gaps and mobilize private sector capital through guarantees and loans.85 Towards the end of the period, operations were expected to support commercial banks for onlending to SMEs, including agro-businesses, and opportunities arising from gas extraction. However, throughout the evaluation period ADB’s strategy was not anchored in a thorough analysis of which sectors had a comparative advantage and, thus, could lead to a more diversified export base and economy.

102. ADB committed $1.145 billion of new financing for private sector investments in Azerbaijan through direct financing, credit enhancement, and commercial cofinancing products (B loans and PCGs). Over the evaluation period there were five new approvals for six nonsovereign transactions. The six transactions included two large approvals to support the

84 In the World Bank’s country rankings for ease of doing business, Azerbaijan’s rank improved from 57 (in Doing Business 2018) to 25 (in Doing Business 2019). 85 The TFP is not included in this assessment. 46 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

expansion of the Shah Deniz gas field, and three approvals (for four loans) to financial institutions focused on increasing access to finance for MSMEs and rural agriculture. The December 2016 approval to SGC, the second of the approvals supporting the Shah Deniz gas field expansion, was part of a One-ADB solution. A $500 million public sector approval for a PCG for commercial financing was provided, and a $500 million NSO loan was separately provided, to deliver $1 billion of ADB financing commitments. Four approvals made prior to 2011 were completed during 2011–2017, including one project to support energy efficient cement manufacturing and three to financial institutions to support strengthening of the banking sector services for MSMEs. One of the 2015 financial institutions transaction approvals was cancelled as the borrower elected to close its business in Azerbaijan due to the economic situation. No new approvals were made in 2017. Four approvals made prior to 2011 were completed during the evaluation, one in cement manufacturing and three to financial institutions. These approvals total $77 million and bring the total commitment assessed to $1.222 billion. See Linked Document A, Table A3 for details.

2. Assessment

103. The nonsovereign infrastructure projects contributed to two sectors. The Garadagh Cement project delivered a new energy efficient facility and its demonstration effect contributed to two subsequent projects in the same cement industry.86 The two recent approvals to support the Shah Deniz gas field development appear to be on track to allow operations to begin as planned and contribute to the economy through project revenues and jobs creation, especially during construction. The second, 2016 approval for Shah Deniz, which was provided as part of a One-ADB solution, has not been drawn. The sovereign side approval’s funding has been nearly fully utilized and provided a PCG for a separate group of commercial lenders, resulting in lower pricing than the NSO approval. The NSO support was a required financing component at the time of approval. The first NSO project supporting the Shah Deniz gas field that is being drawn appears to be on track to meet economic and business results targets, while complying with ADB safeguards requirements.

104. The financial institutions projects have a range of results with recent approvals affected by the economic crisis. Two completed transactions with financial institutions contributed to increased MSME and SME lending, development of new products, and improved banking practices. Another four projects for financial institutions have not yielded the development contributions as planned, with three being directly affected by the economic crisis.87 One institution is in liquidation, following efforts to develop a restructuring plan that was not approved by the Financial Market Supervisory Authority (FIMSA), the supervisor. The other institution, which has two loans approved, is in ongoing financial restructuring discussions that were yet to be resolved in June 2018. The fourth transaction, which was approved prior to 2011 and completed during the review period, did not appear to increase SME lending as planned. A fifth financial institution project was cancelled because the institution curtailed its business development in Azerbaijan in light of the crisis. The financial institutions projects have a range of results for economic and business performance with two successful projects, two not successful, and two with the institutions being liquidated or restructured. All financial institutions projects include requirements to comply with ADB’s safeguards policies by incorporating safeguards reviews into the institutions’ operational procedures. All complied with this requirement, except for the International Bank of Azerbaijan—although the transaction was

86 ADB. 2010. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Garadagh Cement Expansion and Energy Efficiency Project. Manila. 87 Neither the government nor ADB foresaw the economic crisis and the ensuing banking crisis in spite of advice by the IMF on the risks of having fiscal policies tied to hydrocarbon world prices. The issues that arose with the Central Bank of Azerbaijan’s handling of the banking crisis, both before and after it struck, led the government to create FIMSA as an independent entity responsible for regulation and supervision. The SECO has provided TA for these reforms. ADB, the IMF, and the World Bank have also contributed to the reforms, but to a much more limited degree. Sector Program Performance 47 well monitored, the loan document omitted a requirement to report regularly to ADB on safeguards. Separate to the efforts to support economic diversification through financial institutions onlending to MSMEs, the TFP has supported Azerbaijan imports and exports through a small number of transactions early in the evaluation period. With the weakened financial sector, the TFP remained engaged by providing capacity building and monitoring the financial results for potential opportunities. In the second half of 2017 expressions of interest in reactivating trade finance operations began to be received by the TFP.

105. Meeting ADB’s investment profitability requirements has been a challenge. This category considers the profitability of ADB’s investment for ADB based on loan pricing and interest and principal payments. The four completed infrastructure and financial institutions are all satisfactory for ADB investment profitability. The financial institution in liquidation is deemed less than satisfactory for ADB profitability. The financial institution undergoing financial restructuring, for which two loans are outstanding, is also expected to be less than satisfactory for ADB profitability. Of the two ongoing large infrastructure loans, the one that is being drawn is complying with scheduled payments. The second is paying commitment fees, but the loan being undrawn produces less revenue than expected at approval. Considering the results as a whole, the ADB investment profitability is less than satisfactory.

106. The portfolio has a range of results for ADB work quality. For the infrastructure projects, one is completed and is satisfactory, with its selection as ADB’s entry point for infrastructure in Azerbaijan recognized as well-chosen. Of the two loans supporting the Shah Deniz gas field both appeared to meet the requirements for satisfactory ADB work quality at the early stages of these approvals. For the loan that is not being drawn, the responsiveness of the operations to meet the request for support for a One-ADB solution to provide a large financial commitment is noted. The financial institutions projects that are completed include one rated excellent for screening, appraisal, and structuring, recognizing the screening process undertaken to protect ADB’s reputational risks and the transaction’s use of a local currency loan with a mechanism to protect ADB from currency depreciation. Another was less than satisfactory as the sponsor did not appear well-chosen to deliver the agreed development program and had a business model with structural issues that could have been identified at appraisal. The third is satisfactory. The projects for the two institutions that were affected by the economic downturn were selected for their fit with ADB’s development objectives, their market position, and governance standards at the time of appraisal. Sector risks at the time were recognized in the appraisal documents, and ADB’s financing was provided to help the institutions during difficult times. This assessment also considers the financial institution project that was canceled, noting that the financial institution selected for ADB financing could support expansion of MSME lending given its management and established business. The economic crisis following the approval led the borrower to curtail its operations.

107. All projects appear to be closely monitored for compliance with ADB requirements. Three of the four completed projects were rated satisfactory, while the fourth was monitored closely for financial performance matters but downgraded because the loan document did not have a provision requiring the financial institution to provide annual environmental reports. For the two institutions affected by the crisis, close monitoring was possible because there were financial covenants in place allowing increased monitoring and dialog with bank management. ADB’s risk management restructuring team worked closely with other lenders to develop solutions for both financial institutions. In one of the cases the proposed solution was turned down by FIMSA, the supervisor, and the financial institution is in liquidation. The second financial institution is undergoing financial restructuring. The remaining two infrastructure projects are ongoing and the one being used appears to meet all the requirements for satisfactory results. Overall, ADB’s work quality is satisfactory.

48 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

108. ADB additionality includes two components: the extent to which ADB finance was a necessary condition for the timely realization of the project; and ADB’s contribution to the design of the project to improve the allocation of risk and responsibilities and to enhance development impact. The need for ADB’s financing is stated in all appraisal documents which present the funding gaps ADB intends to address. In Azerbaijan, all of ADB’s clients have been supported by other IFIs. In some cases, this teaming is needed due to the size of projects or risk perceptions. The completed cement project is rated satisfactory. The project supporting the Shah Deniz gas field expansion that is being drawn provided capital required for the project to continue construction and also attracted additional commercial financiers through the use of ADB B loans. For the financial institutions projects, two of the three completed were rated satisfactory for ADB additionality. The third was less than successful because ADB’s loan size was small and the provision of tier 2 capital to the financial institution was not an appropriate choice to help the institution increase its involvement with the private sector. For the two financial institutions affected by the economic downturn, ADB has worked on restructuring plans alongside other financiers. ADB’s use of commercial cofinancing products is also recognized. The B loan for the Lukoil Overseas transaction attracted 5 international commercial lenders to commit $225 million to support the Shah Deniz gas field expansion. The use of risk transfers with several insurers for four ADB loans has helped manage ADB’s exposure and increase the insurers’ engagement with Azerbaijan. ADB’s nonsovereign portfolio has satisfactorily provided additionality to Azerbaijan’s economic development.

109. The overall rating for development results and investment profitability for the 2011–2017 program is less than satisfactory. ADB work quality and ADB additionality are rated satisfactory. Overall, ADB’s NSO rating for the 2011–2017 program is borderline less than successful (at the borderline of successful). Linked Document F provides an assessment of the nonsovereign sector program.

F. Summary

110. ADB’s sovereign operations in Azerbaijan concentrated on energy, transport, and WUS, and later included PSM, while the NSO focused on cement, gas, and finance. Work in the sovereign sectors was relevant, and likely to have a development impact. Effectiveness and efficiency were satisfactory in energy and PSM, but not so in transport and WUS. Lackluster performance reflected significant delays and cost overruns, as well as changes in scope that limited the reach of the investments. In transport and WUS, complementary investments by the government have lagged, reducing the effectiveness, efficiency, and development impact of some investments. Examples of these are the investments in road safety or the development of needed wastewater treatment systems. In all cases sustainability hinges on Azerbaijan’s willingness to maintain the course by taking challenging political decisions, such as updating cost-covering tariffs of water and energy, funding road maintenance, or implementing a medium-term fiscal framework.

111. ADB’s recent NSO approvals faced major challenges. These included the lack of interest of a counterpart to use one of the Shah Deniz loans, and the failures faced in finance sector operations largely triggered by the crisis. These, to some extent, reflect the difficult macroeconomic conditions for private sector development in Azerbaijan together with limited Private Sector Operations Department presence on the ground in Baku.

112. The MFF as an instrument helped signal ADB’s commitment to a sector but its use in Azerbaijan has had problems. MFFs can be developed and implemented in stages, without renegotiating loans or paying commitment fees. Their use gave flexibility to ADB’s support, by enabling synchronized assistance to projects that built on previous ones, such as successive sections of a road. The instrument also makes it easier to accommodate needed design changes, such as in WUS. However, the management of the facility could have made greater use of ADB Sector Program Performance 49 in-house technical skills to provide better oversight and improve the effectiveness and efficiency of the support. Indeed, missions could have focused more on assessing important sector issues that underpin the overall sector development and operation, such as, in the case of roads, maintenance, safety, overloading, and tolling.

113. The other lending instruments used in the Azerbaijan program were also appropriate and helpful. The PCGs reduce funding costs of the major projects they supported and were relevant even if they ended up not being used or drawn on. The CSF provided budget support to Azerbaijan, helping dampen the impact of the crisis triggered by the fall of oil prices in world markets, even if it came late in the crisis year. And the programmatic approach with two successive policy-based loans was the appropriate instrument to engage in a constructive policy dialogue and support the design and implementation of needed structural reforms.

Strategic Agendas and Country Priorities 5 52 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Highlights: • ADB’s inclusive economic growth agenda was satisfactorily operationalized, relevant, and had a satisfactory development impact. • ADB’s environmentally sustainable growth agenda was relevant in Azerbaijan but had only a borderline satisfactory development impact. • The program’s contributions to regional cooperation and integration were highly relevant and had a highly satisfactory development impact. • The relevance of ADB’s economic diversification focus in Azerbaijan was satisfactory though its development impact was less than satisfactory. ADB’s focus on capacity development was relevant, and the development impact was highly satisfactory.

114. Strategic agendas and thematic priorities. This chapter assesses how well ADB operationalized its three main strategic agendas in Azerbaijan: IEG, ESG, and RCI; and how well it focused on two centrally stated thematic priorities—economic diversification and capacity development. Throughout the evaluation period, IEG, economic diversification, and capacity development figured prominently in all of Azerbaijan’s development strategies, while all five topics were elements in the CPS and COBPs. This chapter analyzes the relevance and development impact of ADB support for each of these topics.

A. Inclusive Economic Growth

115. Modernizing infrastructure, calming the crisis, and supporting structural reforms. During the evaluation period, the government sought the support of IFIs and bilateral partners, mostly to modernize the country’s infrastructure. Only at the end did it ask for ADB support to help weather the impact of the crisis triggered by the decline of world oil prices and support the structural reforms needed to avoid the procyclicality of future macroeconomic policy.

116. The CSF. The 2016 package put together by the government and supported by ADB included increases in wages, pensions and targeted social assistance, and transfers to the disabled, and the creation of job opportunities in the public sector. Its total cost was $850 million, $500 million of which came from the CSF. It aimed to assist 3.7 million people. The package also included support for low-income groups through housing and tax benefits. In addition, through this operation, ADB supported structural reforms aimed at strengthening macroeconomic management, improving SOE governance, and developing securities and capital markets to promote SME development. All these elements contributed to inclusiveness (Box).

117. The programmatic approach. Following the government’s adoption of the strategic road maps in late 2016, ADB stepped up its support with a programmatic approach composed of two successive policy-based loans, the first of which was approved in December 2017. The broad objectives of the programmatic approach were improving macroeconomic management to reduce procyclicality, boosting the governance of SOEs, and promoting the development of a private non-oil economy. Within the programmatic approach, macroeconomic management was to be buttressed by (i) adopting a rules-based medium-term fiscal framework that smooths cyclical fluctuations in budget revenues and expenditures; and (ii) limiting unforeseen liabilities stemming from pensions, government debt, SOE borrowing, and the use of the State Guarantee Fund. The reform of SOEs also included boosting their transparency and efficiency, starting with 20 of the largest enterprises, and opening space for private sector participation. The efforts to deepen finance while promoting SME development included measures to improve access to finance and strengthen the business environment. Key among these was the setting up of a credit guarantee fund for SMEs, the recapitalization of the ADIF, and the approval of the Law on Credit Bureaus. While these actions have been adopted and are being implemented, their impact on inclusive growth cannot be gauged at this stage. Strategic Agendas and Country Priorities 53

118. ADB support for ADB’s Inclusive Economic Growth infrastructure development also supported inclusive growth. ADB For the Asian Development Bank (ADB), growth is inclusive focused on energy, transport, and when it addresses both the income and non-income WUS. Roads gave way to railways dimensions of well-being. This approach entails three toward the end of the evaluation strategic focuses or pillars: (i) achieving high sustainable period. These projects had either a growth that creates and expands economic opportunities, nationwide coverage or were targeted (ii) broadening access to these opportunities so that all toward specific regions, cities, or towns can participate and benefit from growth, and (iii) developing social safety nets that prevent extreme (Table 2). Sovereign loans and deprivation. guarantees financed a total of 16 infrastructure project loans during the For inclusive economic growth to take place, development evaluation period. All of them efforts must aim to improve human capital, including of supported IEG, mostly promoting a the disadvantaged, through investments in education, diversified, knowledge-based economy; health, and social protection. They must also provide the employment creation for a more poor with access to markets and basic productive assets. balanced (non-oil) economy; and greater access to economic Accordingly, ADB’s support is expected to include investment in infrastructure to achieve high rates of opportunities for women and the poor sustainable economic progress, connect the poor to in secondary towns and rural areas. markets, and increase their access to basic productive Infrastructure can be an important assets. ADB is also expected to support investment in contributor to inclusive growth and education and essential public services, such as water and diversification if it creates and expands sanitation, which particularly benefit the poor and economic opportunities in an optimal women. manner (especially for the poorer population segments in more Source: Independent Evaluation Department. underdeveloped areas) and improves access to economic opportunities.

119. Energy. Official statistics show that the entire country has 100% coverage of electricity. Thus, ADB’s support to the energy sector prioritized rehabilitating power transmission and distribution networks, facilitating regional power and gas trade and cooperation, and promoting reforms aimed at establishing a cost-recovery tariff regime and creating a regulatory environment to promote competition and attract private sector participation. ADB support for expanding and improving transmission and distribution systems had the direct benefit of expanding electricity supply and access, including in rural areas. This, in turn, had the potential to expand economic opportunities for rural communities, including women. ADB support for the rehabilitation of rural power networks is now facilitating continuous supply to some rural customers. In addition, one loan specified gender targets in the training in management expertise with the requirement for at least 50 women to be trained in distribution network management.

120. Water and sanitation. During the evaluation period, Azerbaijan improved its coverage of water and sanitation services, both in urban and rural areas (Figure 14). The issues that needed to be addressed at the beginning of the evaluation period were the intermittent water supply, the low-quality of water supplied to households, and the unreliable and poorly maintained wastewater treatment system that was unreliable and could flood the streets in the rainy season. By 2015, the latest year for which data is available, average coverage of drinking water had increased from an average of 82.3% in 2011 to 84.4% in 2015, while sanitation services had increased from 83.2% to 89.3% in the same period.

54 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Table 2: Regional Location of Asian Development Bank Projects in Azerbaijan Approved Project Title Amount Subnational Location Location impact ($ million) Energy Power Transmission Enhancement Project 160.00 Absheron; Agdas; Aghdash Rayon; Aghsu Nationwide Rayon; Agsu, Gobustan Rayon; Goychay (high) Rayon; Qobustan; Shamakhi Rayon; Xirdalan; Yevlakh Rayon Transport Railway Sector Development Program 150.00 and Baku; Yalama Regional (high) 250.00 Second Road Network Development 250.00 Jalilabad to Shorsulu motorway section Rural (high) Investment Program - Tranche 2 Urban (low) Road Network Development Program - 45.00 Akstafa-Poylu-Sadiqli Bridge; Poylu-Duzqislaq- Rural (high) Tranche 4 Qazax Bridge; Poylu-Sadiqli Bridge; Poylu- Sadiqli-Gurcustan Bridge Second Road Network Development 250.00 Dzhalilabad; Jalilabad District; Masally; Rural (high) Investment Program - Tranche 1 Masally District Urban (low) Regional (high) Road Network Development Program - 200.00 Astara; Astara District; Lankaran Rayon; Rural (high) Tranche 3 Masally; Masally District Road Network Development Program - 55.40 37.5 kilometers of the two-lane paved road Regional (high) Tranche 2 bypassing Ganja Road Network Development Program - 190.00 and Astara; Astara District; Boladi; Hirkan; Rural (high) Tranche 1 10.00 Lankaran Rayon; Lenkeran; Lovan; Masally; Nationwide Masally District; Peisar; Qamisovka; Sahagac; (high) Siyavar; Suparibag; Toradi; Vel; Zovlya Water and other urban infrastructure and services Water Supply and Sanitation Investment 75.00 Agdash; Beylagan Urban (high) Program - Tranche 4 (Additional Financing) Water Supply and Sanitation Investment 150.00 Aghjabedii; Bulqan; Karakhanbeyli; Urban (high) Program-Tranche 3 Nakhichevan; Qaraquq; Tumbul Water Supply and Sanitation Investment 300.00 Aghdash Town; Beylagan Town; Goychay Urban (high) Program - Tranche 2 Townn; Nakhchivan Water Supply and Sanitation Investment 75.00 Baku; Goycay; Nakhchivan Urban (high) Program - Tranche 1 Urban Water Supply and Sanitation 20.00 and Agdash; Goychay; Nakhchivan Urban (high) 10.00 Sources: Asian Development Bank database and study team selection.

Figure 14: Basic Drinking Water and Sanitation Services Coverage 100

90

80

70

60 2011 2012 2013 2014 2015

Water Total Water Rural Water Urban Sanit. Servi. Total S.S. Rural S.S. Urban

Sources: World Bank Sustainable Development Goals database and study team estimates.

Strategic Agendas and Country Priorities 55

121. Uneven but inclusive support for water and sanitation. Although the results were uneven, ADB support for water and sanitation was inclusive. Nakhchivan attained excellent results while the other four towns, Agdash, Aghjabedi, Beylagan, and Goychay, faced implementation delays. All the projects were located outside the Baku-Absheron area, where incomes are lower, and needs are greater. The quality of services also improved markedly. In Nakhchivan, for example, the supply of water improved from a few hours a day for 55% of the population to 24 hours a day for 100% of the population.

122. Roads and Railways. The primary benefit of the road network investment plan was to extend the accessibility benefits of intercity travel to passengers and freight transport nationally. The major thrust of this program was to improve about 3,570 km of national roads and about 6,000 km of secondary roads. The bulk of ADB lending was used to improve portions of national highways M2 linking Baku to the Georgian border and M3 linking Baku with Iran to the south. These investments provided broad-based development to hinterland populations and are generally gender neutral. Inspection of the roads indicates that they provide significant support to the villages and residents. The only tranche with a PCR completed in 2012 and reported in 2013 (Ganja bypass) showed that traffic had increased threefold, and that local business, community and other stakeholders felt that it supported regional trade and better access to markets, economic centers and social services. However, inclusiveness was curtailed to some extent when Azerbaijan dropped part of a project that had a substantial local roads component designed to rehabilitate local roads and extend the benefits of the investment to local towns and villages adjacent to the primary road network (MFF 1, Tranche 1). The railway program has just started and there is little data to allow an assessment at this time.

1. Assessment

123. ADB was responsive to the government’s overall strategy for infrastructure development and provided support for an inclusive agenda at the time of crisis. ADB work in the infrastructure sectors was focused outside of the Baku-Absheron area, attending the needs of the less wealthy part of the country. Coverage indicators such as the ones in water and sanitation in Nakhchivan, as well as feedback from users received during IED’s field visits in energy and roads attest to having addressed their needs in an inclusive way. Moreover, ADB’s timely intervention with the CSF was instrumental in minimizing the stress of the oil crisis on the poorer segments of the population. ADB’s strategy in Azerbaijan was relevant to the government’s inclusive growth strategy, as well as to ADB’s corporate IEG agenda.

124. For a higher IEG impact, ADB should continue its support for the reform agenda to delink macroeconomic policies from world oil markets, ensuring the space for a more stable economy based on the private sector. Additional efforts may be needed in other important areas of the economy, particularly in education, and in labor markets. A better prepared labor force that is free and capable of moving across sectors is essential for a more inclusive process of economic growth. It will also allow Azerbaijan to venture into economic activities that have a higher labor intensity than the oil and gas sector, and create greater value added.

B. Regional Cooperation and Integration

125. Within Azerbaijan, ADB support for RCI focused mainly on infrastructure connectivity. Cross-border infrastructure has been an important focus of ADB’s work in Azerbaijan, including both the transport and energy sectors. Examples of these are the North- South and East-West corridors, as well as the pipeline that will take Azerbaijan’s gas to Europe. Regional public goods are a secondary area where ADB provided some support at a stage prior 56 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

to the evaluation period, such as grant support for early childhood development. By comparison, little has been done on trade and investment, and even less on monetary and financial integration.

126. ADB has provided ongoing support to CAREC and continued engagement with other regional entities. Since its establishment, and with support from ADB (which serves as the secretariat), CAREC has played a role in networking across its member countries and assisting in identifying areas where all can benefit from greater cooperation.

127. Azerbaijan is supporting several cross-border projects with neighboring countries, but there have been issues with one of them. Examples of cross-border projects include the Baku-Tbilisi-Arzurum gas pipeline, the Baku-Tbilisi-Kars railway project, the Baku-Qazakh-Tbilisi highway project, and the Baku-Astara highway project. Another major project is the SGC, which will allow Azerbaijan’s gas to reach Europe. An example of issues is the deletion of the last 2.8 km from the Masalli to Astara expressway leading to the border with Iran. The Government of Iran has been unwilling to relocate the border crossing for a long time. Recently it seems to have agreed to provide a linkage road to the originally planned border crossing, which will also lead to the construction of the final stretch of 2.4 km of expressway to the border on the Azerbaijan side.

1. Assessment

128. ADB’s work on RCI in Azerbaijan and the sub region has grown over time, in line with (i) demand from Government of Azerbaijan; (ii) new opportunities that have arisen for supporting regional integration (through CAREC and other platforms); and (iii) greater focus on regional integration as an ADB strategic agenda, especially under Strategy 2020. With (i) Azerbaijan’s growing influence; (ii) the significant potential benefits that will accrue from further integrating Central Asia (both internally and with neighboring regions); and (iii) the growing number of public goods issues that are affecting development (especially climate change), ADB will want to further strengthen its support for RCI. Support for RCI is highly relevant.

129. With extensive support for RCI over most of the evaluation period, especially in terms of regional investments, ADB’s overall impact on this strategic agenda has been substantial. Cross-border infrastructure has been the focus of ADB’s RCI work, but the main transport and energy investments are in place. Future infrastructure investments would not involve ADB to the same extent as in the past. Yet there seems to be scope to leverage existing and future roads investments into CAREC growth corridors, and to ease the flow of people and goods further by strengthening border capacity for handling transport and trade in all CAREC members. Among other RCI areas, trade and investment could be a focus of future work. Also, regional public goods, such as health and environment-related issues can be potential areas of focus. Environmental concerns are particularly relevant, with climate change science pointing to the impact of climate change being specific to sub-regions. It is not envisaged that ADB would be involved in monetary and financial integration work unless the pending issues with Azerbaijan’s financial system were to be resolved. The development impact of ADB’s support for RCI over the evaluation period has been satisfactory, while there appears to be less scope for RCI work in the future.

C. Environmentally Sustainable Growth

130. ADB’s work in infrastructure, particularly in water and sanitation, has contributed to Azerbaijan’s efforts to face its environmental challenges. To the extent that all projects financed by ADB follow safeguards policies, each one of them help the country’s efforts for a better environment. ADB norms call for assessing the environmental consequences of each project, ensuring a reduced environmental footprint. In some of the projects, the infrastructure Strategic Agendas and Country Priorities 57

investments led to lower emissions, as was the case with energy distribution projects,88 which have measurable decreases in line losses and corresponding carbon dioxide reductions.

131. ADB financed three projects that specifically dealt with environmental concerns. These were the biomass energy TA, the floating solar panels energy TA, and the road project that was duly modified to safeguard a species of turtles.

132. Biomass energy TA. The Renewable Energy Development89 was a feasibility study for a Biomass Cogeneration plant that was completed in May 2017. The TA assessed the feasibility of the plant and provided capacity building for renewable energy covering biomass technology, policy and regulation for renewable energy development, social and environmental impact assessment, and green-house gas accounting and carbon project development. The TA did not lead to a project because the tariffs to support renewable energy projects were not in place, and there were other barriers that were identified. The TA provided policy recommendations regarding these issues.

133. Floating solar panels. This is a recent pilot project to create a system of floating three photovoltaic panels with a capacity of 100 kilowatts each on Lake Boyukshor in Baku. The pilot project is intended to create capacity on renewable energy and encourage private sector participation in solar energy. As in the case of the biomass TA, ADB is also providing policy recommendations on how to make renewable energy profitable and on removing the other barriers for renewable energy.

134. Turtles and a road project. The issue arose when a projected highway that was part of the second MFF was supposed to pass through a wetland of about 7 km in length that was home to a species of turtles. ADB updated a 2007 environmental impact assessment report prepared for the World Bank, bringing it in line with ADB's environmental policy. On that basis, a Turtle Action Plan was prepared in 2016, identifying in detail various measures to protect the species and minimize turtle deaths from construction activities. The action plan was properly implemented.

135. One project of concern was the PCG to support decommissioning of a low-efficiency coal-fired power plant and construction of a gas fired combined cycle plant. The decommissioning of the plant in question has been delayed several years, and is anticipated to be fully demolished by mid-2019. The ongoing TA for the Energy Sector Financial Recovery Plan has recognized the need for the decommissioning of the plant and the stakeholders in this plan have strongly supported this action. They also support the creation of energy market that gives precedence to the most efficient plants.

1. Assessment

136. ADB was responsive to the government’s environmental concerns. ADB supported the overall strategy regarding infrastructure development seeking to safeguard environmental sustainability and has explored with the government options for renewable energy. These ventures into renewable energy have led to a dialogue about the need to address the tariff structure in such a way that private investors find renewable energy worthwhile, as well as the other barriers that hinder renewable energy development. ADB’s support in Azerbaijan was relevant to the government’s ESG strategy, as well as to ADB’s corporate ESG agenda.

88 ADB. 2008. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Power Transmission Enhancement Project. Manila; and ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Azerbaijan for the Power Distribution Enhancement Investment Program Tranche 1. Manila. 89 ADB. 2013. Technical Assistance to Azerbaijan for Renewable Energy Development (Biomass Cogeneration). Manila. 58 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

137. ADB support safeguarded ESG in the investment projects, and in some cases, as in energy distribution, this led to lower emissions. ADB also ventured into renewable energy, starting a dialogue on the main barriers to its development. Yet ADB did not pursue ESG as actively as it pursued other corporate agendas, such as IEG. The evaluation found that ADB has had a satisfactory development impact implementing the ESG agenda in Azerbaijan, but that agenda itself was somewhat limited.

138. ADB has a unique opportunity to further the ESG agenda by continuing the ongoing dialogue with the government on the tariff structures. By making renewable energy profitable and worthwhile for private investors in areas such as biomass or solar energy, the government would be able to open the space for private investments, including by SMEs and even farmers.

D. Diversification and Capacity Development

139. ADB’s support of diversification of the economy was highlighted in the CPS and reflected in all operations. Moreover, the policy-based loan explicitly addressed issues related to macroeconomic management. In addition, of the 17 sovereign loan and guarantee projects covered by this evaluation, 15 had governance and capacity development as a driver of change. None of the operations, however, explicitly targeted the education and skills development sectors.

140. Aside from helping weather the impact of the oil crisis, the CSF provided support for structural reforms aimed at strengthening macroeconomic management. In addition, the accompanying TA was used to help prepare the subsequent programmatic approach that had a more ambitious and detailed reform agenda.

141. Following the government’s Strategic Roadmaps, in 2017 ADB provided two policy- based loans aimed at improving macroeconomic management to reduce procyclicality. These loans addressed a necessary condition for diversification in a resource-rich economy. The main policy action supported was the adoption of a rules-based medium-term fiscal framework that will, when implemented, smooth cyclical fluctuations in budget revenues and expenditures, delinking them from world oil prices. The policy-based loan also laid the groundwork to open spaces for private participation in areas dominated by SOEs, as well as actions meant to improve the business environment, and ease the flow of financing to SMEs.

142. ADB, in collaboration with other development partners, has supported policy and institutional reforms in the energy sector. The aim has been to establish a cost-recovering tariff regime, as well as an enabling regulatory environment to promote competition and attract private sector participation. While progress is being made on the tariffs, on some of the institutional reforms, and on capacity building, there have been some setbacks. The TA on Renewable Energy Development (Biomass Cogeneration) is an ADB-funded pilot program sought to develop two joint government and private sector renewable energy projects that have been delayed for more than 2 years due to lack of capacity and changes in the government.

143. ADB also supported energy sector capacity development. Both Azerenergy and Azershiq commended the quality of the capacity building during project implementation and acknowledged the usefulness of the knowledge transfer for better operations, maintenance, and operational and financial management.

144. ADB projects in water and sanitation did not lead to any significant improvement in private sector participation into the sector. Capacity building was high within the objectives of the MFF that backed most of ADB support to this sector. Through the projects, ADB transferred Strategic Agendas and Country Priorities 59

knowledge and project implementation skill to Azersu, and to SAWMC in Nakhchivan. Capacity building in Nakhchivan was particularly noteworthy, because it went on to use the acquired knowledge to replicate the ADB-financed project in smaller towns within the region, albeit at a lower scale. ADB’s efforts were complemented by some knowledge transfer from Suez to Azersu in the early evaluation period.

145. A byproduct of ADB’s roads projects was the development of a core team capable of scheduled maintenance. Having made significant progress on roads, the government moved that team to work on railways, in the hope of improving that service across the country, including the light rail system of the Baku-Absheron area. To the extent that roads improved links with regions, they contributed to diversification. However, no private sector participation took place.

1. Assessment

146. Several years of the evaluation period passed before ADB focused on the necessary conditions for economic diversification. Indeed, it only focused on those conditions when the crisis hit during the last two years of the evaluation period. While the CPS and the business plans kept hailing the need for a diversified economy, the infrastructure efforts supported by ADB fell short from what was needed to help Azerbaijan diversify its economy towards tradable sectors capable of having a sustained growth path with a continued employment performance that could absorb the growing labor force. Moreover, while economic diversification was a CPS objective, it did not appear to be based on any analytical work describing how it was going to be achieved. Furthermore, ADB did not have a well-defined policy agenda to diversify the economy for most of the period under review. In addition, although ADB’s role as an Azerbaijan’s development partner did not include macroeconomic dialogue as its main topic, ADB did have a strong standing with the government and could have at least raised as an issue the feeble performance of the tradable sectors. Accordingly, ADB’s support on economic diversification is rated as relevant, but it remained a limited agenda most of the time.

147. ADB’s support to Azerbaijan on capacity building addressed a dire need for qualified teams and technicians that could responsibly run the infrastructure sectors. Although TA was relatively limited and unsuccessful, ADB used project implementation to build capacity in Azerbaijan’s side. The support provided by ADB and needed by Azerbaijan included training of key players, use of better systems, including procurement, and improved management of the projects. ADB’s support to Azerbaijan on capacity building, is seen by this report as relevant.

148. ADB’s support needed to overcome the Dutch Disease challenge only came at the end of the evaluation period. The efforts on the infrastructure sectors were not particularly targeted to boost diversification. Rather, ADB’s work in these sectors was meant to improve service delivery, boosting the inclusiveness of growth, but not necessarily Azerbaijan’s competitiveness in the tradable sectors. ADB support had a less than satisfactory development impact on the diversification agenda.

149. IED received positive feedback on ADB’s capacity building efforts. The case of SAWMC in Nakhchivan is a good example, where the knowledge and the incentives came together to deliver an amplified impact of the know-how and technical transfer done by ADB. Similarly, the team that moved from working on roads to working on railroads did so because the government appreciated their advanced capacity to deliver results. ADB’s development impact on capacity building is rated highly satisfactory.

150. Macroeconomic dialogue has not been a central element in ADB’s role in Azerbaijan. Yet, pursuing agendas such as diversification and IEG will be challenging in economies that are resource-rich, and have their macroeconomic policies tied to the cycles in world commodity prices. 60 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

In these cases, ADB ought to be able to undertake a dialogue with the country authorities on the issues related to the tradable sectors, and to the labor markets that cater to them. Growth in non-tradable sectors is likely to be highly dependent on a sustained demand stemming from the expenditures done with the resource-related government revenues. As such it will be procyclical, and it will not lead to a true diversification of the economy.

E. Summary

151. ADB’s contribution to IEG was relevant and had satisfactory development impact, but it is difficult to gauge to what extent regional disparities were reduced because of ADB supported projects. ADB’s interventions were aligned with the country’s needs and priorities, as well as with its own strategies. Valuable interventions included both the support through infrastructure development, as well as the support provided through PSM programs. There is very little statistical evidence, however, to establish the extent to which ADB fostered inclusive growth by reducing regional development disparities. Intuitively, the fact that the bulk of the infrastructure investments financed by ADB were located outside the Baku-Absheron region suggests that this may be the case. More use of outcome indicators in the different projects may have helped to monitor progress in this direction more closely.

152. ADB’s support in diversification was held back during the bulk of the evaluation period because it failed to focus early on the necessary macroeconomic condition of delinking fiscal policy from world prices for fossil fuels. ADB only focused on this condition for diversification when the crisis hit during the last two years of the evaluation period. During the earlier years, any gains in efficiency that may have been attributed to ADB-financed investments were diminished by the real appreciation of Azerbaijan’s exchange rate. The infrastructure efforts supported by ADB fell short from what was needed to compensate the damaging impact of the real appreciation of the manat. Not surprisingly, despite these investments, Azerbaijan was not able to diversify its economy towards the tradable sectors capable of having a sustained growth path with a continued employment performance that could absorb the growing labor force.

Summary, Lessons, and Recommendations 6 62 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

153. This chapter summarizes the performance and development results of the ADB program in Azerbaijan and makes recommendations based on the findings of the evaluation. These recommendations are at the strategic and operational levels. A consultation mission with Azerbaijan authorities on a draft of the evaluation in December 2018 confirmed the findings, assessments, and issues raised in the report. The sector program assessments accessible from the list of linked documents in the Appendix provide more detailed suggestions at the operational level.

A. Summary of Assessments

154. ADB's strategy and support for Azerbaijan have been successful overall, although there was weak progress in economic diversification. This conclusion is based on assessments of sovereign operations in the main sectors, NSO, and ADB's strategic agendas and special priorities in Azerbaijan. This integrated assessment follows ADB's 2015 guidelines for CAPEs, which assign a proportional weight to ADB’s sector and cross-sector thematic performance. A summary of the assessments follows.

155. The overall assessment of ADB support through sovereign operations finds it successful. Aggregated ratings of the sector program assessments, using IED’s standard criteria of relevance, effectiveness, efficiency, sustainability, and development impact are summarized in Table 3. The sector weights reflect the volume of ADB support provided during 2011–2017 through sovereign loans and TA resources.

Table 3: Azerbaijan: Rating of Country Program and CPS Objectives, 2011–2017 Sector Share Relevance Effectiveness Efficiency Sustainability Development Overall Rating (%) Impact Energy 29.2 2.0 2.0 2.0 2.0 2.0 2.0 Successful Transport 35.7 2.0 1.0 1.0 2.0 2.0 1.6 Successfula WUS 16.0 2.0 2.0 1.0 2.0 2.0 1.8 Successful PSM 19.1 2.0 2.0 2.0 2.0 2.0 2.0 Successful Overall SO 2.0 1.6 1.5 2.0 2.0 1.8 Successful CPS = country partnership strategy, PSM = public sector management, SO = sovereign operations, WUS = water and other urban infrastructure and services. a Successful on the borderline. Source: Asian Development Bank Independent Evaluation Department.

156. ADB’s program was relevant in all sectors and aligned with Azerbaijan’s strategies and priorities. ADB regularly adapted its program and interventions to the strategies defined by Azerbaijan in its successive documents, including most recently the Vision 2020 and the strategic road maps. The program was also adapted to the challenges that came about because of the drop in the world prices for fossil fuels. In addition, the program was delivered using appropriate interventions that were delivered on time for the most part. Moreover, the interventions were also correctly structured and sequenced. In this regard, the use of MFFs proved an effective and flexible way of providing support for complex infrastructure projects.

157. ADB support was overall effective on the borderline, because satisfactory effectiveness was held back by the major transport program, which this evaluation found less than effective. ADB support achieved the bulk of outputs and outcomes in energy, WUS and PSM. In transport substantial delays were accompanied by issues that have resulted in many of the roads being constructed but not in use until September 2018. Key factors behind reduced effectiveness are the lack of a preceding learning project, poor technical design, weak implementation capacity, and unfocused monitoring by ADB that did not foresee major issues. Unanticipated land acquisition also triggered additional safeguard issues, while the expansion of Summary, Lessons, and Recommendations 63

a road from 2 lanes to 4 overlooked the need for animal crossings. The implementation of the program has helped build capacity in Azerbaijan and has created a wealth of experience on how to implement infrastructure projects. However, monitoring missions should take a big picture approach to help them identify issues that may arise and work with their Azerbaijani counterparts to find solutions. The delays in building animal crossings or deciding on tolling are good examples of problems that could have been tackled early on to make the investments more effective.

158. The evaluation rated ADB support overall less than efficient, considering the weak performance of the transport and WUS programs. Delays and cost overruns in these programs hampered the projects’ efficiency. In some cases, projects were delayed for more than a year, reflecting slow decision making and issues with the design and preparatory work. In other cases, additional government actions were slow to materialize, which reduced the efficiency of some WUS projects. As with effectiveness, a monitoring framework that takes a holistic, big picture perspective of the projects may help bring into the dialogue the preparatory and the complementary steps needed for project efficiency. Water supply can only be used properly if wastewater has somewhere to go, roads can only allow rapid and efficient traffic flow if safety measures are in place, projects can only be built once the necessary land has been acquired. Indeed, projects can only reach their true effectiveness and efficiency potential if they are accompanied by the necessary complements and are well thought through and prepared.

159. ADB sovereign operations are deemed likely sustainable. Important advances have been made in all four sectors. Yet, in all sectors, there is a need for strong political resolve to sustain those advances. Improved tariff structures are a precondition for financial sustainability in energy and WUS. While a case can be made for budget transfers to fill the gap under certain circumstances, these may not be sustainable in the long run. Moreover, having private investment fill in the gap in certain sectors, such as renewable energy, is only possible if the necessary private investments are profitable enough to entice investors. For road operations, maintaining the roads, ensuring road safety, and keeping cargo weight within acceptable bounds call for resolve and sustained commitment by the authorities. In PSM, adhering to a medium- term fiscal framework, saving hydrocarbon revenues in a stabilization fund, and confronting the capital deficiencies of the banking system are only possible with determination from the highest political levels. ADB can reduce these risks to sustainability by maintaining a constructive dialogue with the authorities to help them confront those challenges while taking on board their concerns.

160. ADB public sector support had a satisfactory development impact in all four sectors targeted. ADB support sought to promote the strategic agendas and special priorities of IEG, ESG, RCI, capacity development, and diversification of the economy. In doing so, these interventions furthered Azerbaijan’s development. In some cases, the development impact is already noticeable, judging by the feedback IED received during field visits from the beneficiaries of power distribution, roads, and water systems. In other cases, such as PSM, statistical indicators of how the number of beneficiaries of different interventions attest to the development impact of those interventions, as in the case of the pro-poor spending supported by the CSF. Some ADB interventions could have had a greater development impact, as would have been the case for example if water supply had the complementary investments in wastewater treatment, or if the CSF had been used earlier in the crisis.

161. ADB successfully built infrastructure sector capacity that is being replicated by other sectors. IED received very positive feedback from all implementing agencies, and, more importantly, witnessed the demonstrated ability of some of them to replicate the ADB projects at a different location and scale. Examples are the SAWMC in Nakhchivan, which replicated WUS projects, and the government’s decision to move to the railways the team that had learned with ADB to take care of and refurbish the roads.

64 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

162. ADB’s support to Azerbaijan through nonsovereign operations was less than successful on the borderline of successful. Table 4 summarizes the ratings following the criteria used by IED for NSOs, which look at development results, investment profitability, ADB work quality, and ADB additionality.

Table 4: Azerbaijan: Overall Rating of ADB Nonsovereign Operations Criteria Development Investment ADB Work ADB Additionality Overall Rating Results Profitability Quality Rating 1.0 1.0 2.0 2.0 1.5 Borderline less than successfula a At the borderline of successful. Source: Asian Development Bank Independent Evaluation Department.

163. Nonsovereign operations supported the cement and the gas sectors directly, as well as other sectors through the financial system. Support to the cement and gas sectors was generally positive, achieving satisfactory development results and profitability. Those operations were well prepared by ADB and made a significant difference by bringing additional projects in the case of cement, and additional financing in the case of gas. The only issue is that one of the gas loans is not being used by the beneficiary, and is unlikely to be used, lowering the investment profitability.

164. ADB support through the financial system has moved from satisfactory before the crisis to a more complex situation at present. The two initial onlending projects through Azerbajani commercial banks had satisfactory development results, were profitable investments, were prepared based on satisfactory ADB work, and provided additionality by channeling resources to SMEs and agribusiness. Another pre-crisis operation did not yield the expected results. The other three operations were channeled through two commercial banks that were hit by the crisis.90 One of them is being liquidated because FIMSA, the supervisory authority, did not accept the proposed financial restructuring. The other is undergoing financial restructuring. A better understanding of conditions in Baku and of the size and breadth of the crisis may have yielded a different outcome in the operations with these two banks.

165. IED evaluated the three strategic agendas and two special priorities for their relevance and development impact. The evaluation assessments of IEG, ESG, RCI, economic diversification, and capacity development are summarized in Table 5.

Table 5: Azerbaijan Rating of Strategic Agendas and Special Priorities Strategic Agendas Relevance Development Impact Inclusive economic growth 2.0 2.0 Regional cooperation and integration 2.0 3.0 Environmentally sustainable growth 2.0 2.0 Special Priorities: Economic diversification 2.0 1.0 Capacity building 2.0 3.0 Notes: The rating categories for the evaluation criteria are as follows: (i) Relevance: highly relevant (3 points), relevant (2 points), less than relevant (1 point), and irrelevant (0 point); (ii) Development impacts: highly satisfactory (3 points), satisfactory (2 points), less than satisfactory (1 point), and unsatisfactory (0 point). Source: Asian Development Bank Independent Evaluation Department.

166. The IEG work is rated relevant and had a satisfactory development impact. ADB’s work in the infrastructure sectors focused for the most part outside of the Baku-Absheron

90 These do not include an intended transaction in which the counterpart commercial bank opted for not doing business in Azerbaijan because of the crisis. Summary, Lessons, and Recommendations 65

area, attending the needs of the less wealthy part of the country. It also incorporated inclusive elements into project designs and had projects in sectors with high inclusion impact. Coverage indicators such as the ones in water and sanitation in Nakhchivan, as well as feedback from users attest to having addressed their needs in an inclusive way. The CSF and the programmatic approach, on the other hand, were meant to help the poorer segments of the population weather the crisis, as well as to fend off future ones.

167. ADB’s RCI work is rated highly relevant and had a highly satisfactory development impact. It is relevant because of the significant potential benefits that will accrue from further integration of Central Asia, as well as the public goods issues in the region. ADB supported integration through CAREC, and through cross-border links in transport and energy. The most salient project in this regard is the Southern Gas Corridor which will take Azerbaijan’s gas to Europe.

168. The ESG work is rated relevant and had a satisfactory development impact. ADB safeguarded ESG in the investment projects, and in some cases, as in energy distribution, led to lower emissions. ADB also explored with the government options on renewable energy, an exercise that led to a dialogue on the tariff structure and the regulations needed to make renewable energy attractive for private investors. Yet ADB did not pursue ESG as actively as it pursued other corporate agendas, such as IEG and RCI.

169. ADB’s work on economic diversification is rated as relevant but it had a less than satisfactory development impact. ADB only focused on the necessary conditions for economic diversification toward the end, when the crisis hit in the last 2 years of the evaluation period. In the face of the substantive real appreciation of the manat, any cost reductions stemming from infrastructure investment did not suffice. Moreover, ADB’s efforts on the infrastructure sectors were more targeted towards IEG than diversification.

170. ADB’s support on capacity development is rated relevant and had a highly satisfactory development impact. ADB’s support addressed a dire need for qualified teams and technicians that could responsibly run the infrastructure sectors. Combined sector and thematic performance is illustrated in Figure 15 below.

Figure 15: Impacts by Sector and Theme Transport WUS Energy NSO PSM Assessment

IEG Successful

ESG Successful

RCI Successful

ED/CD Mixed

66 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Transport WUS Energy NSO PSM Assessment

Less than Gender successfula

Less than PSD successful (borderline)

Less than Assessment Successful Successful Successful successful Successful (borderline) CD = capacity development, ED = economic diversification, ESG = environmentally sustainable growth, IEG = inclusive economic growth, NSO = nonsovereign operation, PSD = private sector development, PSM = public sector management, RCI = regional cooperation and integration, WUS = water and other urban infrastructure and services. Note: Size of the bubble denotes the financial amount (the larger the size, the greater the financial support); and shape of the bubble shows comprehensiveness of ADB support. a The less than successful rating for gender is based on ADB support across all sectors and is not specifically directed at water and other urban infrastructure and services which contained specific gender elements. Source: Asian Development Bank Independent Evaluation Department assessment.

B. Lessons

171. ADB's greatest effectiveness is achieved when capacity building and infrastructure development or policy reform come together. This needs the right alignment of incentives and an accountability framework that lead to sustained progress in institution building and in implementation. A useful complement is to consult with beneficiaries or key actors.

172. When the government borrowing policy changes (a near complete stop to external borrowing being enforced at present) and when there is a consequent need for ADB to venture outside of the infrastructure sectors, then this generally requires applying a broader range of support instruments and modalities. With the increase of the debt-to-GDP ratio, the government’s borrowing policy changed to a policy of zero net increases in public sector exposures to the different creditors. Nevertheless, the government remains interested in exploring greater private sector participation in the provision of public services. Under these conditions, ADB’s engagement with Azerbaijan will have to be creative and resort to a wider set of lending instruments.

173. The pursuit of economic diversification calls for detailed analytical work and a sizable reliance on private sector operations. Economic diversification toward sectors where Azerbaijan has comparative advantage has met little success, increasing the dependence of the economy on the fossil fuels sector. ADB’s support in diversification was held back during the bulk of the evaluation period because it failed to focus early on the necessary macroeconomic condition of delinking fiscal policy from world prices for fossil fuels. ADB only focused on this condition for diversification when the crisis hit during the last 2 years of the evaluation period.

174. ADB’s experience with policy dialogue on tariffs and the fiscal framework with Azerbaijan’s authorities shows that joint solutions can be found. The programmatic approach in PBL was the right way to engage in a constructive dialogue and support difficult reform agendas in testing times.

Summary, Lessons, and Recommendations 67

C. Recommendations

175. While the evaluation considers the performance of the ADB supported program in Azerbaijan overall successful, the following recommendations can help enhance its development effectiveness in ADB’s partnership with the country. The recommendations that follow include three strategic ones, and a couple of operational recommendations. In addition, the sector assessments included in the Appendix consider several recommendations that are sector specific.

Strategic Recommendations

176. The ADB program should have a greater focus on building human and social capital in parallel with developing and improving physical infrastructure and supporting policy reform. In the context of the objectives of IEG, ESG, and economic diversification, where ADB has had its greater success, it has been where these elements came together, as was the case with water and sanitation support in the NAR, or in the ongoing work on a medium-term fiscal framework. On the other hand, capacity development calls for both the supply of the capacity, as well as for the right alignment of incentives and an accountability framework that effectively leads to sustained progress in governance, institution building, and in implementation. Indeed, well-motivated recipients of capacity development have moved forward with reforms more steadily and effectively, as was the case with the reform of the roads system and now the railways. A useful complement of this integrated view is to consult with civil society representatives of some of the beneficiaries and key actors to help finetune some measures to make them more effective.

177. ADB should use a broader range of its instruments and modalities as part of a new strategy in Azerbaijan. This in light of the evolving demands for ADB’s support, together with the limitations imposed by the government’s decision to maintain its external borrowing in check. While continued support of the structural reforms and their implementation will be best served with additional policy-based lending coupled with technical assistance, ADB needs to consider options such as results-based lending, domestic currency financing, self-standing technical assistance, private participation in transaction advisory and project financing of some projects, and more active cofinancing with other development partners Moreover, a period of non- borrowing provides space to undertake policy diagnostic work to inform future reforms.

178. ADB support for the diversification of the economy must include more analytical work, a focus on the non-oil tradable sectors, and a more proactive involvement in private sector operations in Azerbaijan beyond simple onlending operations. The analytical work can be oriented toward more sharply defining the activities, milestones and targets of strategic sector roadmaps, as well as improving their evaluability. ADB will also have to bolster its private operations presence in Baku and develop a deeper understanding of the macroeconomic framework in which it is operating, Azerbaijan’s advantages in non-oil tradable sectors, and the impact of policies on the different sectors and existing market realities. Compared with other development partners that have a greater presence in Baku, ADB’s private sector operations are limited and sparse, a comparison that suggests the need for a more visible and connected presence of ADB’s private sector department in Baku. Greater presence in this area should be attuned to the needs of the client and in cooperation with other development partners, not in competition, so that the combined efforts lead to a stronger private sector. Moreover, this move would be in line with the Strategy 2030, which foresees a greater role for the private sector in upper middle-income countries.

68 Country Assistance Program Evaluation for Azerbaijan, 2011–2017

Operational Recommendations

179. ADB should step up its due diligence and preparatory work for its operations to handle expectations properly and avoid delays or failures, especially in transport operations. The experience from the evaluation period suggests that outcomes would have been much better if project delays in energy, transport, and WUS had been avoided by being mindful of some essential requirements, such as land acquisition, better understanding of the enabling legal environment, consulting affected communities, or ADB safeguards policies. In NSOs, detailed monitoring is imperative to adequately assess the systemic risks facing banks and other potential clients.

180. ADB should expand its policy dialogue, drawing on the iterative and interpersonal approach that has proved valuable in areas such as fiscal and tariff reform. ADB’s experience in policy dialogue with Azerbaijan’s authorities in these two areas has demonstrated the virtues of listening to them, taking their concerns into account, and working with them to find solutions to move forward. In this regard, the Headquarters staff has led the policy dialogue and has been ably supported by the current Resident Mission in Baku. This process should be expanded to all sectors, even though it may be construed as slow and causing delays. By fostering ownership and developing capacity in the government’s side, it has proven to lead to success in dealing with difficult tasks.

Appendix

APPENDIX: LIST OF LINKED DOCUMENTS

A. Azerbaijan Loans, Guarantees, and Technical Assistance Portfolio Covered by the Evaluation, 2011–2017 https://www.adb.org/sites/default/files/linked-documents/A-Azerbaijan-Portfolio.pdf

B. Energy Sector Program Assessment https://www.adb.org/sites/default/files/linked-documents/B-Energy-Sector-Program- Assessment.pdf

C. Transport Sector Program Assessment https://www.adb.org/sites/default/files/linked-documents/C-Transport-Sector-Program- Assessment.pdf

D. Water and Other Urban Infrastructure and Services Sector Program Assessment https://www.adb.org/sites/default/files/linked-documents/D-Water-and-Urban-Sector-Program- Assessment.pdf

E. Public Sector Management Program Assessment https://www.adb.org/sites/default/files/linked-documents/E-Public-Sector-Management- Program-Assessment.pdf

F. Nonsovereign Sector Program Assessment https://www.adb.org/sites/default/files/linked-documents/F-Nonsovereign-Sector-Program- Assessment.pdf