Document of The World Bank

FOR OFFICIAL USE ONLY Public Disclosure Authorized

Report No: 32428-UA

PROJECT APPRAISAL DOCUMENT

ON Public Disclosure Authorized A PROPOSED LOAN

IN THE AMOUNT OF US$106 MILLION

TO

UKRAINE

FOR A Public Disclosure Authorized HYDROPOWER REHABILITATION PROJECT

IN SUPPORT OF THE ENERGY SECTOR REFORM AND DEVELOPMENT PROGW

May 24,2005

Infrastructure and Energy Sector Unit Europe and Central Asia Region Public Disclosure Authorized This document has restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS

(Exchange Rate Effective March 3 1,2005)

Currency Unit = Ukraine (UAH) UAHl = US$0.19 US$1 = UAH5.28

FISCAL YEAR January 1 - December 31

ABBREVIATIONS AND ACRONYMS

APL Adaptable Program Loan BCM Billion Cubic Meters CAS Country Assistance Strategy CEE Central and Eastem Europe CF Carbon Financing CIDA Canadian Agency for Intemational Development co2 Carbon Dioxide ccu Coal Company ofUkraine DPL Development Policy Loan EBRD European Bank for Reconstruction and Development EC European Commission ECU Energy Company of Ukraine ERR Economic Intemal Rate of Retum EMP Environmental Management Plan EU European Union FIRR Financial Internal Rate of Retum G7 Group of Seven GDP Gross Domestic Product GHG Greenhouse Gas GWh Gigawatt-hour HPP Hydropower Plant IMF International Monetary Fund JI Joint Implementation KfW Bank for Reconstruction (Germany) KP Kyoto Protocol MFE Ministry of Fuel and Energy MIS Management Information System MW Megawatt NERC National Electricity Regulatory Commission NOx Nitrogen Oxide NPV Net Present Value OP Operational Policy PAL Programmatic Adjustment Loan PHRD Japanese Aid Agency PrU Project Implementation Unit PPIAF Public-Private Infrastructure Advisory Facility FOR OFFICIAL USE ONLY

PWG Permanent Working Group SCADA Supervisory Control and Data Acquisition Sida Swedish Agency for Intemational Development SIL Specific Investment Loan so2 Sulphur Dioxide TACIS European Commission’s Agency for Technical Assistance to the CIS Countries TEN-E Trans-European Electricity Networks TPP Thermal Power Plant TSO Transmission System Operator UCTE Union for the Coordination of Transmission of Electricity in Europe UHE UkrHydroEnergo USAID United States Agency for Intemational Development WEM Wholesale Electricity Market WTO World Trade Organization

Vice President: Shigeo Katsu Country Director: Paul Bermingham Sector Manager: Peter Thomson Task Team Leader: Dejan Ostojic

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

EUROPE AND CENTRAL ASIA Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

CONTENTS

Page

A . STRATEGIC CONTEXT AND RATIONALE ...... 1 1. Country and sector issues ...... 1 2 . Rationale for Bank involvement ...... 3 3 . Higher level objectives to which the project contributes ...... 4

B. PROJECT DESCRIPTION ...... 5 1. Lending instrument ...... 5 2 . Program objective and phases ...... 6 3 . Project development objective and key indicators ...... 7 4 . Project components ...... 8 5 . Lessons leamed and reflected in the project design ...... 9 6 . Alternatives considered and reasons for rejection ...... 10 C . IMPLEMENTATION ...... 11 1. Partnership arrangements ...... 11 2 . Institutional and implementation arrangements ...... 12 3 . Monitoring and evaluation ofoutcomeshesults ...... 13 ... 4 . Sustainability...... 13 5 . Critical risks and possible controversial aspects ...... 14 6 . Loan conditions and covenants ...... 16

D. APPRAISAL SUMMARY ...... 17 1. Economic and financial analyses ...... 17 2 . Technical ...... 19 3 . Fiduciary ...... 20 4 . Social...... 21 5 . Environment...... 22 6 . Safeguard policies ...... 23 7 . Policy Exceptions and Readiness ...... 24 Annex 1: Country. Sector and Program Background...... 25 Annex 2: Major Related Projects Financed by the Bank and other Agencies ...... 39 Annex 3: Results Framework and Monitoring ...... 43 Annex 4: Detailed Project Description...... 45 Annex 5: Project Costs ...... 51 Annex 6: Implementation Arrangements ...... 53 Annex 7: Financial Management and Disbursement Arrangements ...... 59 Annex 8: Procurement Arrangements ...... 65 Annex 9: Economic and Financial Analysis ...... 72 Annex 10: Safeguard Policy Issues ...... 93 Annex 12: Documents in the Project Files ...... 102 Annex 13: Statement of Loans and Credits ...... 103 Annex 14: Country at a Glance ...... 105

Map IBRD 34052 UKRAINE

HYDROPOWER REHABILITATION PROJECT IN SUPPORT OF THE ENERGY SECTOR REFORM AND DEVELOPMENT PROGRAM

PROJECT APPRAISAL DOCUMENT

EUROPE AND CENTRAL ASIA

ECSIE

Date: May 25,2005 Team Leader: Dejan R. Ostojic Country Director: Paul Bermingham Sectors: Power (1 00%) Sector ManagerDirector: Peter Thomson Themes: Regional integration (P);Regulation and competition policy (P) Project ID: PO83702 Environmental screening category: Partial Assessment Lending Instrument: Specific Investment Loan Safeguard screening category: Limited impact

W' ' Project Financing Data [XI Loan [ ]Credit [ ]Grant [ ]Guarantee [ ]Other:

For Loans/Credits/Others: Total Bank financing (US$m.): 106.00 Pronosed terms: VSL

RECONSTRUCTION AND DEVELOPMENT Total: 261.80 112.70 374.50

Borrower: Ukraine Responsible Agency: UkrHydroEnergo 07300 Vyshhorod Kyiv Region Ukraine

Annual 0.0 7.0 27.0 32.0 17.0 12.0 7.0 4.0 Cumulative 0.0 7.0 34.0 66.0 83.0 95.0 102.0 106.0 Project implementation period: Start: October 1,2005 End: December 3 1,201 1 Expected effectiveness date: September 30,2005 Expected closing date: June 30,2012 Does the project depart from the CAS in content or other significant respects? [ ]Yes [ XI No Re$ PAD A.3 Does the project require any exceptions from Bank policies? Re$ PAD D. 7 [XIYes [ ]No Have these been approved by Bank management? [XIYes [ ]No Is approval for any policy exception sought from the Board? [ ]Yes [XINO Does the project include any critical risks rated “substantial” or “high”? [XIYes [ ]No Re$ PAD C.5 Does the project meet the Regional criteria for readiness for implementation? [XIYes [ ]No Ref: PAD D. 7 Project development objective Ref: PAD B.2, Technical Annex 3 and, therefore, facilitate unimpeded operation of the energy market, both domestically and internationally. The main objective of the Hydropower Rehabilitation Project is to improve operational stability and reliability of power supply by increasing regulating capacity, efficiency and safety of hydroelectric plants, and, therefore, facilitate unimpeded operation and opening up of the electricity market. Additional objective is to support the Ministry of Fuel and Energy and NERC in preparing and implementing the Energy Sector Reform and Development Program, including the Wholesale Electricity Market concept. l Project description [one-sentence summary of each component] Re$ PAD B.3.a, Technical Annex 4 The Hydropower RehabilitationProject comprises five components: Component A: Rehabilitation of hydroelectric plants. This component includes rehrbishment of46 hydroelectric units and associated plant equipment at nine hydroelectric plants. Component B: Dam Safety. This component includes rehabilitation and upgrade of the existing, as well as installation of new dam safety monitoring systems and rehabilitation of drainage facilities and spillway gates on six dams. Component C: UHE Institutional Development. This component includes establishment of a corporate-wide Management Information System in UHE. This component also includes provision of technical assistance to UHE in improving financial management, enhancing dam safety, and project management. Component D: MFE Institutional Development. This component includes provision of technical assistance to the MFE in developing and implementing: (i)an action plan for legal and technical harmonization of the Borrower’s energy market with the European Union Intemal Energy Market; and (ii)a program ofpriority investments and technical assistance in the energy sector. Component E: Implementation of the WEM Concept. This component includes provision of technical assistance to NERC in implementing the wholesale electricity market (WEM) concept.

Which safeguard policies are triggered, if any? Re$ PAD D. 6, Technical Annex 10 The Hydropower Rehabilitation Project triggers the safeguard policy on environmental assessment. It also triggers policies on the safety ofdams and projects on international waterways. Significant, non-standard conditions, if any, for: Re$ PAD C. 7 Board presentation: Not applicable.

Loadcredit effectiveness: - UHE to select an intemational project management consultant under Terms ofReference and with qualifications acceptable to the Bank.

Covenants applicable to project implementation: - the Borrower to ensure that from Fiscal Year 2006 and onwards NERC would establish and maintain tariffs for UHE sufficient to cover project co-financing needs in a timely manner.

- the Borrower to ensure that NERC introduces a two-tier tariff for UHE by December 31,2005.

- UHE to maintain the following financial covenants: (i)debt service coverage ratio of at least 1.5 during the project period; (ii)current ratio of at least 1.2 during the project period; and (iii)to carry out revaluation of its assets in accordance with terms of reference and consultants satisfactory to the Bank by December 3 1, 2007.

- UHE to complete the design proposals satisfactory to the Bank for (i)rehabilitation of: (A) drainage facilities; (B) design profiles (rehabilitation of subsidence); (C) slope protections; (D) concrete spillways and other reinforced concrete works at Kyiv, Kaniv, Dniprovska and Dneprodzerzhinsk dams; and (ii)protection against higher phreatic lines (high piezometric levels) in the dam embankments at Kaniv, Kremenchug, Dniprodzherzhinsk and Kakhovka dams by December 3 1, 2005.

- UHE to establish an adequately staffed Dam Safety Center under terms ofreference acceptable to the Bank by December 3 1, 2005.

A. STRATEGIC CONTEXT AND RATIONALE

1. Country and sector issues

After a decade of economic decline, which halved the country’s economic output and raised the poverty rate to almost a third of population, GDP has rebounded by over 40% since 2000, and indications are that the poverty rates are beginning to decrease. The recent economic growth in Ukraine has been a mixture ofrevival ofold and emergence ofnew activities, both supported by access to inexpensive energy supplied from aging, inefficient and often environmentally polluting sources through extensive electricity, gas and oil networks inherited from the former Soviet Union. Furthermore, the low priced domestic coal (and electricity) is one of key resources helping the revival ofthe steel industry which accounted for 37% of the total exports of Ukraine in 2003. Ukraine now faces the difficult task of ensuring the sustainability of the economic growth and the consolidation of market reforms which are critical if the country is to fulfill its stated aspirations with regard to increasing integration with the European Union (EU) and with the World Trade Organization (WTO).

Developments in the energy sector closely mirror the aforementioned changes in the economy. After a sharp decline in the 1990s, the production ofelectricity in the last three years stabilized at about two thirds of the production in 1990, while the primary energy production (coal, gas and oil) bottomed out at about 40% of the 1990 level. While significant spare capacities freed by declining demand enabled unconstrained energy supplies in 1990s, albeit of low quality and poor reliability, the recent economic revival is exposing a significant loss of available capacity and deterioration of energy infrastructure. The system faces serious challenges in maintaining security, reliability and quality of energy supply due to (i)the lack of investments and deferred maintenance in aging infrastructure; (ii)the poor financial condition of energy enterprises; and (iii)delays in sector reforms. These are far more than sectoral problems, because they threaten the sustainability of economic growth, reduce competitiveness of the country’s products and services, degrade the environment and increase the cost of social services. Furthermore, attracting investments, creating jobs and increasing productivity - key drivers of sustainable economic growth - can not be effectively stimulated without improvements in the security, reliability and quality ofenergy supply.

Ukraine has made considerable progress in energy sector reform which started with the restructuring and corporatization in the oil, gas, and power sectors in 1994. As a result of its reform effort, Ukraine unbundled its power industry’, introduced elements ofcompetition on the wholesale electricity market (WEM) and the coal market, and liberalized the oil market. In dealing with the aftermaths of the 1999 financial crises, the Government has been reasonably successful in reducing non-payments and in moving tariffs towards cost recovery levels. It has established the National Electricity Regulatory Commission (NERC) which is steadily building

As a result of restructuring, the power industry is organized in five thermal power generating companies, one hydropower company, one nuclear power company, one power transmission company and 27 regional power distribution companies. One thermal power company and 13 power distribution companies are owned by private (Ukrainian and foreign) investors, while other power companies are (majority) state-owned.

1 its capacity and has opened the energy sector to private investors. Annex 1 provides an overview of main issues that constrain further improvements in sector performance and key reform measures needed in the power, coal and gas sub-sectors. The common problems affecting all three sub-sectors are outlined below.

The most difficult legacy of the 1990s is the large historical debt which is the main obstacle for achieving sector creditworthiness and continuing its ownership transformation. The main cause of the large debt in the energy sector (about UAH 42 billion in January 2003)2 was a sharp decline in financial discipline and rapid accumulation of payment arrears in late 1990s. For example, in 1999, cash collection in the electricity sector was only 8% and total collections (including barter) were about 80%. Despite significant improvement of financial discipline (cash collections for gas and electricity reached 95% in 2004) due to low tariffs and less than full payment performance, the total sector debt is growing, albeit at a slower rate. Recently, the Government prepared a comprehensive action plan which would bring fuel and energy companies to financial solvency and eliminate further accumulation of arrears of tax and other payment obligations. A key step in this action plan is adoption of a law on debt restructuring in the energy sector. This law would create a legal framework enabling and obliging sector entities to separate historical debts from the current financial operation and requiring the Government to help establish a mechanism for the settlement ofhistorical debts.

Energy demand in Ukraine is characterized by high energy intensity (about three times higher than in the EU) and the high share of industry in final energy consumption. Inefficient use of energy is supported by low tariffs which are tailored more to the ability ofconsumers to pay than to cost and value of services provided. Distorted prices of electricity, coal and gas, less than full payment performance and non-technical losses, result in a large energy-related quasi-fiscal deficit (estimated at about 7% ofGDP in 2003) which is financed through the decapitalization of the asset base and the accumulation of debt. The Government action plan for financial stabilization of the energy sector recognizes the importance of adjusting the level and the structure of energy tariffs to fully cover supply costs and to provide price incentives for energy savings and investments in energy efficiency. At the same time, the Government needs to improve the design and implementation of social assistance programs to help protect vulnerable groups from the impact ofinevitable price adjustments in the energy sector.

Electricity sector restructuring, privatization and market liberalization, which started in the mid- 1990s, slowed down after 2001 when financial discipline in the “single buyer” electricity market was strengthened by increasing NERC’s control over its financial flows. While this measure helped reduce the non-payment problem, it could not compensate for the low tariffs and the lack of market competition in fuel (coal and gas) supply which stifle competition among thermal power producers and further undermine their poor financial viability. A failure of the state management to address increasing financial strains in the power sector prompted the Government’s decision to merge the remaining state-owned power generation and distribution assets (except the nuclear power company) into a single holding - Energy Company of Ukraine (ECU) in June 2004. ECU in many ways resembles the state owned, vertically integrated gas company, Naftogaz, but unlike Naftogaz which has a monopoly in the gas market, ECUdoes not

~~ This includes tax arrears to the state and local budgets, but does not include about UAH 11 billion owed to Russia and Turkmenistan for gas supplies.

2 control the whole power market and most importantly it does not control the high voltage transmission network and power dispatch. A similar increase in market concentration occurred in the coal sector after the Government merged all state-owned coal mines into a national holding company - Coal Company ofUkraine (CCU) in October 2004. The separation between political and economic functions through the creation of national holding companies in the energy sector is expected to help commercialize state-owned enterprises, reduce costs and improve financial discipline. The Government action plan recognizes that meeting these objectives requires the improvement in corporate governance of state-owned energy enterprises and the strengthening of NERC’s independence and capacity in order to mitigate risks of monopoly abuses which arise from the growing market concentration. Furthermore, the Government is committed to develop a strategic action plan for continuing ownership transformation and attracting private sector investments in the energy sector.

2. Rationale for Bank involvement

The Bank has supported Ukraine in its efforts to reform and restructure its energy sector through policy dialogue, technical assistance and financing of adjustment and investment projects since the early 1990s. The Bank prepared several energy sector policy notes3 in the last two years, which reviewed the results ofthe first decade oftransition and mapped a way forward for a more strategic sector-wide approach. This deep country and sector knowledge puts the Bank in a strong position to provide policy advice, lending and technical assistance to further support energy sector reform and sustainable development. Through the proposed Energy Sector Reform and Development Program (the Energy Program) - based on the Government action plan for financial stabilization of the energy sector - the Bank would provide sector-wide support for sustainable energy development which, in Ukraine, requires coordinating and adapting financial support, policy advice and technical assistance to a rapidly changing and growing economy.

The consolidation of energy sector reforms is a cornerstone of the Bank’s CAS. Energy reform cuts through the main themes of the CAS: (i)fostering financial discipline, including reduction of tax arrears to the budget and improvement in payment discipline in the electricity and gas sectors; (ii)improvement of the business environment, including strengthening of the financial and administrative independence of the energy regulator; and (iii)improvement of industrial competitiveness and export performance through the transparent privatization of industrial and energy companies. Therefore, the proposed Energy Program is a key component of the Bank’s assistance strategy and working partnership with Ukraine.

Cooperation in the energy sector is high on the agenda of several donors, notably the European Commission (TACIS), and Governments of Japan (PHRD) and Sweden (Sida), although the overall donors support to the sector declined in the last few years after USAID and CIDA reduced its assistance and focused on the Chernobyl sarcophagus project and the nuclear safety. The Bank, through the multi-donor agency PPIAF, is also providing support for the further development ofWEM. The enhanced cooperation in the energy sector is an important element of the EU-Ukraine Action Plan which was signed in February 2005. This Action Plan outlines a number of concrete steps required to harmonize the structure, regulatory framework and operation of the Ukraine energy market with the EU Internal Energy Market. Two recently

In 2003 and 2004, the Bank energy team prepared sector notes on coal, gas, energy regulation, and electricity.

3 approved TACIS projects will support Ukraine’s progressive participation in the trans-European gas and electricity networks. The proposed Energy Program would help implement priority reforms and investments identified in these technical assistance projects, and, thus, it would facilitate the implementation ofthe EU-Ukraine Action Plan. Furthermore, the proposed Energy Program would help establish a framework for sector-wide cooperation and partnership among the Bank, EBRD and bilateral donors in assisting Ukraine to reform and to further develop its large and strategically important energy sector.

Ukraine is the 11 th largest emitter of Greenhouse Gases (GHGs) in the world4 and has one ofthe largest “surpluses” ofemission reductions (estimated at about 1.8 billion tons ofC02 equivalent) compared to the 1990 baseline emissions under the Kyoto Protocol (KP). GHG emissions in the energy sector of Ukraine account for about 75% of all GHG emissions in the country. The energy sector offers ample opportunities for cost-effective reduction of GHG emissions which could be used to attract significant financial support through the KP mechanisms to meet growing investment needs in the sector. Unfortunately, institutional capacity, which is necessary to implement KP mechanisms, is low in Ukraine and the country is poorly prepared to capitalize on this opportunity, which, at the same time, would help other countries (Le. developed countries) meet their obligations under the KP. Through its unique Carbon Financing (CF) experience and the pivotal position in the Carbon Market, the World Bank can help Ukraine build its institutional capacity in this area and mobilize CF support for Joint Implementation (JI) projects in the energy sector, which would also provide a valuable learning experience for further use ofKP mechanisms.

3. Higher level objectives to which the project contributes

Reform and sustainable development of the energy sector is one of the highest priorities in restoring Ukraine’ macroeconomic fundamentals, improving the investment climate and integrating the county into the global economy.

Addressing emerging fiscal imbalances and inflationary pressures in Ukraine requires hardening budget constraints, including strengthening financial discipline in the energy sector and timely payment of energy bills and taxes to the budget. The proposed Energy Program would help bring energy companies to financial solvency and eliminate further accumulation of tax and other payment obligations to the budget. It will also help reduce quasi-fiscal deficit in the energy sector through gradual elimination of price distortions, reduction of technical and commercial losses, and increase in cash collections.

Advancing energy sector reform and ensuring sustainable provision of reliable, affordable and environmentally acceptable energy services is crucial for improving the investment climate in Ukraine, which has a high concentration ofproduction and exports in energy intensive industries. From this point ofview, key aspects ofthe proposed Energy Program are: (i)resolution of large debts accumulated in the energy sector; (ii)reduction and ultimate elimination ofsubsidies in the sector both explicit (for coal) and implicit (for gas and electricity); (iii)improvement of financial

This assessment is based on the study “Modeling and Analysis ofGreenhouse Gases Emissions in Ukraine” conducted by the Pacific Northwest National Laboratory (USA) and Agency for Rational Energy Use and Ecology (Ukraine) in 200 1.

4 solvency and corporate governance of state-owned energy enterprises; (iv) strengthening the independence of NERC; (v) improvement of security, reliability and quality of the energy supply; and (vi) capacity building in the Ministry ofFuel and Energy (MFE) and NERC.

Ukraine’s location on the main comdor for energy trade between Russia and the EU5 and the country’s large energy resources and infrastructure make energy sector reform and sustainable development essential for integrating Ukraine into the global economy, including its membership in WTO. The proposed Energy Program would support Ukraine’s aspirations with regard to legal and technical harmonization and increasing integration of its energy market with the EU Internal Energy Market. Strengthening energy interconnections and opening access to the EU electricity market will improve energy security and the reliability of energy supply in the whole region and result in significant economic benefits for all market participants. Furthermore, the proposed Energy Program would help Ukraine benefit from its large surplus of GHG emission reductions under the Kyoto Protocol. This would also help other countries (i.e. developed countries) meet their obligations under the Protocol and jointly mitigate the impacts of the growing energy demand on the global climate.

B. PROJECT DESCRIPTION

1. Lending instrument

Bank support to the proposed sector-wide multi-phase long-term Energy Program would initially be provided by use of a series of specific investment loans (SILs). The SIL instrument would enable the Bank to provide support in a selective manner by focusing on priority investments which have a strong ownership on the Government’s part and a clear commitment to technical and governance excellence on part ofimplementing agency.

The series of SILs is well suited to support sector wide programs and long-term investment projects - all ofwhich develop in phases. However, other lending instruments (e.g. development policy loan and adaptive programmatic loan) may also be used within the proposed Energy Program in order to adjust the Bank support to specific objectives and requirements of each phase of the sector reform and development. Each lending instrument within the program will build on the previous one and together will help fund a long-term program based on agreed program objectives, program milestones and performance indicators.

The sector-wide programmatic approach would enable the Bank to provide support to each energy sub-sector (e.g. power, gas, coal) when an individual sub-sector has demonstrated commitment to broader sector reforms and when individual projects are ready to receive Bank support. All sub-sectors might not actually borrow under the Energy Program. However, all sector entities would know up-front that the Bank would support them in achieving reform and development objectives if specific criteria are met and if Bank support is needed. The use of sector-wide programmatic approach, and the regular monitoring and benchmarking that will take place under the Energy Program, would provide greater awareness, as well as peer pressure and

’ In 200 1, about 20% oftotal net EUoil imports (16% ofEU total consumption) and over 40% of EU gas imports (19% of EU total consumption) came from Russia with between 80% to 90% of Russian gas exports moving over Ukrainian territory.

5 incentives for sector entities to improve performance so as to avoid falling behind other program participants.

The first SIL of US$106 million is allocated for the Hydropower Rehabilitation Project.

2. Program objective and phases

The overall program objective is to improve the security, reliability and quality ofenergy supply, and, therefore, facilitate unimpeded operation of the energy market, both domestically and internationally. Also, the proposed Energy Program would support Ukraine’s aspirations with regard to legal, institutional, regulatory and technical harmonization and increasing energy trade with the EU Internal Energy Market.

If successful, the Energy Program would support sustainable economic growth through the consolidation of energy sector reforms, improved security, reliability and quality of energy supply and growing energy trade in the domestic and international energy markets.

The key policy and institutional elements of the proposed Energy Program have been defined and established by the Govemment of Ukraine in partnership with the Bank and in close cooperation with the European Commission and other donors. Specifically, the proposed Energy Program is based on the Comprehensive Action Plan for Financial Recovery of the Fuel and Energy Sector6 prepared by the Government in March 2005 and the EU-Ukraine Action Plan signed on February 2 1, 2005. The Energy Program comprises two partially overlapping phases (2005-201 1) and (2007-2012).

The first phase aims to improve financial and operational stability ofthe energy sector. The most salient activities included in the first phase are: (i)the separation of historical debts from the current financial operation ofenergy enterprises; (ii)the establishment and the implementation of a mechanism for the settlement of historical debts in the energy sector; (iii)the elimination of cross-subsidies through gradual adjustment of the level and the structure of energy tariffs; (iv) opening up the power market by replacing the existing single-buyer WEM with a bilateral contracting market and a balancing mechanism; and (v) the improvement of power system operational stability and the strengthening of its balancing mechanism through rehabilitation and upgrading ofhydroelectric plants.

The second phase will focus on the implementation of a strategic action plan for harmonization of energy policies, regulatory framework and operating practices of the Ukraine energy market with the main principles of the EU Internal Energy Market. The action plan will be developed early on in the first phase of the proposed Energy Program and would include measures to: (i) further improve financial viability of energy enterprises; (ii)improve corporate governance and foster commercialization of majority-state owned energy companies; (iii)strengthen financial and administrative independence of NERC; and (iv) foster competition in coal and electricity supply through further market opening and gradual liberalization of wholesale electricity trade.

The Action Plan has been prepared by the Ministry of Fuel and Energy with a support from the Bank. The Action Plan is expected to be adopted by the Cabinet of Ministers by May 30,2005 as a condition of the DPL1.

6 The second phase of the proposed Energy Program would support priority projects to be identified by the Commission for Energy Sector Reforms and Development7.

The proposed Energy Program has a strong country commitment and a well established coordination mechanism. At the political level (Cabinet of Ministers) program coordination is performed by the Commission for Energy Sector Reform and Development. The Commission has two main tasks: (i)to review, approve and update an action plan for legal and technical harmonization of the Ukraine energy market with the EU Internal Energy Market; and (ii)to coordinate and supervise implementation of the action plan, including reviewing and approving changes in the legal and regulatory framework, and prioritizing reforms, investments and technical assistance to be supported by the Energy Program.

Past experience has demonstrated that a critical success factor for Bank lending in Ukraine is broad ownership of the applicable project. Supporting a project that has a strong Government ownership is more important in terms of cementing the policy dialog than trying to press for a project that may more closely tie to the policy dialog per se. Therefore, the main thrust of the Energy Program is to allow the Government to propose projects that it considers high priority with investment support on the Bank’s part being linked to achievement of key program milestones. The program milestones will be identified but will not be specifically tagged, i.e. the trigger for moving to the next component or loan in the program is achievement of at least one of key program milestones. A list of key reform measures and program milestones is provided in Annex 1. Program milestones are based on the Comprehensive Action Plan for Financial Recovery ofthe Fuel and Energy Sector prepared by MFE.

The critical milestones to support the first investment operation within the proposed Energy Program were achieved with (i)the establishment of the Commission for Energy Sector Reform and Development; (ii)the initial implementation of WEM concept; (iii)the preparation of the comprehensive action plan for financial recovery of the fuel and energy sector; and (iv) the identification ofprogram milestones.

3. Project development objective and key indicators

The main objective of the Hydropower Rehabilitation Project is to improve operational stability and reliability of power supply by increasing regulating capacity, efficiency and safety of hydroelectric plants, and, therefore, facilitate unimpeded operation and opening up of the electricity market. Additional objective is to support the Ministry ofFuel and Energy and NERC in preparing and implementing the Energy Sector Reform and Development Program, including the Wholesale Electricity Market concept.

The performance indicators that will be used to assess fulfillment ofthe Energy Program and the proposed Hydropower Rehabilitation Project in terms of results and outcomes are presented in Annex 3. Key project performance indicators by the end of the project and in comparison to parameters in the year 2004, are:

’ The inter-agency Commission was established by the Cabinet of Ministers order No.1091 on August 25, 2004. The Commission includes high-level representatives of the Ministry of Finance, Ministry of Economy, Ministry of Fuel and Energy, Ministry of Foreign Affairs, State Tax Administration, NERC and the Power Market Operator.

7 - Increased production ofhydroelectric energy by 360 GWh; - Increased (winter firm) hydropower capacity by 250 MW; - Reduced O&M costs in rehabilitated hydropower plants by 20%; and - Reduced emissions from thermal power plants, including emission reduction of 1,300,000 tomes of COz equivalent, due to the increased production of hydroelectric energy.

4. Project components

Eligible program components. Recent sector notes' prepared by the Bank concluded that significant investments in aging energy infrastructure are required for a well-functioning energy market. The following priority investments and technical assistance would be eligible for financing under the proposed Energy Program in order to help the Ukraine energy market to better meet increasing demand in a secure and reliable manner, while converging toward legal, regulatory and technical standards ofthe EU Internal Energy Market.

- Investments to increase operational capacity and flexibility ofhydropower plants which play key role in providing load following, frequency control and other ancillary services in the Ukraine power grid, and, therefore, are critical for opening up the electricity market and meeting technical requirements ofthe EU power grid (UCTE); - Investments to upgrade the capabilities of transmission system operator, UkrEnergo, so that it can implement policy decisions to assure security and reliability ofpower supply, including: (a) removing critical bottlenecks in transmission networks and sub-stations; (b) improving operational stability of power grid; (c) upgrading load dispatch and system control capabilities; and (d) upgrading infrastructure and systems for electricity market administration; - Investment to retrofit critical energy facilities and networks to help improve their environmental compliance and reduce losses; - Investments in metering andor telecommunications programs designed to improve billing and collections and/or coordination and communications capabilities of distribution utilities so that they can more effectively participate in the energy market; and - A wide range oftechnical assistance, for institutional development and prograd project preparation and implementation, to support implementation ofthe WEM (as detailed in Annex 4); and to fund engineering/ environmental services for the preparation and implementation ofinvestment projects (including but not limited to projects financed by the Bank under the Energy Program) necessary for a functioning energy market.

Hydropower Rehabilitation Project comprises five components:

Component A: Rehabilitation of hydroelectric plants. This component includes refurbishment of 46 hydroelectric units and associated plant equipment at nine hydroelectric plants. It also

8 Since September 2003, the Bank energy team has prepared separate sector notes on coal, gas and electricity. These notes identify the key challenges facing the energy sector, including addressing the decapitalization ofthe sector's asset base and inadequate investments in aging energy facilities and networks.

8 includes refurbishment of high voltage equipment in nine switchyards connected to these hydroelectric plants.

Component B: Dam Safety. This component includes rehabilitation and upgrade ofthe existing, as well as installation of new dam safety monitoring systems and rehabilitation of drainage facilities and spillway gates on six dams on the Dnipro river and one dam on the Dnister river.

Component C: UHE Institutional Development. This component includes establishment of a corporate-wide Management Information System (MIS) in UHE. This component also includes provision of technical assistance to UHE in improving financial management, enhancing dam safety, optimal scheduling ofthe multi-purpose cascade ofhydropower plants, capacity building in procurement and project management and training for the UHE staff in dam safety.

Component D: Implementation of the Energy Sector Reform and Development Program. This component includes provision to the MFE of advisory services and consultant assistance in developing and implementing: (i)an action plan for legal and technical harmonization of the Ukraine’s energy market with the European Union Internal Energy Market; and (ii)a program of priority investments and technical assistance in the energy sector.

Component E: Implementation of the WEM Concept. This component includes provision of technical assistance to NERC in implementing the WEM concept, as required for (i)clarifying market design and main principles ofmarket operation; (ii)drafting ofmain codes and rules; and (iii)specifying the supporting tools such as software, telecommunication systems and metering.

Details of the Hydropower Rehabilitation Project are presented in Annex 4 and the project costs are summarized in Annex 5.

5. Lessons learned and reflected in the project design

Political commitment and adequate financial support are key ingredients of successful reform programs. Based on the experience of the prior power sector investment and adjustment operations, an important lesson learned is that assessment of the Government’s long-term commitment and ability to carry out reforms is a key aspect of assessing overall project sustainability. It is necessary to have a reform-oriented government not only during project preparation, but also throughout the entire project cycle. The experience in Ukraine has shown that a reversal of the initially progressive course of economic reforms adversely affected the implementation of the Bank’s energy projects. The proposed Energy Program would mitigate the risk of policy reversal by agreeing up-front with the Government on a long-term comprehensive strategy for the energy sector reform and development and through aligning this strategy with the recently signed EU-Ukraine Action Plan. The proposed project would provide further support in the form oftechnical assistance for these reforms.

One of key lessons from the past is that there is little merit in pursuing comprehensive energy sector reforms in a country in the midst of a major economic crisis. When an economy is fundamentally barter-based, salaries and pensions are in arrears and the Government condones the culture ofnon-payment, there is little possibility to cause consumers to pay for electricity in

9 cash. In such an environment, the introduction of an advanced model of a competitive energy market is likely to fail. Ukraine has made major strides to overcome these past problems and to improve the functioning ofits economy, which has been growing significantly over the past four years. Therefore, the present time is judged more appropriate for implementing the proposed Energy Sector Reform and Development Program.

Another important lesson learned is that projects intended to benefit energy producers, such as UHE, ultimately depend upon the ability ofenergy suppliers to collect revenues from consumers. This is particularly critical for large scope investment operations which require significant local financing. The past experience in Ukraine has shown that initial government commitment to ensure the enabling financial environment through comprehensive reforms requires sustained support from IFIs and bilateral donors throughout the progrard project implementation. In this context, cross-sector adjustment operations have led to the most tangible results on the ground. Therefore, the proposed Energy Program is aligned with the Bank policy lending under which the Government has committed to further improve financial discipline in the energy sector, including reaching full payment performance, and adopted a comprehensive action plan for financial stabilization ofenergy enterprises.

Another factor that is critical for the success is that the beneficiary requires very good technical skills, strong project ownership and commitment to results. UHE has already demonstrated that it has such ownership and commitment under the prior hydropower operation, which was implemented in an adverse reform environment when the power sector was operating mainly through barter and was not yet commercialized and thus required a downsizing ofthe investment program. The financial viability of the electricity market has greatly improved since that operation with payments to UHE at about 94% in the past two years, so that the problems with counterpart funding are less likely to arise again. In order to better ensure that UHE would be able to carry out the substantially larger investment program under this follow-on operation, the proposed project would ensure that proper project management arrangements are in place in a timely manner and supported by consultants and technical assistance as necessary.

6. Alternatives considered and reasons for rejection

The Bank has supported Ukraine in its efforts to reform and revitalize its energy sector through adjustment and investment projects and technical assistance since the mid-1990s. Adjustment lending required that reforms be implemented or maintained during the course of the lending operation, but when the reform targets were not met, the operation either had to be restructured or cancelled. This was the case for the Coal Sector Adjustment Loan and the Electricity Market Development Project. Investment lending, on the other hand, has had more positive results. The first investment project financed by the Bank in Ukraine was the Hydropower Rehabilitation and System Control Project which supported the first phase of hydropower rehabilitation from 1996 to 2002. Despite the successful completion of the first hydropower project (albeit on a reduced scale as mentioned above) and subsequent positive results of two on-going heating and energy efficiency projects’, the Bank concluded that responding to demand ofincreasingly sophisticated clients and addressing sector wide issues call for a new lending approach. The proposed

The Kyiv Public Building Energy Efficiency Project is scheduled for completion in June 2005 and the Kyiv District Heating Improvement Project is scheduled for completion by December 2006.

10 programmatic approach would give the Bank the flexibility to match its commitments to the pace ofreforms implemented by its clients and adapt project design and financing over time to better meet its clients' needs.

The rehabilitation of hydropower plants is the highest priority investment project in the electricity sector due to the acute shortage of regulating capacity in the Ukraine power grid". Increasing hydropower capacity and production of peaking hydroelectric energy would help the development of a functioning electricity market, and particularly its regulating/ balancing mechanism. By improving regulating capabilities of the Ukraine power grid, the Hydropower Rehabilitation Project would help meet one of the key requirements for technical harmonization with the EU electricity market and increasing interconnection with the UCTE power grid. Furthermore, UHE is one of the energy companies that is most committed to technical, commercial and governance excellence among all state-owned enterprises in the power sub- sector, which itself has the most developed reform agenda in the energy sector.

C. IMPLEMENTATION

1. Partnership arrangements

The proposed Energy Program is, in the first place, a framework for sector-wide cooperation and partnership between the Government ofUkraine, energy sector entities, financial institutions and bilateral donors, including the World Bank. As shown in Annex 2, the key IFIs and donors active in Ukraine's energy sector include the European Bank for Reconstruction and Development (EBRD), the EC and its aide agency TACIS, the United States Agency for International Development (US AID), Swedish Agency for International Development (Sida), the Canadian Agency for International Development (CIDA), and the Japanese aid agency PHRD.

A PHRD grant has been provided by the Government of Japan for preparation ofthe first phase of the Energy Program. The $670,000 grant supports the Government and the Commission for Energy Sector Reform and Development in preparing a conceptual action plan for legal and technical harmonization of the Ukraine's energy market with the EU Internal Energy Market. It will also help assess overall investment needs and indicate priorities in meeting technical and environmental norms of the EU electricity market. Finally, the PHRD grant provided initial funding for the Permanent Working Group (PWG) which has been established in MFE for preparation and implementation ofthe Energy Program.

The second phase of the proposed Energy Program would use results of technical assistance (TA) projects funded by TACIS in MFE and Naftogas. It is expected that the recently approved TA projects in electricity and gas sectors (each about Euro 3 million) would help the Government develop: (i)an overall strategy in the electricity and gas sectors; (ii)a time bound action plan for further restructuring and alignment of the Ukraine energy market with the EU directives and regulations for electricity and gas; and (ii)an investment strategy with a due emphasis on environmental issues.

loDue to the large share ofnuclear power production (about 50%) and poor maneuverability ofthermal power plants, Ukraine lacks regulating capacity for load following and frequency control in its power system.

11 2. Institutional and implementation arrangements

A comprehensive coordination and implementation mechanism has been established for the preparation and implementation of the proposed Energy Program. As shown in Annex 6, the mechanism covers and brings together political and administrative leadership, the energy regulator, energy enterprises, financial institutions and bilateral donors.

- A focal point of the program coordination and implementation mechanism is the Commission for Energy Sector Reform and Development which was established in August 2004. The Commission would prepare and present to the Cabinet of Ministers strategic decisions related to energy sector reform and development, including changes in the legal and regulatory framework and prioritize investments to be supported by the Bank. In the process of preparing these proposals, the Commission would review and approve (periodically update) the conceptual plan for legal and technical harmonization of the Ukraine energy sector with the EU Internal Energy Market. During program implementation, the Commission would coordinate and supervise implementation of the conceptual plan, including overall monitoring of investment projects and technical assistance included in the Energy Program. The head of the Commission would report to the Parliament annually on Energy Program activities or on an as-needed basis.

The Commission is supported by the Permanent Working Group (PWG) for Energy Program Preparation and Implementation. The PWG, headed by the Deputy Minister of Fuel and Energy, would act as the Commission secretariat and would be in charge of (i)preparing and updating a conceptual plan for legal and technical harmonization of the Ukraine energy market with the EU Internal Energy Market; and (ii)developing a program ofpriority investments and technical assistance in the energy sector. The PWG would also establish program communication and documentation procedures, manage technical consultants hired to assist in program and project preparation, and assist project implementation entities in meeting program requirements, including fiduciary requirements agreed with the Bank.

- Each beneficiary of the Energy Program would establish a Project Implementation Unit (PIU). The PIU would be responsible for managing the technical aspects of project implementation (preparation of bidding documents, procurement, contracting, supervision of contractors, construction management, payments and disbursement operations) related to each project component. The PIU would be an integral part ofthe project implementing entity and would consist of staff whose regular responsibilities include the implementation of investment projects or technical assistance projects. Where necessary, the PIU would be assisted with international and domestic consultants for project management and procurement. The PIU for the Hydropower Rehabilitation Project has been established by an internal order ofthe UHE.

Implementation of the Hydropower Rehabilitation Project will be the responsibility of the project beneficiary, UHE. It is the successor company ofDniproHydroEnergo (DHE), which has implemented the first stage ofhydropower rehabilitation under the Bank-supported Hydropower Rehabilitation and System Control Project (Loan 3865). UHE is a fully state-owned open joint

12 stock company formed in February 2004 through a merger of the state-owned companies DHE (operating a cascade of hydropower plants on the Dnipro river) and DnisterHydroEnergo (operating a hydropower plant on the Dnister river). UHE operates nine hydropower plants (including the Kyiv pumped storage plant) with the total installed capacity of about 4,600 MW. The overall organization of UHE and the implementation arrangements for the proposed Hydropower Rehabilitation Project are described in detail in Annex 6.

3. Monitoring and evaluation of outcomes/results

At the national level, the Energy Program will be monitored and evaluated by the Commission for Energy Sector Reform and Development which will report to the Cabinet of Ministers. The above described coordination and implementation mechanism, comprising the Commission for Energy Sector Reform and Development, the Permanent Working Group in MFE, and each beneficiary PIU, will monitor and evaluate individual projects included in each phase of the Energy Program. Hierarchical monitoring and evaluation ofeach program component supported by the Energy Program would result in the collection of all relevant program indicators through appropriate data and information processing starting from the level of sector entities (individual project sites) and moving up to the level ofpolicy makers in the Cabinet ofMinisters. The Bank will participate in the monitoring and evaluation process through its continuing dialogue with the Government and through direct supervision ofthe individual investment and technical assistance projects.

4. Sustainability

The current situation and the outlook for the sustainable development of energy market can be briefly outlined as follows:

Market participants. Despite some recent concentration of market power in holding companies in the electricity and coal sectors, these sectors are still dominated by relatively independent public and private market players (see Annex 1) which are engaged in electricity and coal trading. The gas sector is dominated by Naftogaz, a vertically integrated state-owned holding company which acts as the “single buyer” of all gas supplied in the country or transported through Ukraine. While unbundling in the gas sector does not appear very likely in the near-term, the electricity and coal sectors are in need of further market liberalization which would help improve sector performance and attract investments in aging power plants, distribution networks and coal mines.

- Market sophistication. The most advanced market mechanism is in the power sector which is based on the power pool (single-buyer) model established in mid-1990s. The next step in its development will be the introduction of a bilateral contracting market and a balancing mechanism which will be implemented over the next 4 to 5 years (see Annex 4). Subject to the rationalization of state subsidies and mitigation of social and environmental impacts of coal sector restructuring, the coal market is also ripe for further opening which would hrther stimulate competition among power producers.

13 - Market regulation. The power and gas industry is regulated by the NERC while the coal prices are set by the Government. The Government still exerts a considerable amount of influence on regulatory decisions across the energy sector, which partially explains why energy tariffs are below the cost and value of services provided (see Annex 1). To sustain its strong economic growth, Ukraine needs to restore macroeconomic fundamentals including the improvement of financial discipline and the gradual elimination ofprice distortions in the energy sector. The growing economy and falling poverty rate will also created a more favorable environment for further price adjustments, which will be best implemented through strengthening the independence of NERC and better targeting of fiscally affordable and socially adequate subsidies to the sector and/or to consumers.

- Harmonization with the EU Internal Energy Market. The EU and Russia are the major trading partners of Ukraine and energy is one of the main dimensions of this trade (see Annex 1). By virtue of its location, Ukraine has been able to secure significant volumes ofoil and gas transport through its pipelines and competitive prices for the oil and gas imports. Gradual convergence towards the principles governing the regulation and operation of the EU Internal Energy Market (gas and electricity) would strengthen Ukraine’s position as the preferred route for future increases in Russian gas deliveries to Europe. Furthermore, it will open new opportunities for increasing access to the EU electricity market and expand electricity trade. Finally and most importantly, by introducing best practices tested in the EU energy market, consumers in Ukraine would benefit from improved security, reliability and quality ofenergy supply.

5. Critical risks and possible controversial aspects

Risks Risk Mitigation Measures Risk Rating with Mitigation To project development objective

The political commitment to reform The proposed programmatic lending S vanishes during the first years ofthe will help strengthen Government’s program when the benefits are not yet ownership ofthe reform process and fully visible. build up long-term partnership with the Government, IFIs and donors.

Reform objectives and milestones aligned with the EU-Ukraine Action Plan.

The energy sector reform remains one ofkey elements ofthe Bank CAS and policy lending.

14 P Risks Risk Mitigation Measures Risk Rating with Mitigation Slow or no improvement in financial Financial discipline in the energy S viability ofenergy enterprises due to (a sector continues to be one ofpillars of combination of) low tariffs, inadequate Bank policy lending in Ukraine. collections, commercial losses and delays in debt restructuring. A robust program oftechnical assistance to MFE and NERC included in the proposed loan and complemented by donors.

Monopoly abuses and distortions Government’s commitment to improve S arising from market concentration and transparency and corporate governance political interference in NERC’s in state-owned energy enterprises. staffing and decision making. Strengthening administrative and financial independence ofNERC. To component results Changes in MFE, NERC and UHE’s Selection of program and project M management slow down program components on a strict priority basis implementation and raise possible using results ofdonor funded studies. controversies about sector priorities. Maintain regular intra-Government and intra-sector coordination through the Commission for Energy Sector Reform and Development.

Project implementation delays due to NERC’s approval oftariff adjustments lack oflocal financing and poor project to meet local financing requirements S management. and assure full payment from energy market (Energorinok) to UHE.

Technical assistance for project management and procurement during implementation.

Close monitoring and supervision of implementation ofinvestment projects. Overall risk rating S

15 6. Loan conditions and covenants

Conditions for Loan Effectiveness

(a) the Subsidiary Loan Agreement between the Ministry of Finance (on behalf of the Borrower) and UHE to be signed and duly authorized by Ukraine and UHE.

(b) the Project Agreement to be duly authorized by UHE and is legally binding upon UHE.

(c) UHE to select an international project management consultant under Terms of Reference and with qualifications acceptable to the Bank.

Legal Covenants

(a) the Borrower to ensure that from Fiscal Year 2006 and onwords NERC would establish and maintain tariffs for UHE sufficient to cover project co-financing needs in a timely manner.

(b) the Borrower to ensure that NERC would distribute funds due from Energomarket to UHE in a timely manner according to the algorithm in place.

(c) the Borrower to ensure that NERC introduces a two-tier tariff for UHE by December 3 1, 2005.

(d) the Borrower to ensure that NERC introduces a system service charge to be paid to UHE in parallel with the development ofthe WEM balancing mechanism.

(e) the Borrower to open and maintain three separate Special Accounts in US dollars for UHE, MFE and NERC in a commercial bank acceptable to the Bank, under terms and conditions acceptable to the Bank.

(0 the Borrower to maintain throughout the project implementation the Commission for Energy Sector Reform and Development under terms ofreference satisfactory to the Bank.

(8) the Borrower, through the MFE and the UHE, to maintain the PWG and the PIU until the completion the project, under terms ofreference and with a composition satisfactory to the Bank.

(h) the Borrower, through the MFE, to provide the Bank on an annual basis a progress report in accordance with the MFE Monitoring and Evaluation Indicators.

(i) the Borrower, through MFE, and UHE to prepare a consolidated mid-term report and submit to the Bank by September 30,2008, and review such report with the Bank by December 3 1, 2008.

6) the Borrower and UHE to maintain a financial management system and to furnish to the Bank Financial Monitoring Reports for each quarter.

16 (k) the Borrower, through MFE, NERC and UHE, to ensure that the project records, including the Special Accounts and UHE’s financial statements, are audited annually by independent auditors acceptable to the Bank, in accordance with Intemational Standards on Auditing.

(1) UHE to maintain the following financial covenants (see Annex 9 for details): (i)debt service coverage ratio of at least 1.5 during the project period; (ii)current ratio of at least 1.2 during the project period; and (iii)to carry out revaluation of its assets in accordance with terms ofreference and consultants satisfactory to the Bank by December 31,2007.

(m) UHE to prepare a report annually on or about March 31, beginning in FY06, for each year during project implementation containing financial projections and projections of UHE Monitoring and Evaluation Indicators for the upcoming year to be reviewed by the Bank.

(n) UHE to complete the design proposals satisfactory to the Bank for (i)rehabilitation of: (A) drainage facilities; (B) design profiles (rehabilitation of subsidence); (C) slope protections; (D) concrete spillways and other reinforced concrete works at Kyiv, Kaniv, Dniprovska and Dneprodzerzhinsk dams; and (ii)protection against higher phreatic lines (high piezometric levels) in the dam embankments at Kaniv, Kremenchug, Dniprodzherzhinsk and Kakhovka dams by December 3 1,2005.

(0) UHE to establish an adequately staffed Dam Safety Center under terms of reference acceptable to the Bank by December 3 1,2005.

(p) UHE to ensure that a detailed plan for construction supervision and quality assurance, an instrumentation plan, an operation and maintenance plan, and an emergency preparedness plan are prepared and implemented, all in a manner satisfactory to the Bank.

(4) UHE to ensure that all work under Part B of the project is designed and supervised by competent professionals.

(r) UHE to continue periodic dam safety inspections by personnel ofthe Dam Safety Center.

(s) UHE to implement the requirements ofthe Environmental Management Plan.

D. APPRAISAL SUMMARY

1. Economic and financial analyses

Economic analysis. The economic evaluation of the proposed Hydropower Rehabilitation Project was carried out by comparison ofNet Present Value (NPV) and Economic Internal Rates of Retum (EIRTX) for “with rehabilitation” and “without rehabilitation’’ scenarios. The “without rehabilitation” scenario assumes the continued operation of the hydropower units at a progressively deteriorating level ofefficiency. The main plant parameters and other assumptions

17 are presented in Annex 9. The main quantified benefits are: (i)an increase in hydroelectric production of about 360 GWh per year (by 2012) due to the improved efficiency of the generating equipment and improved plant management and control; (ii)an increase in (winter firm) peaking hydropower capacity of about 250 MW (by 2012) due to the increased capacity of rehabilitated units and improved reliability and availability ofunits and plant; (iii)power system dynamic benefits due to the enhanced ability ofhydropower plants to provide load following and frequency control; (iv) reduced O&M costs due to the introduction of modern technologies and standards in operation and maintenance; and (v) environmental benefits due to the reduced emissions from thermal power plants by increasing production of renewable hydroelectric energy.

As shown in Table 1, plant-by-plant ERRS range from 10.5% to 79.5% indicating that the proposed rehabilitation is economically viable for each plant. Economic returns are very robust relative to variation in key project parameters. A switching value for the investment cost (to yield an ERR of 10% for the whole project) is an increase of 85% which shows that cost overruns do not pose a significant risk. Variations in other key economic parameters (such as fuel price in thermal power plants) have even less impact on the project economics.

Table 1. Summary Results of Economic Analysis

NPV Plant Name EIRR (Oh) B/C Ratio US$ million

Kyiv 10.5 1 1.03 Kyiv PSP I 17.2 I 5 I 1.51 I ~ Kaniv I 11.5 I 3 I 1.10 I Kremenchug 21.1 14 1.71 Dniprodzerzinsk 18.5 13 1.59 Dniprovska HPP 1 42.6 19 2.95 Dniprovska HPP2 I 79.5 I 63 I 4.39 1 Kahovka I 26.6 I 8 1 1.95 I Dnister 13.1 1 1.15 TOTAL UHE 23.2 126 1.85

The above-quantified benefits are regarded as a minimum measure ofthe true economic benefits conferred by the proposed Hydropower Rehabilitation Project. Additional, non-quantified benefits of the hydropower rehabilitation include: (i)life extension of the plants (thereby deferring replacement); (ii)improved water quality as a result of reduction of leakage of lubricating-oil fiom old turbine equipment; (iii)enhanced dam safety and reduced risk of flooding; and (iv) improved plant safety resulting from the upgraded instrumentation and control systems.

18 Financial analysis. A financial analysis was carried out for the Hydropower Rehabilitation Project in order to determine the financial internal rate of return (FIRR) of the project. The analysis examined the incremental financial cash flows, defined as the difference between the “with” and “without” project situations both in current and constant 2004 US dollars. Details of the FIRR calculations are included in Annex 9, Attachment 9-3. The FIRR has been calculated to be about 7% in real terms and about 15% in nominal terms. This outcome compares favorably to UHE’s estimated cost of capital ofabout 5%, reflecting the estimated cost ofborrowing from the World Bank under the proposed project and the past project, and considering the interest-free loan from the Swiss Government under the past project. Therefore, it is judged in UHE’s financial interest to undertake the proposed investments.

Projections of the likely financial performance of UHE over the period 2005-2012 have been prepared and are presented in detail in Annex 9. The projections have been prepared to determine the average tariffs” necessary for UHE to undertake the project investment program, repay the proposed Bank loan and other prior loans, remain profitable and maintain satisfactory overall financial performance. The financial analysis shows that the project would require roughly a doubling of UHE’s tariff by January 2007, to a still relatively low level of about US cents 1.2/kWh12. This is mainly due to the large share (about 72%) of financing by UHE ofthe project investment costs which are to be covered by current revenues.

NERC’s methodology for establishing UHE’s tariffs allows for the recovery of the costs of UHE’s operations but not its future investment projects. On April 13, 2005, NERC provided the letter ofsupport for the proposed investment project. Furthermore, at the negotiations, it has been agreed that the Borrower would ensure that NERC would (i)from Fiscal Year 2006 and thereafter establish and maintain tariffs for UHE sufficient to cover project co-financing needs in a timely manner; (ii)distribute funds due from Energomarket to UHE in a timely manner; (iii) introduce a two-tier tariff for UHE by end-2005; and (iv) introduce a system service charge to be paid to UHE in parallel with the development of the balancing mechanism in the wholesale electricity market. With the proposed adjustments, UHE would reach and maintain a sound and generally satisfactory financial position.

2. Technical

UHE is the lowest-cost generator in the Ukraine power system. In addition, hydropower plants operated by UHE are practically the only significant generator of peaking electricity and provider of load following and frequency control services in the Ukraine power system, which currently imports the remaining requirements for peaking electricity and power system ancillary service^'^ from Russia. The rehabilitation of hydropower plants would enhance their ability to provide ancillary services in the Ukraine power system and, therefore, help improve its operational stability and meet technical requirements ofthe EU power grid (UCTE).

I’ The analysis was based on the current singe-tier tariff structure and did not consider potential revenues from the proposed introduction ofcapacity and system service charges. l2 For comparison, average hydropower tariff in Romania is about US cents 21 kWh. l3 The ancillary services, including fast responding generation reserve, are critical for maintaining power system stability and ensuring reliable power supply.

19 After more than three decades ofheavy duty operation, the plants’ electro-mechanical equipment is overdue for extensive rehabilitation. Under the Hydropower Rehabilitation Project, UHE will continue to replace and/or refix-bish key electro-mechanical equipment in nine hydropower plants and associated plant switchyards. This will include (i)replacement of turbine runners, turbine governors, and rehabilitation or upgrade of other related equipment; (ii)replacement, rehabilitation or upgrade of generator stator and rotor windings, generator circuit breakers, excitation and cooling systems; and (iii)replacement ofhigh voltage circuit breakers, disconnect switches, surge arrestors and measurement transformers. UHE would also replace practically all plant control and protective relaying with modem Supervisory Control and Data Acquisition (SCADA), diagnostics and protective systems which will increase plant automation and help reduce operation and maintenance costs through better management of the hydropower cascade and the introduction ofpreventive maintenance ofhydropower equipment. Furthermore, the dam safety component will improve monitoring ofsix large dams on the Dnipro river and one dam on the Dnister river which supply water to the project related hydropower plants and to more than 50 large urban areas with population of about 30 million. Annex 4 provides a detailed description of the project components.

The project costs are summaries in Annex 4. The cost estimates are based on the feasibility study prepared by UkrHydroProject (UHP) in 2004. This study has updated results of the hydropower rehabilitation study prepared by SGI Engineering Ltd (Switzerland) in 1994. Therefore, cost estimates reflect the price level of similar equipment and installation services procured by UHE during the first phase ofhydropower rehabilitation.

3. Fiduciary Lending under the Energy Program will be through IBRD specific investment loans to Ukraine and Bank’s standard fiduciary requirements will apply to the projects and utilities supported. Procurement will be in accordance with the Bank Guidelines for Procurement and Bank Guidelines for the Use ofConsulting Services will apply. The financial management assessment ofthe proposed Hydropower Rehabilitation Project covers three main implementing agencies: UkrHydroEnergo (thereafter -“Company”, UHE), Ministry of Fuel and Energy (MFE), and National Electricity Regulatory Commission (NERC). In UHE, the existing financial management system ofthe entity would be used for this project. In the case ofMFE and NERC the project would rely on the country normal financial management arrangements (use of the agencies’ financial management staff with assistance from financial consultant in the PWG, and use of the agencies’ accounting and reporting systems). These arrangements are acceptable to the Bank due to: (a) relative strengths of the treasury system and MOF in ex ante and ex post control over project funds flow, expenditures and reports, (b) relatively low risk of the components D and E (mostly TA), and (c) small size/value of these components (around 2% of the total project costs). Despite some minor weaknesses in the financial management arrangements in the three agencies, the financial management arrangements ofthe project are acceptable to the Bank. The Country Financial Accountability Assessment (CFAA) for Ukraine confirms that improvement is required in the management of public expenditures, especially for the strengthening of internal and external audits. The CFAA also identified a lack of adequate

20 control over state owned enterprises, but appropriate steps have been taken recently to improve the control over these enterprises. The annual audited financial statements, which will include (a) entity financial statements for UHE (incorporating components managed by UHE), and (b) combined project financial statements for components D and E, will be provided to the Bank within six months ofthe end of each fiscal year and also at the closing of the project. The project will produce a full set of consolidated Financial Monitoring Reports (FMRs) every three months throughout the life ofthe project. Annex 7 and Annex 8 present financial management and procurement arrangements under the proposed project.

4. Social

The main objective of the Energy Program is to stimulate sustainable economic growth and investments in Ukraine by (i)improving the security, reliability and quality of energy supply at reasonable cost; and (ii)supporting the country’s aspirations with regard to legal and technical harmonization and increasing integration of its energy market with the EU Internal Energy Market. The overall social impact of improving energy supply; mitigating environmental impacts of the energy sector; supporting growth, investment and employment; and facilitating introduction ofEU norms and standards is positive.

Access to reliable electricity is a key driver of economic growth and a direct means of reducing poverty by improving the productivity of households and enhancing the delivery of social services. Ukraine has virtually universal electricity service coverage and the tariff system includes a functioning mechanism to support low-income household^'^. The challenge is to maintain the funding and to improve the quality of targeting of this extensive service. The Government has concluded that as a part of ongoing ambitious reform program, implementation ofthe proposed Energy Program is essential to maintain such service.

Ukraine, as well as many countries in the region, is implementing reforms in its energy sector, which inter alia involve tariff adjustments towards full cost recovery and financial discipline including bill collection. This raises the issue of social protection, to ensure that low-income households have access to adequate levels of energy supplies. The Energy Program does not contain additional financial targets or conditions, but reinforces these ongoing national efforts.

The Hydropower Rehabilitation Project will have no negative social impact. No land acquisition or resettlement is required and no social assets will be affected. Hydropower accounts for only about 7% ofthe total electricity generation in Ukraine, so an increase in hydropower cost, as the result of the proposed rehabilitation project, would have negligible impact on the wholesale electricity tariff.

l4 All communal services, including electricity, gas, heat and water, are covered by Ukraine’s social assistance program which provides funding for the costs ofthese services that exceed 20% of monthly income for normative usage by eligible households.

21 The Hydropower Rehabilitation Project continues the work carried out under the earlier project, increasing the number of sites and greatly increasing the number of units to be rehabilitated. Five sets ofstakeholders will benefit from the project: 0 The public - who will receive more reliable electricity supplies at little additional cost; will enjoy cleaner water in the Dnipro River and the Dniester River due to rehabilitation of hydro units that currently discharge oil; and decreased dependence on thermal plants, which will reduce air pollution; 0 UHE management will benefit by having more dependable, efficient equipment that can be managed more effectively and ensure that they can meet their obligations; 0 UHE technical staff and workers will upgrade their skills to operate and maintain updated technologies; 0 Design institutions benefit from updated skills, as well; and 0 Contractors will also acquire new skills and competencies which they can market within and outside Ukraine. These benefits have already been realized through the earlier project, but the number of affected stakeholders in each category will increase through the new project.

The investments included in subsequent phases ofthe proposed Energy Program will be assessed individually to ascertain their likely social impact and to identify ways to enhance social benefits and mitigate negative impacts, ofany.

5. Environment

Environmental strategy. Ukraine has substantial incentives and opportunities to improve environmental performance in the energy sector. As a signatory to the Kyoto Protocol, Ukraine can attract investments in a wide range of technologies that reduce GHG, as well as obtain carbon credits which in effect are a source of capital. Fortuitously, most technologies that offer reductions in GHG which affect the global environment also provide reductions in traditional coal combustion pollutants such as dust and acid gases (SO2 and NO,) which impact local and regional air quality and thus are a serious influence on public health. This is particularly important in Ukraine where most of environmental problems stemming from the energy sector are related to the use ofcoal.

There are other incentives as well. Harmonization of environmental performance in the energy sector with the EU Directives will allow Ukraine to increase its access to the EU electricity market. Thus environmental improvement provides a significant economic incentive for the energy sector as well.

Air pollution problems and air quality impacts are not the only issue. In some regions, ash disposal has also created significant difficulties. For example, the highly inefficient anthracite boilers at the Prednipro combined heat and power plant have created a huge waste disposal problem. The ash contains about 20 per cent unbumed carbon, making it unsuitable as a building material. So, the ash continues to accumulate creating an eyesore and significant source ofwater pollution. In this case, with proper combustion technology, this solid waste could be used as a fuel essentially free ofcharge.

22 Ukraine now needs to develop an overall strategic framework for environmental improvement in the energy sector, and an objective ofthe Energy Program is to support Ukraine in this effort. In the first phase ofthe Energy Program, the Bank would provide technical assistance to support the Government in developing this strategic framework. In subsequent program phases, the Energy Program would either directly support appropriate investments for environmental improvements in the energy sector or further assist the Government in developing expertise in utilizing various financing mechanisms such as the KP-based carbon financing (CF) for their investment strategy. Annex 2 provides a detailed description ofthe overall approach used to mobilize CF support for the Hydropower Rehabilitation Project.

Hydropower Rehabilitation Project. In accordance with the World Bank Environmental Assessment, the rehabilitation of hydropower plants is a Category B project. UHE (the project implementation agency) provided an English language version of the EMP acceptable to the World Bank on March 9, 2005 and disclosed Ukrainian language versions ofthe EMP at each of the nine subproject sites from March 4 to 9, 2005. The World Bank provided the English language version to the Infoshop on March 9, 2005. Prior to disclosure, public consultations were held at each of the nine subproject sites. The EMP and supporting documentation for the public consultations are included in the project file. Project approval by the Ukrainian environmental authorities (State Ecological Expertise) is also presented in the EMP.

UHE’ capacity for implementing the requirements of the EMP was reviewed by the Bank and found to be highly adequate, having benefited from the experience gained in the first hydropower project.

Chief environmental issues are associated with project implementation, and these include: noise and engine exhausts from construction machinery, fumes from welding and painting, oily wastewaters from roofing and waterproofing operations and disposal ofscrap metal and building material (concrete, bricks, etc.) wastes. At four locations, disposal of old batteries and battery acid is an issue. Other than waste mineral oils, there are no significant hazardous wastes, such as heavy metals, polychlorinated biphenyls (PCBs), or asbestos.

Minor environmental issues are associated with normal plant operation and routine maintenance operations. These include noise (turbines and compressors), paint fumes and metal dust in the machine shop, oil leaks, and oily wastewater from runoff at the oil storage site.

All environmental issues for both the project implementation and operation phases are minor, of limited duration and extent and readily managed.

6. Safeguard policies Table 2. Safeguard Policies

Safeguard Policies Triggered by the Project Yes No Environmental Assessment (OPIBPIGP 4.01) [XI El

Natural Habitats (OPIBP 4.04) 11 [XI

Pest Management (OP 4.09) [I [XI

23 Cultural Property (OPN 11.03, being revised as OP 4.1 1) [I [XI

Involuntary Resettlement (OPIBP 4.12) [I [XI

Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [XI

Forests (OPIBP 4.36) [I [XI

Safety of Dams (OPIBP 4.37) [XI [I

Projects in Disputed Areas (OPIBPIGP 7.60) [I [XI

Projects on International Waterways (OPIBPIGP 7.50) [XI [I -

The Hydropower Rehabilitation Project is in full compliance with all environmental requirements of the Government of the Ukraine and the World Bank. In accordance with the World Bank Environmental Assessment safeguard policy and procedures (OP/BP/GP 4.0 1) the project has been assigned Category B and an EMP is required. The proposed financing of the rehabilitation of hydropower plants triggers OP 4.37 on Dam Safety. A detailed description of the dam safety component of the Hydropower Rehabilitation Project is in Annex 10. The hydropower project also triggers OP 7.50 on Projects in International Waterways. An exemption from the notification requirement under OP 7.50 has been approved by the Bank, as the Hydropower Rehabilitation Project does not involve works and activities that would exceed the original scheme, change its nature, or alter and expand its scope and extent to make it appear a new or different scheme, and will therefore not adversely affect the quality or quantity of water flows to the other riparian. The project will not involve land acquisition or resettlement or cultural assets, thus neither OP 4.12 nor OPN 11.03, respectively, apply Annex 10).

7. Policy Exceptions and Readiness

The Project Team has obtained from the Bank management an exception from the notification requirement under OP 7.50, Projects in International Waterways, as the project will not affect the quantity or quality ofwater flows to other riparians, nor be adversely affected by their use. The project is ready for financing.

24 Annex 1: Country, Sector and Program Background UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

PRODUCTION 1999 2000 2001 2002 2003 Washed Coal (Mt) 60.60 60.50 59.90 57.76 57.60 Crude Oil & Condensate (Mt) 3.80 3.80 3.70 3.74 3.96 Natural Gas (Bcm) 18.10 18.10 18.50 18.60 19.46 Peat & Wood (Mt) 3.50 3.50 3.50 3.50 3.50 Nuclear (TWh) 72.06 77.34 76.17 77.99 8 1.40 Hydro (TWh) 14.45 11.39 12.11 9.66 9.30 Total Production (mtoe)" 71.81 72.32 72.15 71.04 72.68 IMPORT Coal (Mt) 4.70 6.00 6.40 5.15 8.40 Crude Oil (Mt) 8.70 5.60 12.80 17.00 19.98 Natural Gas (Bcm) 59.90 58.60 56.90 57.80 59.5 Petroleum Products (Mt) 3.70 4.10 1.40 1.oo 0.507 Electricitv (TWh) I I I I 0.23 I 0.21 Total Import (mtoe) I 65.67 I 62.51 1 65.77 I 69.76 I 75.31

'' Ukraine has large coal resources and significant proven reserves of natural gas and crude oil. The coal reserves are estimated at 34 billion tons. The oil reserves are 227 million tons. The natural gas reserves are 1,136 bcm.

25 * A ton of oil equivalent is defined as 10 million kcal. In addition to significant fossil fuel imports for its own needs, Ukraine is also transiting large volumes of oil and natural gas to the EU and the South East Europe. About 15% oftotal EU oil imports and over 30% of EU gas imports are transported through Ukraine. Transit fees contributed about US$416 million to Ukraine’s budget in 2003, while the official economic activity ofNaftogaz and its subsidiaries made contribution of6.7%.to the gross economic output. Energy demand in Ukraine is characterized by high energy intensity in relation to industrial output and the high share of industry in final energy consumption. This is due to the high share of heavy industry (iron and steel) and the low efficiency of energy conversion technologies. Energy consumption per capita is estimated at US$1040, while the energy intensity is about 2.6 t.0.e. per US$lOOO of GDP. Despite the economic restructuring and the closure of some inefficient industrial enterprises during the last decade, Ukraine’s energy intensity is still about three times higher than in the EU. A close correlation between the electricity demand and the change in the country’s GDP suggests that relatively few improvements in energy efficiency were implemented during the 1990s (see Figure 1). This indicates that significant energy savings could be achieved through employing more efficient operating practices and using more modern technologies in energy intensive industries, all of which require strong price incentives and continued reform in the energy sector.

3. Energy Pricing and Financial Viability Average energy prices have been rising in recent years because of the gradual liberalization of the energy market. Prices of oil and oil products have been freed, but most of other energy tariffs are still tailored more to the ability of consumers to pay than to cost and value ofservices provided. Electricity and gas tariffs effectively cross-subsidize from one group of consumers to others (industry to household), and at the same time do not cover the full costs to suppliers. Table 4 shows that Ukraine must continue its program to raise energy prices to full recovery of supply costs and to correct serious distortions in the pricing structures for coal, gas and electricity. Table 4. Actual vs. Cost Recovery Price in the Energy Sector

Sectors Cost Recovery Price Actual Price

Coal Sector $3 llton $25lton Gas Sector $7211000m3 (based on $4311000m3 import parity price of $6011000m3)

Electricity Sector US 4.7 centslkWh US 2.87 centslkwh

26 Figure 1. Power consumption in Ukraine 1990-2004

mOther 100

s 6" Losses and Own 0 a0 g Needs

0 m mr nResidential Consumers 60 - x' 0 Municipal Sector U 40 0 0 Q 6" Transport -m 20 d 0 Agricultural consumers 0 Industrial consumers 1990 1992 1994 1996 1998 2000 2002 2004 - Years -Real GW, Index, 1990=100 i

Figure 2. Gas Payments Figure 3. Electricity Payments

90 8595 4~- 80 I 75 ' 70 I 65 I 2001 2002 2003 2004 2001 2002 2003 2004 Total Cash Total Cash

The financial viability of the energy sector is further undermined by non-payments which were significantly reduced in recent years (see Figure 2 and Figure 3), but still remain below 100% and cause continued accumulation of debts and payment arrears in the energy sector.

27 Furthermore, accumulation of tax arrears in the energy sector (see Table 5) creates fiscal imbalances and threatens macroeconomic performance ofUkraine. The poor financial performance limits the ability ofenergy enterprises to maintain reliability and quality of energy supply, which is becoming a major threat for sustainable economic development and more quickly so if Ukraine’s economy continues to grow at its current pace. The financial recovery of the energy sector, including (i)further strengthening of financial discipline; (ii)resolution of payment arrears, and (iii)elimination of price distortions, is one of the main challenges facing the Government in fueling a sustainable economic growth. At the same time, the Government needs to improve the design and the implementation of social assistance programs16 to help protect vulnerable groups from the impact of inevitable price adjustments in the energy sector. Table 5. Tax Arrears of the Energy Sector, UAH million

Sectors 2001 2002 2003 2004 I Electricity Sector 1755.6 2446.8 2515.5 2087.9 Coal Sector 1015.3 1832.7 241 1.1 2588.2 Naftogaz ofUkraine 2925.6 4635 4562.6 4448.5 Total 5676.5 8914.5 9489.2 9124.6

4. Energy Sector Reform The progress of energy sector reform over the last decade was uneven and it is characterized by different degrees of restructuring and unequal levels of market liberalization in three main sub- sectors (power, gas and coal). Further delays in sector reform may put at risk some special strategic advantages. By virtue of its location as a crossroads to Europe, Ukraine has been able to secure significant volumes ofoil and gas transport through its pipelines and competitive prices on the gas and oil it imports”. Ukraine needs to maximizing the value of its pipeline opportunities, the revenues from which already represent a significant share of GDP. Furthermore, it needs to invest in its nuclear reactors, hydro and thermal plants, other power facilities and thus secure the growing energy supply it needs, while capturing power export opportunities arising from its increasing access to the EU electricity market. Notably, the upgrading ofthe Ukraine energy infrastructure can be subsidized by selling Kyoto carbon credits on the world market. And while preserving its imports ofcheap oil and gas, the country needs to reserve a competitive place for its own production and sale ofoil, gas and coal resources.

l6 In May 1995, the Housing and Municipal Service Allowance program was launched. The original objective of this program was to shield families from the impact ofrapidly rising fuel costs. While this program benefits from an effective administrative structure there are coNERCns about the effectiveness of its targeting - it suffers from problems ofboth inclusion and exclusion. Consequently the timing ofthe implementation of tariff increases needs to take into account the timing of reforms to the social safety net. ” Ukraine imports gas at $5OIMCM, which is less than half the European parity price (in 2003), estimated at $108IMCM by the World Bank.

28 To protect against its threats and make the most ofits opportunities in the energy sector, Ukraine can do the following: (a) further strengthen financial discipline in the energy sector, (b) eliminate price distortions on a gradual, but firm schedule, (c) improve strategic and operational management of energy sector assets (the power grid, the oil and gas pipelines, state-owned energy companies), (d) improve energy regulation, and (e) attract financial resources for refbrbishing and expanding the sector. By doing this, Ukraine will be able to reap the benefits of more efficient resource allocations and increased productivity across the economy, it will secure the most value out of its strategic advantages in the sector, and it will assure itself of sufficient energy to meet its growing needs. The following provides an outline of the current reform issues in each sub-sector (power, coal and gas), key areas that need attention and reform actions which will help improve the sector performance. 4.1 The Power Sector During the second half of 1990s, the power sector went through major structural reforms, including the unbundling of generation, transmission and distribution, the establishment of a “single buyer” electricity market and the privatization of 15 (out of 27) distribution companies and one thermal power generation company. The reforms produced mixed results in terms ofthe sector performance and slowed down after 2001 when the non-payment problem in the “single buyer” electricity market was alleviated by increasing NERC’s control over its financial flows. In the context of an overall economic revival and an increasing monetarization of the national economy, the administratively managed electricity market shown impressive improvements by increasing the cash collections from 33% in 2000 to 95% in 2004. The tariffs, however, still remain below the economic cost and the residential consumers (about 20% ofthe total electricity demand) continue to pay less than 55% ofthe applicable tariff at the expense ofhigher tariffs for non-residential consumers. The energy regulator (NERC) estimates that this cross-subsidy” amounts to about 2 billion UAH per year. The most difficult legacy of the 1990s is the large sector debt (an equivalent of about US$3 billion)” which is the main obstacle for further reforms, including privatization. Furthermore, because of low tariffs and less than full collections, the total sector debt is growing, albeit at a slower rate. The result is a lack of funds for maintenance and investments in power facilities which are deteriorating at an increasing pace. The decapitalization is particularly pronounced in thermal power companies which are facing lack of working capital and in some cases (e.g. Dniproenergo - the largest state-owned thermal power company) are practically bankrupt. Without an urgent improvement in the management of state-owned thermal power companies and an improvement of their financial condition, Ukraine may face a crisis in meeting its increasing electricity demand2’ despite a large capacity margin2’ in its thermal power generation.

Since all consumers are paying less than full cost recovery prices, these “cross-subsides” are actually simple subsidies, but the tariff methodology developed by NERC recognizes them as “cross-subsidies”. Based on this methodology and due to pressures from trade unions through the Government, tariffs for residential consumers did not change since April 1999 and currently cover about 53% ofsupply costs. 19 The outstanding payment arrears represent about 85% of the annual wholesale market revenue. 2o The electricity demand increased about 3% in 2004 and it is expected to growth at the same or higher rate in 2005. Since the nuclear and the hydroelectric plants are fully utilized, most of the incremental demand must be covered by thermal power plants, which requires higher production ofcoal andor imports ofnatural gas.

29 A failure of the state management to address increasing financial strains in the power sector by using administrative measures prompted the Government’s decision to merge all state-owned assets in the power sector, except for the transmission and power dispatch company (kenergo), into a single holding - NAK Energy Company ofUkraine (ECU) in 2004. The new company in many ways resembles vertically integrated gas company NAK Naftogaz, but unlike NAK Naftogaz which has a monopoly in the gas market, NEK ECU does not control the whole power market and most importantly it does not control the high voltage transmission network and the power system dispatch. Through its holding ofmajority stakes in four thermal power companies and one hydropower company, NAK ECU accounts for about 42% ofthe electricity produced in Ukraine and for about 53% of electricity sales to the wholesale power market2*. Also, the holding company has about 68% ofthe distribution market. Therefore, ECU is a “net buyer” of about 36 TWh on the wholesale electricity market. The main challenge for the management of ECU stems from the poor financial condition of (majority) state-owned companies included in the holding. From the point of view of consolidated financial situation, the amounts owed by ECU exceed the amounts owed to the holding by about UAH 4.5 billion. As shown in the Table 6, practically all debt overhang of ECU comes from the debt overhang of distribution companies (Oblenergos) which were transferred to the holding. Furthermore, these Oblenergos account for about 90% of the debt overhang of all power distribution companies. The amounts owed by the WEM (Wholesale Electricity Market) to all thermal power companies reached UAH 7.8 billion on January 1, 2004, which includes UAH 7.5 billion owed to state-owned generators transferred to ECU. The total payment arrears ofthermal power generators in ECU is estimated at UAH 7.5 billion, about half of which is owed to fuel (gas and coal) suppliers. Table 6. Chain of Payment Arrears in the Power Sector, as of January 1,2003

Consumers to Generators to Item Oblenergos Oblenergos to WEM to Creditors WEM Generators (coal industry) (for coal) Total Arrears of I 10.3 (1.8) 15.5 I 15.6 I 13.4(1.3) I I I I NAK ECU I 7.7’ I 12.2 I 7.5 I 7.5- I I I I I I * Estimated by the Bank The power sector cannot become financially viable without settlement of accumulated payment arrears, which, first of all, requires the adoption of draft law on resolution of debts in the energy sector. The establishment ofproper legal framework and adequate institutional arrangements are necessary but not sufficient conditions for the resolution of debts. The implementation of the debt resolution scheme will critically depend on the readiness and the ability of sector entities to participate in this process, which may include write-offs, mutual settlements, debt restructuring,

2’ Installed generation capacity in the Ukraine Power System (UPS) is about 53 GW, including 13.8 GW in nuclear power plants, 34.4 GW in thermal power plants, and 4.6 GW in hydropower plants. However, the total available generating capacity is estimated at about 43 GW, due to the derating and low availability of aging thermal power plants. 22 The largest producer ofelectricity is Energoatom - the state owned nuclear power company - which accounts for about 50% of electricity production and 36% of sales to the wholesale power market.

30 refinancing and partial payments. The above table shows that a significant portion of debts in the power sector may be resolved within ECU as a number of creditors to generators (e.g. coal companies) are also large debtors to distribution companies. The lack of investments and differed maintenance in aging power infrastructure, particularly thermal power plants, continue to reduce reliability ofpower supply and degrade environment in Ukraine. During the 1990s, the declining demand created a large capacity reserve which masked a rapid loss of available capacity in thermal power plants and increasingly inefficient use of power facilities, including large distribution losses (about 20% of electricity supplied to Oblenergos). The resumption of growth in electricity demand after 2000, exposed the loss of available capacity and highlighted the need for investments in the power sector on the order of US$1.5 billion per year over the next 5 years. About 20% of this amount is needed for rehabilitation and re-powering of the existing thermal power plants and at least the same amount for investments in power di~tribution~~.These investments are also needed to help introduce technical and environmental standards which should enable Ukraine to meet conditions for increasing electricity exports24 to the Westem European Power Grid (UCTE). ECU could help uniformly implement technical and environmental standards across the thermal power sector and facilitate its harmonization with the EU directives. It is important to note that investments in assets managed by ECU (causing improvements in environmental performance ofthermal power plants and/ or reducing losses in distribution companies) could attract considerable financial support under the Kyoto Protocol. In the near to medium term, NAK ECU could solve many problems which the state management failed to address, including commercialization of state-owned entities, reduction of costs and improved payments between distribution companies and power plants. However, lack of Government commitment to continued privatization and delays in sector reforms could increase risks of market concentration associated with the establishment of NAK ECU, particularly the risk of monopoly abuses and weakening of the energy regulator (NERC). The main sector reforms, needed to mitigate these risks and to help meet sector challenges in the near to medium term, include: (i)increasing and balancing electricity tariffs; (ii)improving corporate govemance of the majority state owned power companies; (iii)strengthening the financial and administrative independence of the energy regulator (NERC); and (iv) continuing the process toward gradual market opening based on replacement of the single-buyer wholesale electricity market, with a bilateral contracting market and a balancing mechanism.

Even if successful in meeting the above challenges, ECU is unlikely to solve the current contradictions in the energy sector and to achieve the potential performance which private initiative and competition could. The main such weakness in the energy sector is lack ofmarket competition in fuel (gas and coal) supply which stifles competition among power producers. In fact, without market pricing for gas and coal, it is difficult to clearly identify viable parts of the thermal power sector and to target necessary reforms, including decommissioning of non-viable

23 The largest investment needs in the power sector (up to US$500 million per year) will continue to be in improvement ofnuclear safety and other programs of “Energoatom”. 24 In 1990, Ukraine exported 28 TWh to the nowadays EU member countries or EU-candidate countries in Central and South East Europe. Electricity exports practically disappeared in the mid 1990s but re-started in 1999 and reached 4.3 TWh in 2003. Key conditions for increasing access to the EU electricity market include (i) harmonization of technical standards; (ii)reciprocity in market opening; (iii)improvements in environmental protection; (iv) nuclear safety; and (v) pricing based on full cost recovery.

31 power producers. It is important to note that the relative stability ofthe price of gas25points out to the coal sector as the main source of market distortions and non-transparent subsidies which are passed through the power sector to final consumers.

4.2 The Coal Sector

The coal is the largest indigenous fuel source in Ukraine and, therefore, it plays an important role in ensuring the security of energy supply. The coal sector is also the largest recipient of Government subsidies in the energy sector due to complex and environmental issues associated with the coal production which is concentrated in the Donbas region. The unusually difficult geological conditions (thin, steeply inclined coal seams at great depth) in the central Donbas make the mining of coal costly and labor intensive. The legacy of decades of mismanagement and unfinished reform agenda from 199Os, further increase the social and environmental costs of the sector reform. The main reform issues in the coal industry and mining communities include: (i)governance in the coal sector, (ii)coal pricing, (iii)state support for the coal industry, and (iv) mitigation of social and environment impacts of sector restructuring.

Deficiencies of govemance permeate the Ukrainian coal sector and constitute the overarching problem that will require resolution if restructuring is to succeed and the industry set firmly on the path to recovery. The most important attributes of the sector govemance problems are: murky ownership structure of the industry, poor mine safety record2’, non-transparent pricing and marketing arrangements, and opacity in allocating subsidies. In order to address governance deficiencies there is a need to restore Government authority, accountability of mine operators, and to further involve the private sector through an outright privatization or other forms of private sector participation through transparent and fair competition and establishing binding clear rights and obligations ofboth the public and the private operators.

The coal underpricing represents a core problem of the industry with coal prices reflecting neither the cost of production nor the cost of alternative energy sources. While the coal prices have been growing during 2003 and 2004 they are still below production costs. The difference between the production cost ($30.7/ton) and market price ($25.2/ton) in 2003 was $5.5/ton resulting in annual revenue loss ofabout $322 million. Achieving coal prices that fully cover the production cost ofviable mines and reflect economic alternatives to domestic coal could be done in two phases. First, it is necessary to identify viable mines having production cost below the

25 Following the settlement of gas debts (US$1.4 billion) in August 2004, Ukraine and Russia signed two framework agreements on the transit of oil and gas through Ukraine for the next 15 and 25 years, respectively. According to the 2005-2030 gas transit agreement, Russia guarantees additional gas transits (raising from 5 bcm in 2005 to 19 bcm in 2010) above the previously agreed levels of 122-127 bcm per year in 2002-2006. Furthermore, after 2007 Gazprom will be a single source supplier of gas to Ukraine as the company contracted practically all available gas production in Turkmenistan from 2007 to 2028. 26 In 2001, about 480,000 people were employed in the coal sector. While the labor productivity increased from about 25 tons per month in 2001 to 28 tons per month in 2004, it is still significantly lower than the productivity in Poland (56) and Western Europe (140). Despite the increasing productivity, the cost ofproducing a ton of coal continues to grow due to non-competitive procurement ofmining equipment and materials, deteriorating quality of coal and increasing environmental costs. 27 The number offatal accidents has decreased in the last few years to about 3 person per 1 million tons ofextracted coal, but it is still higher than in 1991 (2.2 persons) and much higher than in Russia (0.5) and USA (0.03).

32 economic alternatives and to introduce (temporary) price regulation forbidding the sale ofcoal at price below cost recovery levels. Second, the regulation ofcoal prices should be phased out with the development of fuel markets. Hopelessly loss-making mines with depleted economic coal reserves and those with unacceptable and economically unsolvable safety parameters should be closed.

The subsidies to viable core ofthe industry are to be provided on market and not cost basis with revised levels and forms of support and improved administration. The coal industry has been receiving sizable subsidies for the State budget exceeding 3 UAH billions per year over last two years. However, the subsidies were not efficiently utilized through nontransparent ad hoc allocations and the sector performance has been deteriorating. There are two aspects pertaining to the subsidy subject that should be considered and addressed, namely the level and form of support, and its administration. The level of subsidies should go down with coal price realignment toward cost recovery and other forms of subsidization, such as interest-free credits should be gradually introduced. World experience with administration of subsidies shows that the most effective subsidy systems share two key attributes: (a) they are provided for clearly defined purposes under transparent rules; and (b) they are provided for a limited period of time. Policy goals will be most effectively achieved when Governments make public their programs of subsidizing specific industries and unsure that they are diligently implemented.

The sector downsizing and resulting social and environmental aftermath need to be addressed in a more decisive and rational manner if restmcturing benefits are to be fully realized. There are now more than 100 mines that have been shifted from the production to closure since the beginning of the restructuring in 1996. However, none of those mines has been completely closed and written off from the industry balance, because of inflated design cost of closure and inadequate budget resources to fully cover these costs. As a result, there is growing displeasure of both the profile ministry charged with the closure of mines (MFE) and population living around ex-mining sites that is suffering from poor environmental, healthy, and infrastructure conditions. In order to rectify the current unsatisfactory situation with the mine closure and mitigation ofsocial and environment impact it is necessary to undertake to following measures: - Rationalize the plans of physical closure of mines by excluding unrelated costs, optimizing the remainder expenses, and accelerate the completion ofthe closure; - Assistance in finding new employment and other forms of social support should be focused on most vulnerable groups of population i.e. women, elderly people and children. The priority should be given to low cost measures such as supporting the migration. Creation of new jobs for miners from closed mines should be replaced with assistance to move to the regions where there is shortage of mine force (according to MFE, there are several tens ofthousands vacancies at operating mines); - Environmental expenses are to be prioritized with clear delineation of urgent works to be supported from the mine closure budgets and the other less burning measures to be excluded from the closure plans and financed in the context of broader regional environmental management programs; - Revise cumbersome legal and regulatory framework for accelerating the transfer of social assets from mines to municipalities. Provided continued migration from ex-mine settlements, rationalize the social assets and develop plans for restoration and financial viability ofremaining assets;

33 4.3 The Gas Sector

The gas sector plays a major role in the economy of Ukraine. Gas represents about 50% of Ukraine’s primary fuel consumption, domestic gas production meets about 12% of the country’s primary fuel needs and the transit gas pipeline system is a significant strategic asset generating annual revenues of about $1.5 billion2*. The sector, however, provides implicit subsidies to the economy on the order of 2% of GDP and does so at the cost of being unable to generate the funds needed for prudent reinvestment in the sector both to maintain existing assets and to expand operations with the objective of more effectively exploiting Ukraine’s underlying hydrocarbon resource base and strategic location. These subsidies are effectively provided by NAK Naftogaz, which is a vertically integrated state-owned company and the “single buyer” of all gas supplied in Ukraine and transported through the country. In providing these subsidies, Naftogaz and its subsidiaries have been forced to forego potential profits associated with domestic gas production and attributable to payments received in kind for the transit of Russian gas. Naftogaz has also proved unable to meet its full tax obligations with the result that it is now the largest tax debtor in the country with tax debts in excess ofUAH 4.6 billion (equivalent to $0.85 billion). While collection problems, which have been substantially reduced over the last few years, contribute to the creation of these implicit subsidies, by far the lar est component of the subsidies results from gas being priced at below its true economic value2’. Continuing efforts to improve collections and a focus on reducing operating costs and commercial losses are needed and will contribute to an improvement in the financial outlook for the gas sector. However, until gas price tariffs are brought up to levels that cover the full economic cost of the gas, the sector will remain financially susceptible and the country’s ability to achieve optimum exploitation of its gas resources and infrastructure will be constrained.

Ukraine is endowed with substantial gas reserves and has the potential to increase production significantly. Naftogaz’s own assessment suggests that gas production could be increased by as much as 12 BCM per year or more. A production increase of this magnitude will require investments on the order of $1.5 to $2 billion, which the country would be hard pressed to generate from internal sources. In addition, Ukraine has sizeable funding needs to maintain its existing infrastructure and would also require substantial capital if it is to expand the gas transit line to take advantage of a potential future increase in Russian gas exports to Europe. Consequently, Naftogaz already started raising resources on the international bond market with its US$450 million Eurobond issue in 2004. In order to do that, Naftogaz organized an audit of its consolidated financial statements by an international recognized auditing firm.30 It also worked with international advisors to enhance its own ability to develop strategic plans, and made progress on consolidating control over its own subsidiaries. In the future, current and

28 The transit tariff is currently paid largely in kind, in the form of gas. In 2002, the tariff consisted of a cash payment of about $141 million and a payment in the form of gas of about 26 billion cubic meters. This represented a total value ofalmost $1.5 billion. 29 At present, the economic value of all the gas consumed in Ukraine is equivalent to import parity cost which is approximately $60 per thousand cubic meters. 30 In particular, it hired international firms to conduct oil and gas reserve evaluations, assessment ofthe value ofits fixed capital, and the audit itself.

34 potential investors are going to demand continued improvements in operational performance of Naftogaz, and more transparency of the company. Thus, Naftogaz should take all necessary steps to embrace best practice transparency requirements for national oil companies both at the holding company and at the subsidiary level.

If Ukraine is to take maximum advantage of the opportunity for future trade with the EU, it should plan to harmonize its own gas market structure with the structure of the EU Internal Energy Market. From this point ofview, an unbundling ofgas operations both vertically (Le. by separating production, transmission, storage and distribution) and horizontally (i.e. by setting up a series of competing production companies) would go a long way in meeting applicable EU directives which provide common rules on storage, transmission, supply and distribution of natural gas. This would also eliminate potential conflict of interest and would promote gas to gas competition in Ukraine. The unbundling does not require a break-up ofNaftogaz, as it can be done through full separation of subsidiary units into discrete operating companies with financial and managerial autonomy, with each company being expected to function as an independent commercial enterprise, but with an obligation to report financial and operating results to the holding company. This “internal unbundling” would have the added benefit of separating specific investment components financed by bond or other instruments. This should help attract investment to the most viable projects, while narrowing and strengthening management accountability ofthe use ofraised funds by project, without surrendering the ability ofNaftogaz itself to borrow on behalf ofits subsidiaries. Ukraine’s high pressure gas transit line is a major strategic asset. However, if Ukraine is to extract the maximum benefit from this asset it needs to convince Russia that it will behave as a “good transit country” for the indefinite future and that it should be the preferred route for future increases in Russian gas deliveries to Europe. At the same time, Ukraine needs to ensure that the State receives a fair share of the economic rent associated with gas transport. It should also provide support to the development of the domestic gas production sector by ensuring that some transmission capacity is available for exports ofUkrainian gas. Discussions have been underway about establishing a consortium involving Ukraine, Russia and, possibly, one or more European partners to manage the operation of the transit pipeline system. Discussions have addressed both the existing transit system and a possible new transit pipeline. Such an arrangement, particularly for the existing transit system, should go a long way to achieving the goal of convincing Russia that Ukraine will act as a “good transit country” in the future. If structured as a concession or outright privatization, it should also address the question of funding sources for needed capital investments in the system. With or without a new arrangement for the management and operation of the transit pipeline system, the transit tariff needs to be reviewed and the amount allocated to the State budget3’ needs to be re-examined. Ukraine should also seek to have the payment of tariffs converted from a predominantly in kind arrangement to a 100% cash arrangement.

3’ The transit arrangements calls for a tax payment by Naftogaz of $0.29lMCM per 100 kilometers of gas transited through the system. In 2002, this tax payment amounted to about $380 million which represented the total of direct contributions to the State associated with the transit.

35 4.4 Key steps and program milestones In light of the issues outlined above, the following recommendations summarize key next steps that should be considered by the Government of Ukraine. This effort can be supported by the Bank through both technical assistance and financial resources under the Energy Sector Reform and Development Program. The overall objective of the Energy Program is to improve the security, reliability and quality of energy supply and, therefore, facilitate unimpeded operation of the energy market, both domestically and internationally. Also, the Energy Program would support Ukraine’s aspirations with regard to legal, institutional, regulatory and technical harmonization and increasing energy trade with the EU Internal Energy Market through priority investment projects and technical assistance. To achieve this overall objective, the Energy Program is designed to help with the following: - Adopt an action plan for harmonization of energy policies with the main principles of the EU Internal Energy Market, including EU Directives on electricity (2003/54/EC) and gas (2003/55/EC); - Converge toward market principles: > Improve financial viability of energy enterprises through: (i)reducing payment arrears; (ii)increasing collections; (iii)reducing energy losses; and (iv) reducing price distortions; > Improve corporate governance and commercialization of majority state-owned energy enterprises through: (i) contracting of performance targets with independent (from company management) and professionally qualified Supervisory Boards; and (ii)increasing transparency and compliance with reporting and disclosure requirements applicable to publicly quoted private sector enterprises in the EU energy market; > Strengthen the energy regulator (NERC) through: (i)adopting low on the state regulation which will exempt NERC’s decisions from reviews by individual ministries and other Government agencies, enable NERC to set its own staffing and salary policies, and establish a source of funding for NERC separate from the state budget; and (ii)building institutional capacity ofNERC through provision of necessary technical assistance; > Introduce EC regulations related to the third party access to electricity and gas networks, cross-border energy trade, public service standards (quality of service) and environmental protection requirements; > Open up the power market by replacing the single-buyer wholesale electricity market model with a bilateral contracting market and a balancing mechanism; > Implement priority investment projects need to improve safety, security and reliability of energy supply, reduce environmental pollution and meet technical requirements for increasing access to the EU Internal Energy Market. - Adopt a strategic action plan for further restructuring, ownership transformation and private sector participation in the energy sector.

36 - Adopt an action plan for increasing electricity interconnection of the Ukraine power grid with the UCTE power grid.

5. Energy sector investments as affected by the Kyoto Protocol Ukraine is one of the countries with the most to gain from the entry into force of the Kyoto Protocol (KP) on Greenhouse gas (GHG) emissions in February 2005. By taking advantage of financial mechanisms introduced under the KP, significant financial resources and foreign investment could be harnessed to meet growing investment needs in the energy sector. Ukraine is the 1lth largest emitter of GHGs in the world3* and has one ofthe largest “surpluses” ofcarbon emission allowances33estimated at about 1.8 billion tons of C02 equivalent under the KP. This gives Ukraine the opportunity to eam billions of dollars starting in 2008. This additional foreign exchange can be earned through two separate mechanisms: either by selling excess permits (AAUs) or by undertaking investments projects co-financed by OECD countries which reduce emissions of greenhouse gasses. Regarding the first mechanism, Ukraine can cash in these excess emission permits on the international emission trading market. In order to do this it will need to meet UN eligibility requirements for (a) calculating its excess emissions units, and (b) managing transactions and reporting, by January 1, 2007. In addition, OECD countries have indicated they will buy these excess emission permits provided the selling country, Ukraine for example, re-invests the corresponding proceeds in projects that reduce emissions, the so-called “green” investments. If Ukraine meets these requirements, it will be able to start selling excess greenhouse gas units (Le., a ton ofcarbon) at the market price34, starting on January 1,2008. Using these proceeds to invest in “green” projects would enable Ukraine to reduce its emissions further and generate additional excess emission permits which can also be traded on the international market. But Ukraine should be ready to enter the market on January 1, 2008, and be aware that the price of carbon credits will fall significantly in case Russia enters the market. This is because the excess emission permits by Ukraine and Russia combined far exceeds the shortage of emission permits among OECD signature countries (which exclude the US). The second mechanism, and a more palpable approach at the moment, is that Ukraine can cash in through investments co-financed by OECD countries that reduce GHG emissions. GHG emissions in the energy sector of Ukraine account for about 75% of all GHG emissions in the country. The energy sector offers ample opportunities for cost-effective reduction of GHG emissions35which could be used to attract significant financial support through the above KP mechanisms to meet growing investment needs in the sector. Unfortunately, institutional capacity, which is necessary to implement KP mechanisms, is low in Ukraine and the country is poorly prepared to capitalize on this opportunity and at the same time to help other countries (i.e.

32 This assessment is based on the study “Modeling and Analysis ofGreenhouse Gases Emissions in Ukraine” conducted by the Pacific Northwest National Laboratory (USA) and Agency for Rational Energy Use and Ecology (Ukraine) in 2001. 33 Ukraine’s carbon emission allowances or Assigned Amount Units (AAUs) under the KP are well in excess of what the country needs to meet its obligations in the first commitment period from 2008 to 2012. 34 The market price is expected to vary from US$2 to US$lO per ton ofC02 equivalent. Therefore, proceeds from emissions permit trading may be $300-500 million per year or more between 2008 and 2012. 35 The National Strategy ofUkraine for Joint Implementation and Emissions Trading estimated that Ukraine has an emission reduction potential of about 565 million tons of C02 through the implementation ofenergy savings measures from 2003 to 2012.

37 developed countries) meet their obligations under the Protocol. Through its unique Carbon Financing (CF) experience and the pivotal position in the Carbon Market, the World Bank can help Ukraine (i)build its institutional capacity in this area; (ii)mobilize CF support for Joint Implementation (JI) projects in the energy sector, which will also provide a valuable learning experience for further use ofKP mechanisms.

38 Annex 2: Major Related Projects Financed by the Bank and other Agencies UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

The following is a selective listing ofrelated projects and highlights ofthose that are directly supporting le proposedEner y Program. Donors Activities

The World Hydropower Rehabilitation and System Control Project (completed). Bank Total Project Cost: US$190 million World Bank Loan: US$114 million. Co-financing from the Swiss, Canadian and Norwegian governments. Board Date: April 11, 1995 Completed: June 30,2002 The objectives of the Hydropower Rehabilitation and System Control Project were to: (a) improve the efficiency, reliability, safety and environmental performance of hydropower plants; (b) increase hydropower generation capacity; (c) improve the quality of electricity supply by upgrading load and frequency control; and (d) reduce fuel costs by facilitating the economic dispatch of generating units. The project includes the following components: (1) partial rehabilitation of the Kiev pump storage plant (PSP); Dnieper Iand 11, Kakhovka, Kiev, Kanev, Kremenchug and Dniprodzerzhinsk hydropower plants; (2) installation of dam safety monitoring systems at the main dams on the Dnieper river; (3) upgrade of communications, dispatch, system control and protection, and generating unit control; and (4) technical assistance for project implementation, and optimization of the use of the reservoirs on the Dnieper river.

Coal Sector Adjustment Loan (Coal Secal) (completed) Total Project Cost: US$300 million World Bank Loan: US$300 million. Board Date: December 11, 1996 Completed: December 3 1, 1999 The objectives of the Coal SECK project were to : (a) to support balance of payment and budget financing needs through 1996 - 2000, including the part of the fiscal costs of restructuring the coal sector; (b) to help transform the coal sector onto a self-sustained sector; and (c) to improve the productivity of the coal sector.

Coal Pilot Project (completed) Total Project Cost: US$28.5 million World Bank Loan: US$15.8 million Board Date: May 16, 1996 Completed: December 3 1,2000 The main objective of the Coal Pilot Project was to mitigate the social and environmental consequences that have arisen from the government's decision to close uneconomic coal mines, as part of govemment's overall restructuring program for the coal sector. The project also aimed to help: (a) test ways to implement the government's decision to close mines safely, with due regard to technical, environmental, economic, financial and social aspects at three pilot mines; (b) ensure

39 that mine workers were afforded opportunities to either transfer to other jobs in the sector or exit the industry with reasonable compensation and a choice ofassistance for seelung other employment; (c) transfer social assets to municipal management, support their rationalization and help ensure that adequate social protection measures are put in place to support the most vulnerable people; and (d) gain experience from the project for subsequent bank assistance operations in the sector. The project consisted of the following five components which will serve as the basic framework for mitigation initiatives in subsequent sector operations requested by the govemment: (1) mitigation of mine closure including physical closure and environmental mitigation; (2) social mitigation; (3) social infrastructure divestiture; (4) institutional strengthening and job counseling; and (5) technical assistance.

Kyiv District Heating Improvement Project (under implementation)

Total Project Cost: US$250 million World Bank Loan: US$200 million, Finnish and US Govemments provided project preparation funding. Board Date: May 2 1, 1998 The objectives of the Kiev District Heating Improvement Project are: (a) to replace and increase heat production capacity to better meet existing and expected future demand and to improve the reliability and service levels in the Kiev District Heating (DH) system; (b) to extend the life of, increase the efficiency of, and enhance conservation of the Kiev DH system, through rehabilitation and introduction of modem technologies and materials; and (c) to promote sound cost recovery policies and practices and the commercialization an institutional strengthening ofproject DH companies, to identify the most efficient corporate and institutional structure for provision of DH in Kiev and ways to facilitate the eventual privatization of the service, and to support project implementation. The components include: (1) heat production capacity improvement; (2) DH rehabilitation; and (3) institutional support.

Kyiv Public Building Energy Efficiency Project (under implementation) Total Project Cost: US$30 million World Bank Loan: US$ 18.29 million Board date: January 27,2000 The Kiev Public Buildings Energy Efficiency Project supports the Government's Comprehensive State Energy Conservation Program, which aims at achieving energy savings through targeted investments. The components include: (1) Energy efficiency improvements in public buildings, healthcare and educational buildings. The component supports installation of heat meters, automate substations, radiator reflectors, ceiling fans, faucet flow restrictors, and hot water heat exchangers. (2) Technical audits, to yield engineering estimates of the buildings' present energy consumption, and identify feasible retrofit actions for energy efficiency. Technical designs for retrofit measures will be required, as well as technical specifications for competitive bidding. Substantial training will be provided. (3) Consulting services for project management, to include monitoring and evaluation, and, to develop training modules for energy efficiency measures. An awareness campaign will be developed, and training programs included. Consultants will review regulations for social assistance support, and strengthen communications, through computerizatior provision. (4) Financial audits, to cover incremental audit costs.

40 European Balkan Gas Transit I1 Bank for Year signed: 2001 Reconstruction EBRD loan: Long-term loan ofup to US$97 million (€1 12 million) to finance and construction expenditure of 70 km of parallel gas pipelines. There are also potential Development co-financing opportunities to commercial banks. (EBRD) Total Project cost: $ US 118 million Project objectives: Project aims to reduce the bottleneck in the Ukrainian gas transportation system and increase supply, especially in winter periods, to Turkey, Bulgaria, Romania, FYR Macedonia and Greece. K2R4 Safety Upgrade In July 2004 the EBRD Board of Directors approved a $42 million loan to modemise and improve safety for two nuclear reactors in Ukraine: unit 2 at Khmelnitsky (K2) and unit 4 at Rime (R4). The 1,000-megawatt reactors are being built by Energoatom, Ukraine’s state-owned nuclear power-generating company. As Ukraine completed construction of these reactors, it has requested that the EBRD and the European Community help finance post start-up safety and modemisation measures. In addition to the EBRD’s $42 million, the EC plans to lend a further $83 million.

Ukraine Energy Service Company Year signed: 1998 EBRD loan: US $30m Project objectives: UkrEsco identified and implemented energy-saving investments in SMEs and public sector institutions. Currently the second energy efficiency project is being considered by the Bank. Canadian Energy and Nuclear Safety International 3 projects from CAD $3,900,000 up to CAD $32,200,000 for the period of 1997/12- Development 2007/12) Agency (CIDA) European The Project on Creation of the Gas Metrology Centre at Boyarka (split up into t Union contracts for the design, supply ofequipment and certification of the Centre) (TACIS) An overall amount - Euro 7,9 million: RAP INOGATE 1999 Financing small scale investments in oil and gas RAP INOGATE 1999 Inogate metrological station eastern Europe - TA: Validation and certification RAP INOGATE 2002 Gas Meter Test and Calibration Equipment for the East European Regional centre for Metrology ofNatural Gas in Boyarka, Ukraine.

AP 2000 Technical Assistance Support to NERC in strengthening the energy market reform and assessment ofthe energy sector sustainability (Euro 3 million). USAID USAID programs in the energy sector produced substantial results and were instrumental in achieving current threshold for infrastructure reforms. The key programs that contributed to this result include: (a) Legal, Regulatory and Market Development Reform; (b) Support to Privatization in the Energy Sector; (c) Education of Energy Managers; (d) Partnership ofUtilities. USAID programs produced following results: - Electricity Market has been created, including generation, transport, distribution companies set up, Market Agreement signed, energy regulator

41 (NERC) established; - Successful transparent privatization occurred in 6 power distribution companies; - Tariff policy developed and approved for power distribution utilities; - Financial stability restored due to cash collection improvements. While USAID’s assistance has directly led to the creation ofpower market and privatization ofsome energy assets, further liberalization ofthe energy sector was not supported by the previous Government ofUkraine.

There three areas ofUSAID investments in energy sector:

District Heating and Energy Efficiency Total amount: US$ 11.7 million Projects: Installation and Monitoring of Energy Efficiency. Equipment for ESCO Alexandrina; Municipal Energy Efficiency (Alliance to Save Energy); Energy Efficiency - Kharkiv; Industrial Energy Efficiency; Energy Efficiency Center; Demand Side Management.

Energy Subsector Restructuring - Privatization and Restructuring Total amount: US$ 5 1,8 million Projects: Power Sector Restructuring GeneratiodRegulatory Reform; Distribution Companies Restructuring; Coal Safety and Restructuring; Coal Mine Safety; Coal Bed Methane; Coal Marketing; Alternative Fuels Center; Utility Partnerships; Oil and Gas; Power Sector Privatization; Debt Restructuring; Ukraine Regulatory Association; Coal - US Dept ofInterior; Energy Market Development.

Nuclear Safety Total amount: US$45,00 million Projects: Chemobyl Initiative; Nuclear Safety; Nuclear Safety-Chomobyl; Energy Efficiencv-Chomobvl

42 Annex 3: Results Framework and Monitoring UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

Table 7. Results Framework

PDO Outcome Indicators Use of Outcome Information

The Energy Sector Reform and (1) Progress in energy market An increasing number ofeligible Development Program would (1) reforms in accordance with the electricity consumers are free to help the Ukraine energy market to program milestones agreed under the choose their electricity supplier. better meet increasing demand in a Energy Program. secure and reliable manner, while converging toward legal, regulatory (2) More than 70% ofhydroelectric Ukraine is better prepared to meet and technical standards of the EU units in UHE are refbbished and the UCTE requirements related to the Internal Energy Market; and (2) balancing mechanism ofliberalized load following, frequency control provide priority investment support power market operates with a help and stability ofits power grid. for rehabilitation and upgrading of ofancillary services provided by hydropower plants. UHE.

Intermediate Results Results Indicators for Each Use of Results Monitoring One Der ComDonent ComDonent Component A: Component A: Component A: Main contracts for rehabilitation of Rehabilitation is completed and Transmission system operator (TSO) hydropower units are awarded by ancillary services are available from uses the ancillary services made November 30,2005. 8 units in 2007; 8 units in 2008; 9 available by UHE. units in 2009; 9 units in 2010; 7 UHE participates in the balancing units in 201 1; and 5 units in 2012. mechanism and provides key ancillary services..

Component B: Component B: Component B: Design proposals for dam safety Computer-aided dam safety DamSafety Center uses monitoring strengthening measures completed monitoring systems is installed and systems for immediate analysis and by December 3 1,2005 operational at Dniprovska, interpretation ofall relevant dam Dniprodzerzhinsk, Kaniv and safety data Dnister dams. Component C: Component C: Component C: UHE hires an international project UHE uses MIS for financial A modem Management Information management and procurement management, including sales, billing System (MIS) is established in UHE. consultant by September 30, 2005. and collections fimctions. Component D: Components D: Components D: Permanent Working Group in MFE A conceptual plan for legal and MFE harmonizes energy policies prepares an indicative list ofpriority technical harmonization ofthe with the main principles ofthe EU investments in energy infrastructure Ukraine’s energy sector with the EU Internal Energy Market. by March 3 1, 2006. directives and norms is established and periodically updated. Component E: Component E: Component E: NERC hires consultants for Power producers and eligible Balancing mechanism is established development ofmarket rules by wholesale buyers are using bilateral based on market rules approved by March 3 1, 2006. contracts for electricity trade. NERC.

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2.C 00 e FE a e .C3 0 Y E +-e, -e, B v1 8 L 9 f 0 3 w 5 d 0 0 cu E CI z Annex 4: Detailed Project Description UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

Project Component A: Rehabilitation of Hydroelectric Plants. This project component deals with the rehabilitation of nine hydroelectric plants which account for practically all hydropower production in Ukraine and meet about 7% of the total electricity demand in the country. The Table 9 summarizes main features ofthese nine hydroelectric plants.

Table 9. Main Parameters of UHE’s Hydroelectric Plants

Installed Turbines Capacity Year of Plant Name Type and Comwiaain,. MW Number Kviv 408.5 I Bulb(20) I 1964-1968 I 749.6 21 Kyiv PSP I 235.5 I Frances(6) I 1971-1972 I 182.9 I 9 ~~

Kaniv I 444 I Bulb(24) I 1972-1975 ~ 924.5 1 24 Kremenchug 625 Kaplan ( 12) 1959-1960 1,496.6 27 Dniprodzerzinsk 356.4 Kaplan (8) 1963-1964 1,278.9 41 Dniprovska HPP1 627 Frances (9) 1932-1950 3,85 1.4 29 Dniprovska HPP2 876.6 Kaplan (2) 1974-1980 Propeller (6)

Kahovka 311.6 Kaplan (6) 1955-1956 1,439.2 53 Dnister 702 Kaplan (6) 1981-1983 1,060.2 17 TOTAL UHE 4,586.6 99 units 1932-1983 10,983.4 27

The proposed project will build on the previous Hydropower Rehabilitation and System Control Project (Loan 3865) which was successfully completed in 2002. Beneficiary ofthe Loan 3865 - DniproHydroEnergo (DHE) - completed rehabilitation of 16 hydroelectric units between 1996 and 2002. After the Loan closing, DHE continued the rehabilitation and its successor company UHE3’ will complete refurbishment of another 10 units by the end of2005. The proposed Hydro Power Rehabilitation Project will support the next phase of hydropower rehabilitation (2006- 201 1) which includes refurbishment of 46 hydroelectric units at nine hydropower plants. The experience gained during the first Bank project and sound financial condition of UHE (due to improved financial discipline in the power sector) are main reasons for the increase in number of units to be rehabilitated during the next 6 years in comparison to the first phase ofhydropower rehabilitation.

37 UHE is fully state owned Open Joint Stock Company (OJSC) which was established by merging OJSC DniproHydroEnergo and OJSC DnisterHydroEnergo in February 2004.

45 The rehabilitation ofhydroelectric plants involves:

0 Rehabilitation of generating units, including replacement of turbine runners, turbine governors, and replacement, refurbishment or upgrade of other related equipment (guide vanes, servomotors, measuring and control devices). It will also involve rehabilitation of generators including replacement, refurbishment or upgrade ofstator and rotor windings, generator circuit breakers, excitation and voltage control systems, and unit transformers.

0 Modernization of plant monitoring and control systems, including introduction of hierarchical Supervisory Control and Data Acquisition (SCADA) system, upgrade of protective relaying, metering and telecommunication systems, and refurbishment ofplant auxiliary systems (e.g. low voltage substations and compressors).

0 Rehabilitation of plant switchyards, including replacement of high voltage circuit breakers, disconnect switches, surge arresters, measuring transformers and protective relaying.

The total cost of the above rehabilitation program (2006-201 1) is estimated at about $342.5 million equivalent, of which $87.3 million (25%) represents the foreign exchange component. Annex 5 shows detailed cost estimates for each project component. The project base costs are in 2004 prices and are estimated based on actual costs for rehabilitation completed so far by UHE and on contract prices for on-going works. Physical contingencies are calculated for each project component separately and vary between 5% and 10% for locally supplied components and are about 10% for foreign supplied components. The price escalation for costs expressed in foreign exchange (US$) has been calculated in accordance with the anticipated intemational price escalation. The price escalation for costs expressed in local currency is calculated according to the projected local inflation rates. Taxes and duties are estimated on the basis ofcurrent levels of VAT and custom duties in Ukraine.

The breakdown ofthe project costs into foreign and local components reflects UHE’s decision to procure most of heavy electromechanical equipment in Ukraine, such as turbine runners (estimated cost about US64 million), generators (estimated cost about US$36 million) and power transformers (estimated cost about US$6 million). During the loan negotiations, the Bank confirmed that the share of Bank financing could be enlarged to cover the cost of the required electromechanical equipment subject to its ICB procurement in accordance with the Bank procurement guidelines. The preparation of necessary bidding documents and the international competitive bidding for this equipment will take at least one year. Therefore, the equipment scheduled for replacement in 2006 will need to be procured through direct (non-competitive) contracting which is not eligible for the Bank financing. It was agreed that the Bank will consider additional (supplemental) financing for the procurement of equipment needed in 2007 and onwords subject to (i)GOU’s approval of the international competitive bidding for the procurement of this equipment; and (ii)UHE’s submission of the applicable bidding documents satisfactory to the Bank by December 3 I,2005.

Since the rehabilitation of all hydroelectric units (64) has a long implementation period (12 years), a phased financing approach would avoid tying up financial resources that could be used

46 for other projects with more immediate needs under the Energy Program. Furthermore, such approach would help reduce financing costs for UHE. No problem is envisaged for UHE in raising foreign exchange financing for the third phase of hydropower rehabilitation (2012-201 7) at a later date. Therefore, it was agreed that the proposed loan would be used to finance the second phase (2006-201 1) of hydropower rehabilitation which includes 46 units and nine hydropower plants. This would not prevent Ukraine from seeking additional assistance from the Bank for the third phase ofthe hydropower rehabilitation project.

Project Component B: Dam Safety. This project component includes measures to rehabilitate and upgrade the existing dam safety and monitoring systems which are described in detail in Annex 10.

Project Component C: UHE Institutional Development. The Hydropower Rehabilitation Project will initiate the establishment of a modem Management Information System (MIS), including financial management system (FMS) in UHE. The MIS will include systems and procedures to enable the company management to exercise better and timely control over critical matters, including its financial transactions. The strategy involves a phased approach to developing a corporate wide MIS, with the first phase under the Project aimed at FMS which would be designed and implemented first at headquarters of UHE. This will assist UHE in automated information exchange and analyses of critical data related to sales, billing and collections. A consultant will be recruited to design the MISRMS, define the specifications and assist in procurement of suitable IT systems, supervise the implementation ofthe selected system and organize a training for the UHE staff.

The design phase of the MIS is expected to span over a two-year period. Technical assistance estimated to cost about US$0.3 million will cover design, procurement and implementation of MIS. The consultants will first design an appropriate MIS for UHE, prepare the specifications and tender documents and assist UHE in the procurement of the necessary IT systems. The design scope includes both hardware and software and any required customization. Subsequently, the consultants will also assist UHE in supervision of the implementation of the MIS and in training ofUHE staff.

Institutional development in UHE would also include provision of technical assistance in capacity building in procurement and project management, enhancing dam safety, optimal scheduling of the multi-purpose cascade of hydropower plants, revaluation ofUHE’s assets and auditing ofproject and company financial statements.

Project Component D: Implementation of the Energy Sector Reform and Development Program. One of the main project objectives is to help the Ministry of Fuel and Energy in establishing longer-term development priorities and sector policies based on sound technical, economic, social and environmental principles. The initial funding for preparing the Energy Program was provided by the Government of Japan through the $670,000 PHRD Grant, which was signed in November 2004. The Grant provides funding for the PWG which includes (i) program coordinator; (ii)financial management specialist; (iii)power sector specialist; (iv) gas sector specialist; and (v) coal sector specialist. The core PWG team may be expanded, as needed, by international experts on specific legal, economic, environmental and engineering

47 issues. The PWG, and other consultants which may assist the Government, will help MFE develop: (i)an action plan for legal and technical harmonization of the Ukraine energy market with the EU Internal Energy Market; and (ii)a program of priority investments in energy infrastructure. Specific investment loans, such as the proposed Hydropower Rehabilitation Project, will continue to support institutional development ofMFE through funding ofPWG and other technical assistance needed in preparing and implementing the proposed Energy Program.

Project Component E: Implementation of the WEM Concept. NERC is a lead member ofan Inter-Agency Commission (IAC) which is implementing the new Wholesale Electricity Market (WEM) concept based on an action plan approved by the Cabinet ofMinisters on June 15,2004. The on-going technical support (funded by PPIAF and managed by the Bank) helped NERC, inter alia, define implementation stages of the WEM concept in terms ofkey steps; sequencing; organizational responsibility; and technical assistance needs. The Table 10 summarizes technical assistance needs related to the following three phases in implementing the WEM concept: (1) clarifying market design and main principles of market operations; (2) drafting of main codes and rules, and (3) specification and implementation of supporting tools such as software, telecommunications systems and metering. Table 10. Key Steps, responsibilities and TA needs in implementing WEM

TA Step Comments Agency Task I 1 1 needs I 1 Clarify industry Any changes in the ownership structure MFE structure or unbundling needs to be clarified; e.g. the dominant role ofNJSC is a significant factor in market design i-I Finalise the principles ofhow the market NERC 5 will work, participants, market opening steps, interaction between the two markets 3 Eligibility analysis Ifprices to ECs in the administered NERC, 2 market (pool) are below cost, the MFE competitive market will not open. Need an analysis ofreal costs ofsupplying the large customers 4 Market rules Define the detailed operation ofthe NERC 4 market, e.g. pricing, settlement, information flows Revisions to primary Following development ofthe market MFE, 3 legislation rules, changes may be necessary in NERC electricity or other primary legislation Simulation model of Develop model for simulating new NERC, 2 new market market trading arrangements, to examine EM, TSO price impacts and to assist with training participants 7 1 Commercial code (Balancing and settlement code) 1 NERC I 6 I Grid code Needs to be consistent with commercial TSO, 7 "[ code, includes scheduling code, dispatch NERC

48 code, metering code, communication standards 9 Distribution codes and NERC, 4 access agreement Obl, TSO 10 Distribution network Tariffs for ECs connected to the NERC 3 pricing distribution network, or for embedded generators

~ ~ ~~ ~ ~ ~ ~ ~~ 11 Transmission pricing Tariff regulation for use of system NERC 5 12 Revaluation ofassets Methodology for asset revaluation in NERC. 10 ofpower companies power companies subject to NERC’s Obl, TSO, regulation GenCos 13 Transmission access Draft contract for third party access NERC. 3 agreement TSO 14 Connection agreements Tariffs and rules for connecting to the NERC 2 networks (could be part of9-13) 15 Ancillary services Tariffs and rules for procuring ancillary NERC, 4 agreements services, to be consistent with 8 TSO 16 Standard bilateral Model or template contracts EM 2 contracts 17 Supplier of last resort Specify who takes over supply if NERC 1 rules competitive supplierigenerator fails 18 Allocation ofinitial Allocation of generation capacity to each MFE 2 contracts market

~ 19 Credit rules Credit guarantee rules for the balancing EM market

~ ~ 20 Consultation exercises Communication and participation in consultation meetings with wider group ofstakeholders, and public INERC 21 Specifications for Required systems by SO and EM TSO, EM software and hardware systems l4 22 Hardware requirements Load Frequency Control and Automatic Gencos, for generators Generation Control I TSO,EM, I2 23 Hardware, software Systems required by Oblenergos requirements for Discos 24 Market registration Meter registration, contract registration, NERC, participant registration rules EM, TSO l2 25 Upgrade metering and Ensure that all market participants have TSO, MFE 3 telecoms necessary commercial standard meters and telecommunications facilities to comply with market requirements 26 Trading system Develop the software to run the software balancing market trading system 27 Financial settlement Develophmplement the software for svstem software financial settlement of imbalances Total staff-months I I I 90

49 The sequencing ofthe above implementation steps is shown in Figure 4.

Figure 4. Sequencing of WEM implementation steps

Clarify industry structure Market design Eligibility rules Detailed market rules l Revisions to primary legislation Simulation model of new market Commercial code Grid code Distribution codes Distribution network pricing Transmission pricing Transmission access agreement Connection agreements Ancillary services agreements Standard bilateral contracts Supplier of last resort rules Allocation of initial contracts Credit rules Consultation exercises Specifications for systems Hardware specs for gencos Hardware, software for discos Market registrartion systems Upgrade metering, telecoms Software for trading system Settlement systems, financial

Phases > 1 2

50 Annex 5: Project Costs UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

Table 11. Cost Estimates for Hydropower Rehabilitation Project (2006 - 2011)

Estimated Project Cost Foreign r------Project Component US$ million as YOof Total Local Foreign Total cost A.l Rehabilitation ofgenerating units 137.8 28.6 166.4 17% Generator circuit breakers Unit controls and diagnostics Turbines Generators Power Transformers A.2 Modernization ofplant systems 7.3 22.3 29.6 75% SCADA and protective relaying Telecommunications Plant auxiliaries A.3 Rehabilitation of switchyards 2.5 9.1 11.6 78% Circuit breakers Disconnect switches Surge arresters Measurement transformers B. Damsafety 4.1 2.6 6.7 39% Monitoring system Hydro-mechanical equipment C. UHE Institutional development 0.5 6.6 7.1 93% Management Information System 2.6 2.6 Technical assistance 0.5 4.0 4.5 D. MFE Institutional development 1.o 1.5 2.5 60% E. Imdementation of WEM conceut 1.o 2.0 3.0 67% 154.2 72.7 226.9 32% 10.8 6.4 17.2 3 7% 47.8 5.1 52.9 10% 49.0 15.8 64.8 24% 261.8 100.0 361.8 28% 12.2 12.2 100% 0.5 0.5 100% 261.8 112.7 374.5 30% Note: IDC includes commitment fee

Detailed cost estimates are shown in Attachment 5-1.

51 I I I I I I I I Annex 6: Implementation Arrangements UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

Energy Sector Reform and Development Program

The key policy and institutional elements of the proposed Energy Program have been defined and established by the Government of Ukraine in partnership with the World Bank and in close cooperation with the European Commission and other donors. The program has a strong country commitment and a well established coordination mechanism shown in Attachment 6-1. At the level of Cabinet of Ministers, the program coordination is performed by the Commission for Energy Sector Reform and Development3*. The Commission has two main tasks: (i)to review, approve and update conceptual plan for legal and technical harmonization ofthe Ukraine energy sector with the EU Internal Energy Market; and (ii)to coordinate and supervise implementation of the conceptual plan, including review and approval of changes in the legal and regulatory framework, prioritization of investments in energy infrastructure and identification of priority programs of technical assistance. The Commission is supported by the Permanent Working Group (PWG) for preparation and implementation of the Energy Program. PWG is established in the Ministry of Fuel and Energy and acts as the secretariat of the Commission for Energy Sector Reform and Development. Initially, PWG is funded by the PHRD Grant39provided by the Government of Japan, which will be rolled over to the technical assistance component of the Hydropower Rehabilitation Project. The main tasks of PWG include: (i)developing an action plan for legal and technical harmonization of energy market in Ukraine with the EU Internal Energy Market, including regulatory requirements for electricity and gas markets, environmental requirements, regulation of cross-border trade and monitoring and evaluation program; (ii)developing a program of priority investments in energy infrastructure; (iii)identifying technical assistance needs and preparing proposals for donors support in the energy sector; and (iv) assisting the Ministry of Fuel and Energy and other Government agencies in preparing and coordinating implementation of specific investment projects supported by the Bank, such as the Hydropower Rehabilitation Project. Hydropower Rehabilitation Project

The implementation of the Parts A, B and C of the proposed Hydropower Rehabilitation Project will be responsibility of UHE (the Loan Beneficiary) which was formed through a merger of OJSC DniproHydroEnergo (DHE - the beneficiary of the Loan 3865) and OJSC DnisterHydroEnergo in February 2004. The merger did not significantly affect the structure and the staffing ofDHE because it only increased the number ofhydropower plants operated by the company from eight to nine (the total number of employees of UHE is about 2,500). The main

38 The inter-agency commission was established by the Cabinet of Ministers order No.1091 on August 25, 2004. Commission includes high-level representatives of the Ministry of Finance, Ministry of Economy, Ministry of Fuel and Energy, Ministry of Foreign Affairs, State Tax Administration, NERC and Energorinok. 39 The PHRD Grant Agreement was signed by the Government of Ukraine and the World Bank on November 18, 2004.

53 new function assumed by UHE after the merger is that the company now has an overall responsibility for investment planning in the hydropower sub-sector. This function is performed by the department for development and investments. The overall organization of UHE and the responsibilities under the proposed hydropower rehabilitation project are shown in Attachment 6-2.

UHE has experience in all aspects of hydropower development and operations. It utilizes UkrHydroProekt, an engineering firm, for specialized support on a regular basis, including the preparation of the Hydropower Rehabilitation Project. The rehabilitation of hydropower plants will be based on the same engineering and procurement approach which UHE used during the first phase of hydropower rehabilitation which was successfully completed in 2002. However, due to increasing scope of rehabilitation activities included in the next phase, an experienced international consultant will be engaged to assist UHE in project management, scheduling, procurement and contract management. The process to select the consultants is currently underway.

Due to its large size, the proposed project practically include the entire investment program of UHE over the next 6 years. This requires a strong support from all parts of the company and, as shown in Attachment 6-2, a project unit (section) has been established in each department to provide necessary technical support in implementing the project. The department for reconstruction and hydropower production has been be reorganized and strengthened to lead all engineering activities. Furthermore it will coordinate project implementation units which will be established at each plant. The overall management responsibility will be with the President of UHE who will be assisted by (i)procurement unit; (ii)financial management unit; and (iii) project management consultants to be hired under the technical assistance component of the proposed loan.

The procurement unit (PU) will be responsible for procurement scheduling, preparation of bidding documents, contract management, reporting and other aspects ofproj ect implementation which require technical coordination of various project activities. The financial management unit (FMU) will be responsible for financial management and disbursement under the project. PU and FMU will be integral parts of UHE and will consist of staff whose regular responsibilities include the investment planning and financial management in the company. PU and FMU will be headed by Deputy Project Mangers (DPMs) who will report to the President of UHE. The selection ofan international proiect management consultant under Terms ofReference acceptable to the Bank is a condition ofloan effectiveness.

UHE has prepared and will implement an Environmental Management Plan for the project. It will also continue to carry out a dam safety program outlined in Annex 10.

PWG established in the Ministry of Fuel and Energy (see Attachment 6-1) will provide an overall reporting on all program activities, including the implementation of the Hydropower Rehabilitation Project. Therefore, PWG will periodically collect and integrate implementation progress reports prepared by the project implementing agencies in accordance with reporting requirements to be established under the Loan Agreement and accompanying project documentation. Furthermore, PWG will be responsible for all implementation arrangements

54 under the Part D of the Hydropower Rehabilitation Project. It is expected that procurement and financial management specialists hired by MFE for the implementation of the PHRD Grant will continue to provide these services for the implementation of MFE institutional development component ofthe Hydropower Rehabilitation Project.

The implementation of the WEM concept (Part E of the Hydropower Rehabilitation Project) is the responsibility ofNERC. Since its establishment in 1994, NERC has steadily built its capacity for implementation of TA projects. It regularly hires and manages local and international consultants funded by donors, IFIs and its own funds. Therefore, NERC will rely on its existing organizational structure to implement the Part D ofthe Hydropower Rehabilitation Project.

UHE will monitor and evaluate on an ongoing basis the carrying out of the Parts A, B and C of the project and the achievement ofthe objectives, and will submit to the Bank, at the end of each calendar year, annual progress reports. UHE will also prepare and furnish to the Bank, by September 30, 2008, a mid-term review report integrating the results of the monitoring and evaluation activities. UHE will review the mid-term report with the Bank, by December 31, 2008, and will take all measures required to ensure the efficient completion of the Project, based on the conclusions and recommendations ofthe mid-term review.

MFE and NERC will monitor and evaluate on an on-going basis the implementation ofthe Parts D and E of the project, respectively. MFE and NERC will submit to the Bank annual progress reports (at the end of each calendar year) on the achievement of the objectives of the Energy Program, including the implementation of the WEM concept. MFE and NERC will also prepare and furnish to the Bank, by September 30, 2008, a mid-term review report integrating the results of the monitoring and evaluation activities. MFE and NERC will review the mid-term report with the Bank, by December 31, 2008, and will take all measures required to ensure the efficient completion of the Project, based on the conclusions and recommendations of the mid-term review.

Implementation schedule. According to the draft implementation plan (see Attachement 6-l), the project will be implemented over a period of 6 years and is expected to be completed by December 31, 2011. The replacement of turbine runners and governors and refurbishment of generators is on the critical path of the project implementation. The installation of new monitoring and control equipment (at three hierarchical levels - unit, plant and the cascade) is also a challenging task which will require close coordination with other project components. Rehabilitation of plant switchyards and expansion of dam safety monitoring system is expected to proceed without difficulties since it is not critically related to other project components.

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* h N Annex 7: Financial Management and Disbursement Arrangements UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

1. Financial Management Assessment Summary

Country Financial Management Issues

The 2001 Country Financial Accountability Assessment (CFAA) for Ukraine confirms that improvement is required in the management of public expenditures, especially for the strengthening of internal and external audits. Accordingly, the audits of the entity and project financial statements would be conducted by acceptable private sector auditors acceptable to the Bank. The CFAA also identified a lack of adequate control over state owned enterprises, but appropriate steps have been taken recently to improve the control over these enterprises. UHE would be subject to regular internal and external Government and energy sector regulatory control, and it has been involved in the successful implementation of previous Bank’s financed project.

Implementing entities

A focal point ofthe program coordination and implementation mechanism is the Commission for Energy Sector Reform and Development, which is supported by the Permanent Working Group (PWG). It is expected that the PWG would provide centralized project implementation monitoring and will prepare consolidated FMRs for the project. The projects would be implemented by the implementing entities: UHE, MFE, and NERC, which will implement their respective project components independently. UHE has established Project Implementation Unit (PIU) through a reorganization and creation of project implementation sections in all main departments, as shown in Attachment 6-2. MFE and NERC will function as PIUs for Parts D and E, respectively, by using their existing organizational model and staff whose regular responsibilities include the implementation oftechnical assistance projects. In UHE, the existing financial management system of the entity would be used for this project. MFE and NERC would rely on the country normal financial management arrangements for project implementation. MFE and NERC will prepare financial reports with the support of the financial consultant from the PWG.

Strength and weaknesses The strengths of UHE that provide a basis of reliance on its financial management system include: (i)the experience of UHE and its finance staff in implementing Bank-financed project; and (ii)the assessed strengths ofthe financial management system ofthe UHE. Although MFE and NERC are familiar with the project and energy sector, they have not finalized their implementation arrangements for the projects. Both agencies have no prior experiences with Bank’s financed projects. Both MFE and NERC would be relying on the

59 country normal financial management arrangements. It is expected both agencies would need some capacity building and support in financial management, especially with regards to World Bank’s policies and procedures. However both agencies will receive support from the procurement and financial management consultants in the Permanent Working Group (P WG) within the MFE.

Funds flow The MOF, as the borrower, will control all loan funds. Because there are three implementing entities, there will be three separate special accounts. UHE will open a special account in a commercial bank acceptable to the World Bank. This account will be used for loan funds processing and will be under control of the MOF and the UHE’s management. Nevertheless, it is expected that major part of the project money would be disbursed through the direct payments as most of the contracts under the Components A, ByC are high value and are using ICB tendering procedures. It is expected that fund flow scheme under the Component D (MFE) and Component E (NECR) will use two separate Special Accounts, which are to be opened in the commercial banks acceptable to the Bank. These accounts will be used for loan funds processing and will be under control ofthe MOF and the management ofthe two implementing agencies. There are two sources ofcounterpart financing under the project: the financing from UHE’s own sources and state budget financing from the MFE and NERC. There will be no separate accounts for counterpart financing.

Staffing Components A, B and C of the project will be implemented by the employees of the UHE. Formally, UHE assigned responsible employees to deal with project financial management issues (including disbursement and reporting), and all accounting, budgeting and reporting for UHE’s needs will be managed within the existing financial system. The UHE’s financial management structure and financial management staff are adequate for the project implementation. Additional training on project financial management and disbursement arrangements would be necessary.

Both MFE and NERC appointed regular financial staff from their entities to work on financial management matters of this project. These staff would need support and additional training. They will be supported by the PWG, which will have procurement and financial consultants. MFE has hired a financial consultant in the PWG who will provide technical support to MFE and NERC on financial management matters, including support in disbursement arrangements, preparation of consolidated FMRs for all components, and responsibility for audit arrangements for components D and E. The financial consultant will be financed by PHRD grant initially, and will be financed by the project subsequently.

Accounting Policies and Procedures There will be no centralized accounting for the project. Accounting functions would be performed by each implementing agencies separately, in accordance with the accounting standards applied in those entities.

60 UHE uses the current national accounting standards as the basis for its accounting policies and for the establishment of accounting procedures for main type oftransactions. Loan funds will be accounted both under local accounting standards and under IFRS. IFRS statements based on IAS, will be prepared annually for the ISA audit. UHE will prepare regular Financial Monitoring Reports (FMRs) for the components which are implemented by the Company. The UHE’s FMRs will be combined with reports for other components in consolidated FMRs for the project, to be done by the PWG. The PWG will prepare a financial manual to be used by the project. MFE and NERC will rely on the accounting policies, procedures, regulations and controls of the State Treasury. Reporting for the components under this project will also follow the Cabinet of Ministers regulations and State Treasury regulations which cover accounting and reporting formats in case of donors’ funds receipt. Both entities will also prepare FMRs, with the assistance from the PWG, in the simple format to reflect funds inflow and outflow. Based on the separate FMRs, the PWG will prepare consolidated quarterly FMRs for all components.

Planning and budgeting UHE has a budget unit within the “Financial and Economic” department. This group is responsible for preparation of the Company budget, its monitoring and analysis as well as the budget for the components under the project. Company Budget system allows keeping budgets in physical and monetary units. The budging function is one of the most important functions in the Company. It is considered that such budgets are sufficient in content and in format for project cost planning and monitoring. MFE and NERC run their planning and budgeting functions according to the State Budget regulations. Cash management and cash planning follow the regulations of the State Treasury, which require monthly projections forecast. MFE and NERC would be required to include project funds in the State Budget and would provide supporting documentation, projections and procurement plans. It is planned that the PWG would support both entities in expenditure planning under the project, based on the procurement plans. MFE and NERC will provide monthly financial reports, including cash forecast statement, to the MOF.

Reporting and monitoring The accounting for the project is cash basis with additional information provided for commitments on signed contracts. The project, through the PWG, will prepare quarterly consolidated financial monitoring reports (FMRs) for the Bank throughout the life of the project. All three entities will provide separate FMRs, for their respective components, to the PWG for consolidation. Sample FMR formats have been prepared and will be agreed upon during negotiations. The FMRs will include the following areas: (a) Financial Reports (b) Project Progress Reports; and (c) Procurement Management Reports. These financial reports will be submitted to the Bank within 45 days of the end of each quarter. The first quarterly FMRs will be submitted at the end ofthe first quarter in which disbursements commence.

61 Information system It is not planned to have separate accounting systems for the project needs. Accounting and reporting will be provided within the existing accounting and reporting programs in the UHE, MFE and NERC. All implementing entities are capable to provide proper accounting within their financial information system, keeping track records and audit evidences. Those systems allow retrieval of necessary information which would allow preparation ofthe FMRs for the project needs. UHE has financial information (accounting) system, which is based on 1-C accounting system. The system is fully sufficient for the project accounting needs as well as it allows tracking information for the project FMRs needs. It is considered that UHE may require more advanced and integrated Financial Management Information System (FMIS) in order to run integrated budgeting, online accounting, cash management and other functions, which are not supported by current system. MFE and NERC will rely on the Treasury system for the payments, accounting and reporting. Because both entities would only need to report on one component and one disbursement category, the treasury system would be able to generate appropriate financial reports.

Impact of procurement arrangements The overall procurement risk and capacity assessment indicates that the project has been rated as high-risk. Initial review of project design suggests that project will have a lot of large value contracts. These contracts will be most probably paid by direct payments, which simplify funds flow controlling and monitoring but requires more attention to the control over counterpart funding in case if taxes to be financed by borrower. Control should also be provided over the assets safeguards, which to be procured and installed at the stations. The perceived risk associated with the project’s financial management arrangements will be mitigated by an increased level ofBank supervision.

Supervision Plan

The project will be part of the risk based supervision model, which is based on the project risk assessment. It is considered that minimum number ofFM supervisions is to be at least once per annum. During project implementation, the Bank will supervise the project’s financial management arrangements in two main ways: (i)review the project’s quarterly financial management reports as well as UHE’s and the project’s annual audited financial statements and auditor’s management letter; and (ii)during the Bank’s supervision missions, review the project’s financial management and disbursement arrangements for all three agencies to ensure compliance with the Bank’s minimum requirements. A Bank-accredited Financial Management Specialist will assist in the supervision process.

2. Audit Arrangements

Internal audit

62 Although UHE has an internal controlling and revision department, and the head of the department is reporting to the Chairman of the Board of Directors. The project will not rely on the internal audit as there is inadequate capacity.

External audit There will be two audits under this project, including: (a) the audit ofUHE’s financial statements which include adequate disclosure of the information related to the project funds for component A, B and C; and (b) the audit of the consolidated project financial statements for component D and E. The UHE’s entity financial statements would be prepared using IFRS and audited according to ISA. The project financial statements, using cash accounting, for Components D and E would be audited separately. It was confirmed that the UHE’s entity financial statements will incorporate information ofthe components A, B and C by including additional footnotes on these components, which were agreed with the Borrower during the negotiations. The UHE’s entity audited financial statements will continue to be acceptable only if the following conditions continue to be met: o the entity financial statements are prepared in accordance with IFRS; o the entity has an acceptable independent auditor in place; and o the entity audits are conducted in accordance with International Standards on Auditing. Terms of reference for both audits have been agreed during the negotiation. Both audits will be conducted by the independent private auditors, accepted by the Bank, according to the acceptable terms of reference. The annual audited financial statements will be provided to the Bank within six months after the end of each fiscal year. The contract for the audit awarded during the first year ofproject implementation and thereafter extended from year-to-year with the same auditor, subject to satisfactory performance. The cost ofthe audits may be financed from the proceeds of the loan.

3. Disbursement Arrangements

Allocation of loan proceeds is shown in the Table 12:

Table 12. Allocation of Loan Proceeds

Expenditure Category Amount in US$ million Financing Percentage 1. Goods (including installation) 90.00 100% of foreign expenditures, 100% of local expenditures (ex- factory cost) and 80% oflocal expenditures for other items procured locally. 2. TA: Consulting Services 10.00 100% 3. Unallocated Amount 5.47

Total Project Costs with Bank 105.47 Financing Front-end fee 0.53

63 Use of Statements of Expenditure (SOEs): Bank funds would be disbursed under the Bank’s transactional procedures including SOEs and direct payments. Supporting documentation for SOEs including completion reports and certificates would be retained by the Borrower and made available to the Bank during project supervision. Disbursements for expenditures above the SOE thresholds would be made on the basis ofthe presentation of full documentation relating to those expenditures. All disbursements would be made on the basis of full documentation for (a) contracts for goods costing more than the equivalent ofUS$200,000 each; and (c) services under contracts ofmore than the equivalent of US$200,000 for each consulting firm and more than the equivalent of US$lOO,OOO each for individual consultants. Disbursements below these thresholds, and all contracts for training and study tours, would be made according to certified Statement of Expenditure (SOEs). This documentation would be retained by the MFE, NERC and UHE for at least one year after receipt by the World Bank of the audit report for the year in which the last disbursement was made. Disbursements for expenditures above the SOE thresholds would be made against presentation of full documentation relating to those expenditures.

Special Account: For the purposes of the project, three Special Accounts (SAs) would be opened and managed in commercial banks acceptable to the World Bank, including appropriate protection against set- off, seizure and attachment, in the case of a commercial bank. The first signatures would be delegated to the Deputy Minister ofthe MFE, representative ofthe MOF, and second signatures would be delegated to the Chief Accountant ofthe MFE and NERC and CEO/CFO ofthe UHE. Replenishment for the SA would follow IBRD procedures. The MFE, NERC and UHE would submit a replenishment application monthly, or sooner if desired, but quarterly at the latest. A bank statement and reconciliation of the SA against World Bank records would support the replenishment applications. The minimum amount for applying for direct payment and for special commitment would be 20 percent ofthe authorized allocation to the SA. MFE. The initial allocation to this SA for the Component D would be limited to US$ 500,000. The Authorized Allocation shall be limited to an amount equivalent to US$ 250,000 until the aggregated amount of withdrawals from the Account plus the total amount of all outstanding special commitments are equal to or exceed the equivalent ofUS$ 1.O million. NERC. The initial allocation to this SA for the Component E would be limited to US$ 500,000. The Authorized Allocation shall be limited to an amount equivalent to US$ 250,000 until the aggregated amount of withdrawals from the Account plus the total amount of all outstanding special commitments are equal to or exceed the equivalent ofUS$ 1.O million. Ukhydroenegro Company (UHE). The initial allocation to this SA for the Component A, B and C would be limited to US$ 1.0 million. The Authorized Allocation shall be limited to an amount equivalent to US$ 0.5 million until the aggregated amount of withdrawals from the Account plus the total amount of all outstanding special commitments are equal to or exceed the equivalent ofUS$3.0 million.

64 Annex 8: Procurement Arrangements UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

General

Procurement for the proposed project would be camed out in accordance with the World Bank's "Guidelines: Procurement under IBRD Loans and IBRD Loans" dated May 2004; and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" dated May 2004, and the provisions stipulated in the Legal Agreement. For each contract to be financed by the Loan, the different procurement methods or consultant selection methods, the need for prequalification, and time fi-ame are agreed between the Borrower and the Bank project team in the Procurement Plan in Table 13. The Procurement Plan would be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. Other procurement information, including IBRD's review process etc. is presented in Table 14.

1. Procurement of Goods and Technical Services

Procurement of Goods: Goods procured under this project would include: electrical and mechanical equipment for use in power generating stations. Information and control technology and dam safety equipment.

- International Competitive Bidding (ICB) procedures would be used for contracts above US$200,000 equivalent. In the comparison of bids for goods procured through ICB, a domestic preference would apply in accordance with the provisions of the Procurement Guidelines. Bid documentation for ICB would be prepared in accordance with the latest applicable Bank Standard Bidding Document (SBD) for the Procurement of Goods or Supply and Installation ofPlant and Equipment (S&I), single or two stage as appropriate. Prequalification shall be undertaken where justified for large S&I contracts using the latest applicable Bank Standard Prequalification document and procedures.

- National Competitive Bidding (NCB). Contracts for the procurement of goods that are estimated to cost less than US$200,000 equivalent per package may be procured in accordance with NCB procedures subject to the prior agreement ofthe Bank. The ECA regional Standard Bidding Documents (SBD) for NCB Goods would be used and the conditions applicable for conducting NCB procurement as agreed with the Bank would be followed.

- Shopping procedure would be used for off-the-shelf goods estimated to cost less than US$lOO,OOO per contract. Shopping, which requires to obtain three quotations, is used here because more competitive methods are not justified on the basis of cost or efficiency. The ECA Regional sample format for shopping "Invitation to Quote" would be used.

65 - Direct Contracting (DC): would be used to finance the procurement of proprietary equipment and software after prior consultation and agreement with IBRD.

2. Procurement of Works

Procurement of civil works will be undertaken by the Borrower using local procurement procedures. Such procurement will not be financed by the Bank.

3. Selection of Consulting Services and Training

Consulting services are required for project management, procurement and auditing assignments. The procurement will be carried out using the latest published version of Bank’s RFP for all QCBS and for other procurement methods such procedures and documents as are agreed with the Bank.

Contracts shall be packaged for consulting and training services required from firms and individuals. Short lists of consultants for services estimated to cost less than $200,000 equivalent per contract may be composed entirely ofnational consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. The following methods of procurement would be followed:

- Quality and Cost-based Selection (QCBS) procedures would be used for contracting consultant services for contracts estimated to cost over US$200,000. As an alternative, Fixed Budget Selection and Quality Based selection may also be used where this is included in the Procurement Plan.

- Consultant Qualification (CQ) procedures would be used for contracting consulting and training services with the most qualified firms from a shortlist of firms expressing interests for contracts estimated under US$200,000.

- Least Cost Selection (LCS) procedures may be used for contracting the financial audit services. The shortlist shall consist offirms acceptable for Bank financed projects.

- Individual Consultants (IC) would be hired in accordance with Section V of the Guidelines. Individual consultants would be hired for small assignments of short-term duration for consulting services to meet the requirements ofthe proposed IBRD Loan.

- Single Source (for firms)/sole source (for IC) procedures would be used for contracting the consulting and training services following the procurement plan after prior consultation and agreement with IBRD.

- Expenses for the study tours and training related to the project would be disbursed based on SOE. Training and seminars will be procured directly from the service provider subject to the Bank’s agreement to the course content; list ofparticipants and budget.

5. Notification of Business Opportunities

66 A General Procurement Notice (GPN) would be published in the UN "Development Business" on -line (UNDBonline) and in the Development Gateway's dgMarket at the tiem of appraisal. For ICB goods contracts and large-value consultants contracts (more than US$200,000), Specific Procurement Notice would be advertised in the Development Business on-line (UNDBonline) and in the Development Gateway's dgMarket and national press, and in the case of NCB, in a major local newspaper (in the national language).

6. Review by the IBRD of Procurement Plan

The Borrower has developed a Procurement Plan for project implementation. The plan provided by the Borrower is shown in Table A. Procurement ofgoods, works and services for the project would be carried out in accordance with the agreed procurement plan, which would be updated in agreement with the Project Team annually or as required to reflect the actual project implementation needs and improvements in institutional capacity.

7. Prior Review

The following contracts will be subject to the Bank's prior review and no objection prior to signature:

- Goods: Prior review of bidding documents, including review of evaluation, recommendation of award and contract would be conducted for all contracts over US$200,000, all ICB and DC and first NCB and first shopping contracts, if used.

- Consulting Services and training: Requests for Proposal (RFP), short lists, terms of condition ofcontracts as well as evaluation reports and recommendation for award would be prior reviewed by IBRD for contracts for individual consultants above USD100,OOO and for firms above USD200,OOO. All documents and recommendations involving single source selection would be subject to IBRD prior review. Terms of reference for consulting assignments and training may be reviewed and cleared by the Task Team Leader.

After award ofcontracts, should any material modifications or waiver ofterms and conditions of a contract resulting in an increase or decrease above 15 percent of the original amount, IBRD would undertake a prior review of such modifications (including modifications to contracts for consulting services).

8. Borrower's procurement

The project envisages several contracts that would be placed directly by the UHE using its own budget funds and in accordance with its own rules and procedures (see section 9 below). This includes single source contracting for refurbishment and replacement ofcomponents essential for the project from its existing long-standing local sources, for standardization purposes. These include the following contracts:

67 Turbines: Turboatom Generators: Elektrotezhmash Transformers: Zaporizhe Transformatorski Zavod

UHE will provide details ofprevious supply contracts for these items, with contract prices, to the Bank for its review in order to determine that the pricing structures are reasonable, considering that the contracts include refurbishment of existing units. Contracts for single source contracts should as a minimum include detail on contract terms including payment, inspection, delivery, force majeure, contract language, liquidated damages, responsibilities of the parties, arbitration and guarantee period.

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

Procurement activities will be carried out by the Borrower, UkrHydroEnergo (WE), which will be staffed by a sufficient number of skilled personnel to satisfactorily implement the project. A Project Management and Procurement Consultant will be appointed to provide advice and training on working with Bank’s procedures. A Procurement Manual will be prepared which will include, in addition to the procurement procedures, reference to the SBDs to be used for each procurement method. The project will provide for procurement training.

An assessment of the capacity of the Implementing Agency to implement procurement actions for the project has been carried out. The assessment reviewed the organizational structure for implementing the project and the experience ofUHE in similar contracts.

The first stage of Hydropower Rehabilitation and System Control Project (IBRD 3865-UA) was implemented during September 1995- June 2002. It was one of the first investment loans to Ukraine. At that time, the Public Procurement System was not in place and the company had no experience in competitive procurement procedures. A Canadian firm (Hydro Quebec International) provided project management and procurement services. Only the two last ICBs were managed solely by the company staff.

Currently the company has a tender committee and procurement is undertaken according to Order #1455 dated December 25, 2002 of the National Commission for Regulation of Electric Energy in Ukraine. The provisions ofthis order are mainly based on the provisions ofthe Public Procurement Law. The company undertakes about 10 open tenders (equivalent ofNCB) per year and a number of procurement according to request for quotations, mainly for works (equivalent to Minor Works).

Two departments will be involved in the process of bidding documents preparation and project implementation. The technical part will be handled by the Department of Reconstruction and Production and the commercial/financial part by the Department of Finance and Economy. Different ‘sectors’ (groups of 2-6 employees) within the Departments will be responsible for different contracts, depending upon the specialization. None of the UHE staff can work in English and relies upon 3 professional translators. They will translate bidding documents and correspondence the company intends to hire more translators, as needed. UHE were encouraged to seek some experienced English speaking staff that would be able to directly assist with bid document preparation, interface with contractors and importantly check the translations before

68 issue. It was made clear to UHE that the Bank cannot accept sub-standard English language documents and that this was a potential source of project delays. The tender documents will be also reviewed by an Expert Group consisting of the Heads of Departments and extemal experts (about 8 people). The Expert Group comes under the control of the Managing Director. After this, the documents will be submitted for Bank's no-objection and the comments, if any, will be taken into account according to Departments' recommendations.

The Country Procurement Assessment Report (CPAR) completed in 2001 indicates that projects should be rated "High" risk based on the then assessment of the country's national procurement system. The staff of UHE has little experience of carrying out procurement under international tenders, most oftheir larger contracts being sole source with monopolist Ukrainian producers.

Based on assessment ofthe capacity for procurement administration ofthe Project, the following Action Plan to strengthen the procurement administration capacity of the UHE is recommended:

- UHE procurement staff would be given the opportunity to attend intensive procurement training in Russian language, such as the one offered by ILO in Turin. - Consulting services of an individual consultant to assist with tender document preparation should be provided under the separate PHRD Grant. - Consulting Services of a Project Management and Procurement Consultant (firm) to assist with the implementation and management ofthe project is included in the Loan. - Initiating a Project Launch Workshop before the loan effectiveness, as part of the project implementatiodcapacity building initiatives, especially in procurement. This to be supplemented by further training for management and members ofthe Tender Committee ofthe UHE in Bank procurement procedures. - The project would be subject to supervision by the Bank and support from the Kyiv Office. During each of the first two years ofproject implementation, there would be at least two supervisions.

10. Re-assessment of agency's procurement capacity and use of country systems.

A revised CPAR will be prepared in 2005. This will focus on assessment of the Public Procurement Law (PPL), regulations, procedures and practices with a view to eventual certification for use of country systems under World Bank financed projects. This is not expected to have an impact on this project due to the large value of the proposed contracts and the fact that all equipment covered by the Loan is in any case imported.

Currently, use of country systems is not recommended for World Bank financed projects due to the following fundamental issues:

- Lack ofin-country training capacity and therefore capacity ofprocurement staff - lack ofstandard bidding documents for any form ofprocurement - lack ofrecognition ofconsultancy services in the PPL - lack ofclear written procedures for tendering, evaluation and contracting - lack ofstandard contract forms

69 - overuse of restrictions, exemptions and exceptions in the PPL restricting openness of tendering procedure - unrestricted use of merit points with no pre-defined allocation leads to ineffective, un- transparent and costly procurement - Lack of status ofthe Public Procurement Department

The Government of Ukraine is addressing most of these issues with the assistance of the Bank and is in the process ofpreparation ofa development strategy to be agreed with the Bank.

Overall Procurement Risk Assessment: High

Table 13. Procurement arrangement involving International competitive bidding

Estimate Expected Ref. Contract Procurement Domestic Review by Bid No. (Description) Method P-Q Preference Bank (US$m) Opening 1 2 3 4 5 6 7 8

1 Generator Circuit 12 8 ICB NO NO PRIOR 15-Jul-05 Breakers

2 Speed Governors 8.1 ICB NO NO PRIOR 16-Jul-05

3 Static Excitation 20 0 ICB NO NO PRIOR 17-Jul-05 Systems 4 Diagnostics 87 S& 1 YES NO PRIOR 30-Sep-05

5 SCADAIEMS, 20.4 S& 1 YES NO PRIOR 15-NOV-06

70 High Voltage 0.7 I ICB NO NO PRIOR 20-Oct-05 Surge Arresters

14 High Voltage 2.5 ICB NO NO PRIOR 25-Oct-05 Disconnect and Earthing Switches

15 High Voltage 3.6 ICB NO NO PRIOR 30-Oct-05 Current and Voltage Measuring Transformers 16 Dam Safety 8.2 S& 1 YES NO PRIOR 30-Sep-05 equipment 17 Management S& 1 YES NO PRIOR 6 -Dec - 05 Information 4.1 System I I TOTAL 119.3 2 Consul1 (a) List of Consulting Assignments with short-lists including international firms. Estimated Expected Selection Method S$m 4 QCBS Project Management Consultant IC PRIOR assistance for dam safety component Technical 0.4 QCBS PRIOR assistance for MIS

0.3 QCBS PRIOR revaluation

Audit of project LCS and company accounts in UHE IC/ CQ PRIOR assistance to MFE

Technical 3.0 IC/ CQ PRIOR assistance to

I I TOTAL I 10.00 PRIOR I I

71 Annex 9: Economic and Financial Analysis UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

A. Economic analysis

The economic evaluation ofthe proposed Hydropower Rehabilitation Project was carried out by comparison of ‘with and without rehabilitation’ scenarios. The economic investment cost is estimated at a total of $219.5 million disbursed over 2006-201 1. The economic investment cost does not include the cost ofdam safety, institutional development (MIS) and technical assistance for which no direct economic benefit can be assigned. The economic investment cost includes physical contingencies but does not include price contingencies, taxes and duties. The project economic benefits have been assessed under the following five categories:

- Increase in hydroelectric production ofabout 360 GWh per year (by 2012) due to:

> Improved efficiency of the generating eauipment. This is primarily the result of the replacement of turbine runners, refurbishment of generators, replacement of unit control systems and the main unit transformers which are all ofmore modem design. The replacements also provide as-new performance in contrast to the significantly poorer performance from the old units (typically the units replaced are over 40 years old). As a result, with the same water flow, energy production is increased on average by about 2 to 8%, and > Improved plant management and control. The application of upgraded plant controls and modem management systems (including the optimization of water flow through units, plants and reservoirs) together with related personnel training is expected to increase the amount of energy produced and also to enhance its timing and value relative to power system demands.

- Increase in (winter firm) peaking hydropower capacity ofabout 250 MW (by 2012) due to:

> Increased capacity ofrehabilitated units. The rehabilitated turbines and upgraded generators are expected to increase the installed (maximum) capacity by 10 to 30%. > Improved reliability and availability ofunits and plant. This is largely attributable to the as-new physical condition of the replacement equipment - not only the turbines and generators but also transformers, circuit breakers, switchgear and protection equipment.

- Power Svstem dvnamic benefits. The value of these benefits is difficult to establish without a comprehensive production costing and system dispatch study, covering both the current and the future power system operation. Research within the industry on the dynamic benefits attributable to hydropower plants has yielded a wide range ofvalues, ofthe order of$1 to $20/kW/year. The variation is

72 due to the characteristics of the power system as a whole and to those of the hydropower plant itself. Given the difficulties already evident within the Ukraine system in providing adequate load-following and frequency control a relatively high value of system dynamic benefits could be justified. However, in view of the lack of detailed modeling and system studies, a conservative estimate of$SlkWlyear was adopted.

- Reduced Operation and Maintenance (O&M) Costs. Recent O&M costs were provided by UHE. In total they amount to over $10 million. By international standards these costs are on the low side, probably due to the relatively low cost of labor. The introduction of both new equipment and improved operating systems will lead to a substantial reduction in O&M costs. Staffing levels can be gradually reduced, particularly if the plants ultimately revert to fully automated remote control ofhydroelectric units. The improved instrumentation and monitoring will reduce the number and frequency of outages and the scope of repairs. By introducing modem diagnostic tools in monitoring and on-line evaluation ofunit condition, UHE can implement preventive maintenance techniques which can further reduce maintenance costs. Finally, the as-new major equipment components (turbines, generators, transformers etc.) will reduce the need for and frequency ofmajor overhauls. The cost reduction is estimated to amount to 50% ofthe normal i.e. current cost.

- Environmental Benefits. These are derived from the reduction in polluting emissions attributable to the reduction in electricity generation from thermal power plants replaced by the increased hydroelectric production under the project. Three harmful pollutants have been considered: Sulphur Dioxide (S02), Nitrous Oxide (NOX) and Carbon Dioxide (C02). Data from thermal plants in Ukraine has established representative amounts ofthese emissions. The benefits associated with reducing SO2 and NOX emissions have been valued at the corresponding mitigation costs, based on the results in the (Global Environmental Facility) GEF Klaipeda Geothermal Demonstration Project, Report No. 14614 LT. The benefit ofreducing C02 emissions was based on estimates provided by the Prototype Carbon Fund (PCF). Ukraine is eligible to participate in carbon emissions trade and therefore the Hydropower Rehabilitation Project can directly benefit from reductions in (C02) emissions.

Table 14. Summary Results of Economic Analysis

Discounted Total Investment NPV Benefits EIRR (Yo) B/C Ratio cost US$ million Plant Name US$ million US$ million

Kyiv 25 26 10.5 1 1.03 Kyiv PSP 9 14 17.2 5 1.51 Kaniv 32 35 11.5 3 1.10 Kremenchug 19 33 21.1 14 1.71 Dniprodzerzinsk 22 35 18.5 13 1.59

73 Dniprovska HPP 1 10 29 42.6 19 2.95 Dniprovska HPP2 18 81 79.5 63 4.39 Kahovka 9 17 26.6 8 1.95 Dnister 5 6 13.1 1 1.15 TOTAL UHE 149 275 23.2 126 1.85

The economic analysis was performed in a series of spreadsheets (base case analysis is shown in Attachments 9-1) for each power plant. The investment costs and benefits were discounted over the expected project life (30 years). Table 14 summarizes the project economic viability in terms of its Net Present Value (NPV) in US$ as discounted to 2004 at the 10% discount rate, the Economic Internal Rate ofReturn (EIRR) and the Benefit to Cost (B/C) ratio for each plant and for the whole project.

The above results confirm that the proposed hydropower rehabilitation project has excellent economic characteristics. It is important to note that its energy and capacity benefits ($166 million out of the total discounted benefits of $275 million) alone exceed the economic investment cost. Also, the project is economically robust, as illustrated by the sensitivity analysis which shows that an increase in the investment cost of20% would reduce EIRR to 18%. Furthermore, the switching value for the investment cost (to yield an ERR of 10%) is an increase of 85%. Variations in other key economic parameters (such as fuel price in thermal power plants, discount rate etc.) have even less impact on the project economics.

B. Financial Analysis

Background. UkrHydroEnergo (UHE) State Joint Stock Company was established by Order of the Ministry of Fuel and Energy dated December 3 1, 2003 by merger of DniproHydroEnergo State Joint Stock Company and DnisterHydroEnergo State Joint Stock Company. The State, in the person of the Ministry of Fuel and Energy, is a Founder and single shareholder of the company.

The company operates 8 hydroelectric plants located along the Dnipro River and 1 hydroelectric plant located on the Dnister River, together with an available capacity of 4,600 MW at design head. Production volumes of the hydropower plants are coordinated by UkrEnergo and the electricity generated is sold to the Energomarket. Tariffs are regulated by NERC and are set on a monthly basis in consultation with UHE’s management.

The company is governed by (a) the Superior Body; (b) the Supervisory Board; (c) the Board of Directors; and (d) the Auditing Committee. The Superior Body is the State, represented by the Ministry of Fuel and Energy, and, as a body, is authorized to govern various activities primarily related to changes to the company’s statute, approval of annual business results and audit findings, profit distribution procedure, establishment ofsubsidiaries, branches and representative offices, and liquidation. The Supervisory Board performs control over the Board of Directors with regard to staffing and corporate management, among other things, and consists of 7 members. The Board of Directors, which consists of 11 persons, is an executive body of the

74 company that manages its current operations. The Auditing Committee of 5 members submits audit information to the Superior Body and the Supervisory Board.

On June 22, 2004, by Regulation of the Cabinet of Ministers, a National Joint Stock Company “Energy Company of Ukraine” (ECU) was established, and 100% of the state shares in UHE were transferred into the statutory fund of ECU.

Past and Current Financial Performance. The past financial performance of DniproHydroEnergo and DnisterHydroEnergo for the years 2002-2003, when operating as separate companies, and for UkrHydroEnergo for 200440is shown at the end of this Annex and the financial highlights are shown below in Table 15 and Table 16. The financial highlights show that electricity sales vary considerably from year to year depending on the weather conditions and water inflows into the Dnipro and Dnister Rivers, with electricity sales between 8.85-1 1.09 TWh during 2002-2004. As a result, the average tariff for electricity sold to the Energomarket varies considerably from year to year, with higher average tariffs in years of lower electricity sales (e.g., 3.53 kopekslkWh in 2003) and lower average tariffs in years of higher electricity sales (e.g., 2.97 kopeks/kWh in 2004).

Table 15. Summary Income Statements4’ for DniproHydroEnergo and DnisterHydroEnergo, Separate and Combined Operations, and for UkrHydroEnergo for Years Ending December 31,2002-2004 (UAH million)

40 Actual performance for 9 months and estimated performance for the remaining 3 months of2004. 4’ The 2002 and 2003 income statements have been adjusted to exclude revenues from the surcharge for investments in the Dnister Pump Storage Plant and for taxes on the surcharge, which were managed by (former) Dniprohydroenergo on behalf ofthe Dnister Pump Storage Plant, a separate enterprise.

75 2002 2003 2004 Item Dnipro- Dnister- Combined Dnipro- Dnister- Combined UkrHydro- Hydro- Hydro- Operations Hydro- Hydro- Operations Energo Energo Energo Energo Energo Current Assets 301.2 56.6 357.8 335.3 58.4 393.7 410.7

Investmentshong- I 14.5 I 54.5 69.0 I 14.5 I 54.5 69.0 69.0 term Receivable Fixed Assets 916.4 184.0 1,100.4 88 1.2 174.7 1,055.9 1,04 1.6 Current 117.3 8.5 125.8 75.3 3.7 79.0 57.7

Long-term I 202.5 1 19.0 221.5 1 181.9 I 16.5 198.4 180.8 Liabilities Equity 912.3 267.6 1,179.9 973.8 267.4 1,241.2 1,282.8 Current Ratio 2.6 6.7 2.8 4.5 15.8 5.0 7.1 Long-term Debt as % of Equity 22.2 7.1 18.8 18.7 6.2 16.0 14.1

The financial statements show that the combined hydropower company had increasing revenues, with revenues in 2004 of UAH 329.6 million (about $ 62 million) and profits on operations, averaging about 30% of revenues during the three-year period. Except for 2002 when DniproHydroEnergo took an extraordinary expense for the foreign exchange losses on the first World Bank loan which had accumulated over the prior five years, the combined hydropower company eamed profits after taxes. Beginning in 2003, the company has paid dividends to the state on its shareholdings.

Apart from water inflows and tariffs received for electricity sold to the Energomarket, the financial performance of UHE is affected by the payment performance of the Energomarket. The payment performance ofthe Energomarket was highly problematic in the past, with payment levels as low as 30-45% during 1995 and 1996. As of June 2000, cash payments of electricity bills were required to be paid into bank accounts managed by an authorized bank and distributed to market participants according to an algorithm established by NERC. As a result, payment performance has greatly improved during the period 2001-2004, with average payment ratios to UHE of94.8% in 2003 and 94% in 2004, reflecting the general improvement in the economy and electricity market conditions, but still less than full payment performance.

The past poor payment performance of the Energomarket has resulted in a significant level of debts for electricity sold by UHE. The level of trade accounts receivables estimated as of end- 2004 is UAH 357 million or about US$ 67 million (somewhat more than 1 year of revenues). While debts are continuing to build up as long as payments from the Energomarket are less than loo%, the amount of annual debt build-up currently is relatively small. Resolution ofthese past debts will require resolution of the whole chain of debts starting from the consumers to oblenergos and oblenergos to the Energomarket, which would in tum allow the Energomarket to repay UHE, as well as other generators and fuel suppliers.

76 The Government, together with the Parliament, are working on a comprehensive debt resolution plan for the energy sector, for settling debts between the various parties. The plan creates greater transparency conceming the size and structure of the debts and debt overhang, clarifies how much debt is to be written off and mutually offset, identifies the mechanisms for debt write-off and mutual offsets, and allows for debt restructuring and payment through the tariffs for the residual debt obligations. In order for the plan to be fulfilled, a law is needed, particularly given the magnitude of the debts to be resolved. A comprehensive law on debt resolution was submitted to the Parliament (for the second reading) on May 19, 2005, which, when passed, is expected to form the legal basis for carrying out debt resolution schemes. Passage of such legislation is an expected outcome under the World Bank-financed Development Policy Loan (DPL1).

Despite the significant level ofdebts from the Energomarket to UHE, the company has relatively smaller debts to its suppliers and contractors, with trade accounts and other payables estimated at about UAH 41.8 million (about US$ 7.86 million) at end-2004. Taxes payable to the state budget are estimated at about UAH 11.4 million (US$ 2.1 million) at the same time. UHE also has two significant prior borrowings for capital investments - one loan from the World Bank in the amount of US$ 35.2 million and a loan from the Swiss Government in the amount of UAH 59.0 million equivalent.

Another factor affecting the financial performance of UHE is the value of net fixed assets in operation, which isjudged to be substantially below the current replacement value ofthe assets4*. Net fixed assets are estimated at only about UAH 1 billion (about US$ 188 million) according to Ukrainian accounting standards at end-2004 and about UAH 1.25 billion (about US$ 235 million) according to IAS at end-2003. As a result, the proposed project investments appear large because of the low value of net fixed assets. The low fixed asset values result in too low depreciation charges, thereby limiting UHE’s ability to finance needed capital investments. Therefore, it has been agreed during negotiations- that UHE will carry out a proper revaluation of its assets not later than December 31, 2007 in accordance with terms of reference and with the assistance of consultants satisfactow to the Bank. It was also agreed that the revaluation of UHE’s assets will help establish a consistent methodology and a practical approach for the revaluation ofassets ofother power companies regulated by NERC.

Based on today’s tax laws, an increase in the value offixed assets through a revaluation is treated as a realized capital gain43 and is thus subject to a tax liability of 30% on the increase in value. Thus the present tax laws act as a disincentive to companies to revalue their fixed assets as the basis for the depreciation charge. It is therefore recommended that the tax legislation be reviewed to encourage depreciation charges to be based on the replacement costs of fixed assets. The proposed asset revaluation consultancy should review the tax implications of its proposals for revaluing UHE’s fixed assets.

42 Conservative estimates place the value of net fixed assets at about 10 times the value in UHE’s accounting records. 43 Countries utilizing international accounting standards typically treat a revaluation of fixed assets as an unrealized gain in value.

77 UHE's tariff structure. UHE currently has a one-tier tariff which varies according to electricity generation. However, UHE's hydroelectric generation is characterized by large variations in the production volumes per month due to changing weather conditions, with peak periods during the periods February-April and October-December and low production levels in the summer months, as shown in Figure 5 below.

In addition, unlike other generators, its cost of production does not have a fuel component and thus the variable items in its cost structure are small, with most costs items considered to be fixed costs. This rigid dependence on the weather for electricity generation and the high level of fixed costs results in frequent revisions of the tariff by NERC during the year (as many as 9 times during 2002), as shown in Figure 6 below and with wide variations in the tariffs from month to month, as shown in Figure 7 below for 2003. This tariff policy makes it difficult for UHE to operate with stable revenues throughout the year to cover costs which are also largely stable and unrelated to production levels.

Figure 5 Dynamics of DniproHydroEnergo Electricity Sales in 2002-2003

0 91 6,636 0 0 0- :o io,

496,428

+2002 -w- 2003

78 Figure 6. Dynamics of DniproHydroEnergo Tariffs in 1999-2004

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4.00

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Figure 7. Actual Sales of Electricity and Tariffs for DniproHydroEnergo in 2003

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800000 4.00 c 5 600000 m 3.00 5 E m I ea v1 0 400000 2.00 .% 5 418,181 le9 1.9 200000 1.oo

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79 In order to overcome these difficulties, UHE initiated a study, with the approval of NERC, to establish a methodology for introducing two-tier tariffs for the company. The proposed new tariff structure would include a capacity charge to cover UHE’s fixed costs of operation and a variable charge for its variable costs. The new tariff structure is expected to even out the revenue flows on a monthly basis to better ensure the efficient operation ofthe company and its ability to make its required operational payments in a timely manner. It has been agreed with NERC that the new tariff structure would be introduced on an experimental basis from January 2005 and, if judged satisfactory, would be introduced in 2005. During negotiations, it was am-eed that the Government would ensure that NERC introduces a two-tier tariff for UHE by end-2005.

As UHE provides an essential service for maintaining frequency and tie-line flows in the electricity system, it is important for it to receive proper compensation for providing those services. The necessary compensation for such services is a topic currently being examined by consultants working with NERC on implementation of the WEM Concept reform, specifically regarding the establishment of a bilateral and ancillary services market. It is anticipated that a separate system service charge for UHE would be established in the future in connection with the establishment of the balancing mechanism. During negotiations, it was agreed that the Government would ensure that NERC introduces a system service charge to be paid to UHE in parallel with the development ofthe balancing mechanism in the Wholesale Electricity Market.

Future financial performance of UHE. Projections ofthe likely financial performance ofUHE over the period 2005-20 12 have been prepared and are presented in summary form in Table 17- 20 and in detail in Annex 1. The financial projections include a forecast of UHE’s income statements, sources and applications of funds statements and balance sheets along with financial performance indicators. The analysis has been based on UHE’s statutory accounts which are prepared in accordance with Ukrainian accounting standards44 as these accounts closely correspond to the accounts which are considered by NERC when establishing tariffs. The projections have been prepared to determine the average tariffs45necessary for UHE to undertake the project investment program, repay the proposed World Bank loan and other prior loans, remain profitable and maintain satisfactory overall financial performance. The projections have been prepared on a conservative basis assuming that:

(a) the electricity generation forecast includes the benefits of increased efficiency of hydropower production from the project investments;

(b) the general rate of domestic inflation in Ukraine would be 9.8% in 2005, 6.5% in 2006, 5.9% in 2007,5.6% in 2008, 5.3% in 2009, and 5% thereafter;

(c) the UAH/US$ exchange rate would be 5.30 in 2005, 5.36 in 2006, 5.47 in 2007, 5.58 in 2008, 5.69 in 2009, 5.80 in 2010 and 5.85 thereafter;

44 Ukrainian Accounting Standards are not substantially different from Intemational Accounting Standards (IAS) but some significant differences arise from the restatement of the value of net fixed assets and depreciation charges when IAS is used. 45 The analysis has not yet considered potential revenues from introduction ofsystem service charges for UHE.

80 the majority of UHE's expenses would increase annually with the estimated rate of domestic inflation, with the exception of charges for water use which would reduce per unit of electricity generated due to the efficiency gains of the project investments; other project benefits from reduced O&M costs have also been included in the financial forecast;

payment performance of the Energomarket to UHE for its electricity sales would gradually increase from 95% in 2005 by 1% per year to full payment performance by 2010;

UHE would undertake a capital investment program, including technical assistance, of about US$356.2 million over the period 2006-2011, of which the World Bank would finance about $ 100 million or about 28%;

UHE would finance the balance of the capital investment program, including all taxes and import duties, out of current revenues which would be supported by sufficient tariffs;

the World Bank loan would be at an interest rate of about 5%, with a maturity of 18 years, including a 6-year grace period;

UkrHydrogEnergo would pay interest during construction annually and not capitalize these charges into the World Bank loan amount (as under the prior World Bank loan); and

the proposed payments from carbon trading have been included at an estimated annual amount ofabout US$ 1.04 million during 2009-2013.

Expenses 251.4 261.9 275.6 296.8 317.7 337.5 357.1 375.2

Net Operating Income 36.1 137.2 350.8 278.3 369.5 224.0 206.9 200.5

Net Income 14.2 72.3 195.2 149.0 201.2 113.3 102.4 98.8

~ Operating Income as % of Revenues 12.6% 34.4% 56.0% 48.4% 53.8% 39.9% 36.7% 34.8 %

81 Net Income as '70of Revenues 5.8% 21.3% 36.7% 30.5% 34.4% 23.7% 21.4% 20.2% Return on Equity 1.3% 6.2 % 14.7% 10.2 9'0 12.3% 6.5% 5.6% 5.2 Yo

Table 18 Summary Forecast Balance Sheets for UkrHydroEnergo as of December 31,2005-2012 (UAH million)

Table 19 Summary Forecast Sources and Applications of Funds Statements for UkrHydroEnergo for Years Ending December 31,2005-2012 (UAH million)

Construction Projects 10.0 331.9 397.2 313.4 394.1 283.7 250.7 250.0

Technical Assistance 2.7 5.5 5.6 5.7 2.9 2.9 Taxes and Dividends 21.6 59.8 143.8 112.9 148.8 89.4 82.5 80.4

Working Capital 26.3 12.2 11.0 14.4 3.5 5.5 0.6 0.2

82 Increase (Decrease)

Debt Service 33.0 36.4 43.3 48.3 39.8 42.0 42.9 81.2

Equipment Lease 1.1 1.1 1.1 1.1 1.1 1.1 1.1 1.1

Total Applications 92.0 444.1 601.9 495.6 593.1 424.5 406.4 391.8

The forecast shows that the project investments, which would bring about electricity generation efficiency improvements and increased electricity sales, would require significant increases in the average electricity tariff, due primarily to the large share (about 72%) of financing by UHE of the project investment costs which are to be covered by current revenues. The schedule of proposed increases in the average electricity tariff based on the above assumptions are as shown in the Table 2 1. Table 20. Schedule of UHE’s average electricity tariff

As Ukrhydrogenergo’s share oftotal electricity generation in Ukraine is relatively small (around 6-8%), the above tariff increases would not, however, be expected to have a major impact on the average wholesale electricity market price.

NERC’s methodology for establishing UHE’s tariffs allows for the recovery of the costs of UHE’s operations but not its future investment programs. In accordance with current regulatory requirements, NERC must approve investment programs prior to any tariff increases. NERC has provided its approval in the form of a letter of support on April 13, 2005 for the proposed investment project to be undertaken by UHE.

During its meeting of December 29, 2004, the Cabinet of Ministers decided to start preparation of the proposed investment operation with the World Bank and requested NERC to consider including project costs in UHE’s tariff. With the proposed increases in average tariffs during the project period, UHE would be able to generate the counterpart contribution to the project investment costs and maintain satisfactory financial perfonnance, with a satisfactory operating ratio46(averaging 57% over the project period), adequate working capital4’ (current ratio above

46 Ratio is calculated as operating expenses divided by operating revenues.

83 1.2) and debt service coverage48 (well above the minimum advisable ratio of 1.5). In order to protect UHE’s financial position. it was agreed that the company will maintain a debt service coverage ratio of at least 1.5 during the proiect period. Also, in order to ensure adequate liquidity. it was agreed that UHE maintain a current ratio ofat least 1.2 during the proiect period. To properly monitor financial performance, UHE will prepare a report annually on or about March 3 1. beginning in FY06. for each year during proiect implementation, containing financial proiections for the upcoming year to be reviewed by the Bank.

As mentioned previously, the financial performance of UHE is affected by the payment performance of the Energomarket. As the economy continues to improve, it is anticipated that payment performance would also continue to improve, gradually increasing to full payment performance, assumed by 2010. It was agreed during negotiations that the Government will cause NERC to ensure the distribution of funds due from Energomarket- to UHE in a timely manner according to the algorithm in place.

The financial forecast incorporates the estimated savings in water charges as a result of the improvements in the efficiency of electricity generation brought about by the project investments. The forecast also incorporates potential savings in staffing and operations and maintenance costs from the project investments. In addition, the forecast has included the revenue from the sale ofgreenhouse gas Emission Reduction Units (ERUS)~~created through the increase of hydroelectric production under the Hydropower Rehabilitation Project. Based on a preliminary analysis of the expected amount and the price of ERUs, it is estimated that UHE would earn about US$ 1.04 million per year starting in 2009 for five years.

47 Ratio is calculated as current assets divided by current liabilities; a ratio greater than 1.0 is required to ensure company solvency. ‘’ Defined as the ability of UkrHydroEnergo to cover its interest and principal payments on loan obligations out of internally generated funds. 49 In parallel with the preparation of the Hydropower Rehabilitation Project, the Bank assisted UHE in preparing a carbon financing operation based on the “Second Track Joint Implementation’ arrangements under the Kyoto Protocol.

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s 0 ,% 3 w5 Annex 10: Safeguard Policy Issues UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

Most of the investment projects supported under the Energy Program are expected to be B- category projects. Hydropower Rehabilitation Project is a B-category project. However, future investment projects included in the later phases ofthe Energy Program may contain components that would be rated as belonging to other categories. Therefore, compliance with the Bank safeguard policies will be evaluated separately for each phase ofthe Energy Program.

Hydropower Rehabilitation Project triggers OP 4.37 on Dam Safety:

The existing Cascade System ofDamsResewoirs on the Dnipro River in Ukraine, is one of the largest system in dam engineering in the world (see Table 21). While many other cascade systems of dams/resewoirs could be identified as equally important in many other countries, these systems are mainly founded on solid rock foundations. A majority ofthe damsh-eservoirs ofthe Dnipro Cascade system, however happen to be founded on sandy foundations and built of sandy soils, thus, necessitating continuous protection against dam safety hazards, and greater emphasis on regular dam safety inspections and dam safety monitoring. The Dnipro HPPl built as the first dam structure of the system, is the only one structure built on solid rock foundations. When its gigantic horseshoe dam was built in 1934, it was considered as one of the most important projects in dam engineering in the world. Currently, UHE has overall responsibility for the safe operation and maintenance ofthe Dnipro Cascade system of dams/reservoirs and the Dnister damheservoir. Table 21. The Dnipro and Dnister System of Dams

Note: ED = earth dam; CD = concrete dam

93 The Dnipro river is the third largest river ofEurope, with a catchment area ofabout 505,000 km2. More than 30 million people use the Dnipro river water. For Ukraine, the Dnipro river is often considered as its life line, where more than 50 large cities, over 10,000 industrial enterprises, over 2,000 rural, more than 1,000 public utilities, and over 50,000 irrigation systems are provided with Dnipro water. The reservoirs ofDnipro Cascade system are for multi purpose and the water resources are used for: - supply ofurban, rural and industrial water, - hydroelectric generation, - irrigation, - fisheries, - navigation (water transportation), and - recreation.

The various damdreservoirs of the Dnipro Cascade System interrelated and continuous so that the lake levels of the downstream reservoir more or less control the tail water level of the hydropower station ofthe upper reservoir. It is important to note that five of the damslreservoirs of the Dnipro Cascade system are identified among the world’s major dams, two among the longest dams (Kyiv, Dniprodzerzhinsk) and two with very large reservoir volume (Kremenchug, Kahovka). Also, all these damslreservoirs are located in the most industrialized and heavily populated regions of Ukraine. The dams safety thus, plays a greater role in Ukraine than many other countries, due to the likely tremendous hazard to population in future, in case of any uncontrolled happenings.

The Dnister dadreservoir is located on the Dnister river in the south westem part of Ukraine, at a distance of about 15 km upstream from the point where the river forms the border line between Moldova and Ukraine (or a distance of about 678 km from the Dnister mouth). The multi-purpose use of the reservoir includes water supply, irrigation, navigation, hydropower generation, and flood control. The Dnister dam (Dnister river) is also founded on sound rock as the Dnipro HPPl (Dnipro river), but the lake length happens to be very long (194 km) necessitating continuous monitoring.

The project team performed an overall assessment of dam safety and found it very encouraging that UHE attaches great importance on the safety of Dnipro Cascade system of dams (Dnipro river) as well as on Dnister dam (Dnister river). The UHE has already taken several steps in this respect as required in accordance with the Bank Guidelines for Safety ofDams (OMS 3.80, 1977 and the revised OPBP 4,37, 1996), specially in respect of: - The dam safety monitoring. - Annual dam safety inspections. - Emergency Preparedness Plan (including the Emergency Action Plan through the Emergency Ministry and other relevant organizations). - Operation and Maintenance. - Dam Safety Legislation (Draft).

The overall Dnipro cascade system of dams/reservoirs appear to have been successfully monitored, operated and maintained by the UHE for periods varying from over 30 to 60 years without any major safety hazard so far. A team of 4 staff members is understood to be

94 maintained for each of the six damsheservoirs of the Dnipro Cascade system and for Dnister dam (Dnister river), for dam safety inspections, instrumentation observations and dam safety monitoring.

The draft Dam Safety Legislation has been prepared by the UHE, the Hydropower Design Institute, and the Institute of Environmental and Water Problems, and submitted to the Ministry ofFuel and Energy in July 2004, for further processing through other Government agencies, and thereafter for final approval by the Government. The draft is currently under review by the various committees and Ministries and UHE is following up on the required processing of the draft law.

Ukraine is not yet a member of the Intemational Commission on Large Dams (ICOLD). With such an important Dnipro Cascade System of damsheservoirs, and other substantial water resources and hydro potential in Ukraine, and so much commitment being given by the UHE to Dams Safety, it is essential and it is strongly recommended that the Ukrainian Government should consider joining the Intemational Community in the field ofDams and Water Resources, and becoming a member ofthe ICOLD.

The project team reviewed the design of some of the more important dam embankments and appurtement structures of the Dnipro Cascade system (Kyiv, Kaniv, Kremenchug, Dniprodzerzinsk, Dniprovska and Kakhovka) along with the engineering professionals and the design personnel from UHE and their consultants UkrHydroProject (UHP). The designs of the relevant concrete structures and the dam embankments, in general, appear to have been well designed, more or less meeting the international standards. Also, the quality of construction of works is understood to appear to be excellent and well controlled during construction. The existing condition ofthe structural concrete and the dam abutments even after a period ofover 30 to 60 years, is apparently an ample proof of the well designed and constructed dam structures of the Dnipro Cascade system.

Due to the very long operating periods for these damshtructures, and the recent detailed dam safety inspections by the UHE and UHP professionals, some immediate dam safety strengthening measures have been identified comprising of civil works including (drainage channels, dam embankments, and concrete works), and rehabilitation or replacement of the hydro-mechanical gates for some dams/spillways which need to be undertaken in the near term, i.e. within the scope ofthe proposed hydropower rehabilitation project.

- Geological: Only one dam (Dniprovska) of the Dnipro Cascade system is founded on geologically good rock foundation. All other five dams are founded on geologically pervious (sandy) foundations, and the dam embankments built of sandy soils. Thus, the continuous dam safety monitoring for these dams on pervious (sandy) foundations becomes most important for safety ofthe Dnipro Cascade system.

- Hydrological: The hydrology of the Dnipro is characterized by pronounced seasonal regime, with the highest floods during the spring, strongly influenced by the snowmelt. The Hydrological Forecasting Department ofthe HydroMet Center in Kyiv is responsible for preparation of hydrological forecasts in the Dnipro Basin. The hydrological data (by

95 HydroMet) is understood to be based on nearly 200 hydrological gauging stations located within Dnipro Basin (more than 80 of these stations located in Belarus and Russia), and some 2 10 stations for snowmelt depth (including 1 18 in the territory ofUkraine). Some hydrological instrumentation is required to be upgraded and replaced for the HydroMet, for reliable measurements, assessments, and accurate flood forecasting. Most of the dams/structures ofthe Dnipro Cascade system have been provided for 10,000 year design floods (covering present international standards). However, the two structures ( Kyiv and Kaniv), which are the first structures on the Cascade system, are apparently designed for 1000 year flood, which could not be considered adequate from the presently adopted norms in ddspillway designs.

- Sedimentation: No sedimentation surveys for any of the reservoirs are understood to have been done so far, with apparently no knowledge of the behavior of the sediment deposits and/or the sediment delta movement in the reservoirs, for future planned actions, which is important specially for Kyiv reservoir (which is the first structure ofthe Dnipro Cascade system), and the sediment deposits are understood to have been hrther complicated due to the Chemobyl NPP accident in 1986 and the resulting radiated sediments.

Instrumentation, mainly comprising of embankment piezometers, foundation piezometers, observation pipes, settlement devices, survey points, inclinometers, and the seepage discharge measurement devices are provided on almost all the dam structures of the cascade system to monitor the dams behavior. Some of the instrumentation is understood to have been damaged and is inoperative.

The previous Bank project (Hydropower Rehabilitation and System Control Project, Loan 3865) provided the first successful step towards dam safety monitoring ofthe Dnipro Cascade system, with provision and installation of the needed instrumentatiordequipment and the computer-aided monitoring system for Kyiv dam and HPP (the uppermost structure of the entire system), as a model, incorporating installation of: - new drill holes and piezometers; - water flow transducers; - jointmeters; - inclinometers; - data concentrators; - concrete shelter boxes, and concrete towers; - cables/trenches, and - computer hardware and software.

A site inspection by the project team, along with the UHE and UHP professionals, for the installed dam safety monitoring instrumentatiordequipmentand its computer-aided operation, for Kyiv dam and HPP, indicated that provision and installation of computer-aided dam safety monitoring system for Kyiv dam and HPP, has been very successful safety monitoring system, providing immediate monitoring control ofthe collection and interpretation of all the dam safety monitoring data (including the piezometer readings, the safe phreatic lines in the dam embankments, the drainage channel water levels, the drainage discharges and variations with

96 reservoir levels, the concrete joint openings, the concrete block defections and inclinations, the water temperatures, and other relevant data, and an automatic alarm system for critical data observations), at the Monitoring Center at Kyiv HPP, and that the same need to be duplicated and provided to other needed dams ofthe system, for an overall monitoring control ofthe whole system.

While the computer aided dam safety monitoring instrumentation provides an extremely useful tool for the overall reliable surveillance of the dams safety, specially for long dams, it is necessary to continue physical dam safety inspections, since every foot length of dam could not be covered by instrumentation or for interpretation of the readings from adjacent areas for reliable results.

Based on the experience gained on the dam safety monitoring system for Kyiv dam, the UHE has also installed similar dam safety systems at: (i)Kremenchug dam and HPP (completed in September 2004); and (ii)Kakhovka dam and HPP (scheduled for completion in December 2005). Measures Required to Strengthen Dam Safety

The overall dam safety strengthening measures as presently needed for the Dnipro Cascade system and the Dnister dam and HPP (Dnister river), as per detailed proposals by the UHE and UHP (and reviewed by the project team), could be identified as: - Computer aided dam safety monitoring system for Dniprovska, Dniprodzerzhinsk, Kaniv and Dnister dams and HPP. - The needed strengthening civil works for Kyiv, Kaniv, Dniprovska, and Dniprodzerzhinsk dams, incorporating rehabilitation of: > drainage facilities; > design profiles (rehabilitation ofsubsidence); > slope protections; > concrete spillways and other reinforced concrete works. - Protection against high phreatic lines (high piezometric levels) in the dam embankments at Kaniv, Kremenchug, Dniprodzherzhinsk and Kakhovka. The design proposals for above civil works should be completed by December 31,2005. - Rehabilitation and/or replacement of the needed hydro-mechanical gates for Dniprovska and Dniprodzerzhinsk damdspillways.

Provision for these identified dam strengthening measures has been made as a part of the Dam Safety Component under the Project. Possible additional measures related to rehabilitation and/or replacement of any of the spillway gates for Kremenchug and Kakhovka dams will be evaluated by UHE by December 3 1,2005.

With the modernization and automation ofthe dam safety monitoring and telecontrol ofthe dam surveillance for the overall Dnipro Cascade system of damdreservoirs, it is essential that a Dam Safety Center (DSC) should be established, for immediate analysis and interpretation of all the relevant data, specially the questionable (or alarming) data. During negotiations, it was am-eed that UHE will establish and maintain an adequately staffed DSC under scope ofwork acceptable to the Bank by December 31, 2005. The scope of work would include, inter alia, to (A) inspect

97 and evaluate the safety status of the existing- dams, its appurtenances, and its performance history; (B) review and evaluate UHE's operation and maintenance procedures; (C) provide a written report of findings and recommendations for any remedial work or safety-related measures necessary to upwade the existing dam to an acceptable standard of safety; and (D) provide an immediate analysis and interpretation of all relevant data, specially the questionable or alarming one, gathered from the operation of the dams under the project. Furthermore, at the negotiations, it would be aweed that UHE ensures that (i)a detailed plan for construction supervision, an instrumentation plan, an operation and maintenance plan, and an emergency preparedness plan would be prepared and implemented: (ii)all work under the dam safety component is designed and supervised by competent professionals; and (iii)DSC performs periodic dam safetv inspections.

The proposed project will also include the needed technical assistance related to the dam safety component : 1. Study for the Safe Design floods for Kyiv and Kaniv reservoirs (presently designed for only 1000 year flood), with safe and economical options including necessity or otherwise of (emergency spillway, increased reservoir capacity, optimized reservoir regulations, and/or installations of additional hydrological instrumentatiodequipment for accurate flood forecasting). 2. Upgradingheplacement of hydrological instrumentation for the HydroMet, for more reliable measurements, assessments, and flood forecasting. 3. Study, Assessment and Analysis ofthe Reservoir Sedimentation for Kyiv dam (sediment volume, sediment profile, and sediment characteristics) specially in view of the fact that Kyiv reservoir is the first reservoir on the Dnipro Cascade system of dams, and the reservoir sedimentation has been further complicated due to the Chernobyl NPP accident in 1986, and the resulting radiated sediments. 4. Training ofProfessionals in dam safety management. 5. Eight local professionals, in 2 groups of 4 engineers each, for 3 month training, will be identified at an early stage ofthe project, for specialized training in the fields of - Computer aided monitoring system design. - Monitoring, maintenance, and operation ofsystem. - Dam safety inspections and safety monitoring. These trained professionals will later assist in implementation and monitoring of the Project Dam Safety Component.

UHE will prepare criteria for selection of candidates for training acceptable to the Bank by December 31, 2005. The criteria will meet various requirements as proposed by the UHE, including: - the relevant basic qualifications; - working professionals at the dams and HPP, and the Design Institute; - an arrangement with the professionals to stay with the UHEDesign Institute for a minimum of3 years after training.

98 Rehabilitation of Hydropower Plants triggers OP 7.50 on Projects in International Waterways:

Hydropower plants included in the proposed rehabilitation project are located on the Dnipro and Dnister rivers, which both flow into the Black Sea. An exemption from the notification requirement under OP 7.50 has been granted to the project team because the Hydropower Rehabilitation Project does not involve works and activities that would exceed the original scheme, change its nature, or alter and expand its scope and extent to make it appear a new or different scheme. Consequently, it falls within the exception set forth in paragraph 7 (a) of OP7.50 as: (a) it will not adversely affect the quality or quantity of water flows to the other riparians; and (b) it will not be adversely affected by other riparians’ water use.

Ukraine is signatory of the Black Sea Convention and Agreements with the Republic of Belarus (the Belarus Convention), Russia (the Russia Convention) and the Republic of Moldova (the Moldova Convention) on the joint use and conservation of boundary water bodies. The Bank’s project team reviewed the relevant provisions5’ of these Conventions and concluded that any notification requirement under the applicable Conventions is triggered only in cases of negative effects or consequences. The team also assessed that the works falling within the scope of the Hydropower Rehabilitation Project will not cause any negative or detrimental effects (along the ones described in the applicable Conventions) and, therefore, no notification or information requirement under the applicable bilateral or multilateral agreements would be applicable.

Rehabilitation of Hydropower Plants does not trigger Social Safeguards.

Rehabilitation ofthe hydropower units will take place entirely within existing sites, thus no land acquisition will be required and no resettlement will occur as the result of the project. No indigenous peoples will be affected by the project. Thus it does not trigger either OP 4.12 Involuntary Resettlement pr OD 4.20 Indigenous Peoples. Likewise, it does not trigger 0P:N 11.03, Cultural Property for the same reasons.

50 Article 3, third paragraph of the Belarus Convention; Article 3, second paragraph of the Moldova Convention; Article 3, third paragraph of the Russia Convention; and Article XV, paragraph 5 of the Black Sea Convention.

99 Annex 11 : Project Preparation and Supervision UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

Table 22. The Project cycle schedule

Activity Planned Actual PCN review September 2004 September 22,2004 Initial PID to PIC December 7.2004 Initial ISDS to PIC Appraisal March 2005 March 2005 Negotiations June 2005 May 10-13,2005 Board/RVP approval September 2005 June 16,2005 Planned date of effectiveness October 15, 2005 Planned date of mid-term review June 2008 Planned closing date September 201 1

Key institutions responsible for preparation ofthe project:

- ESRDP - The Government ofUkraine, Ministry ofFuel and Energy - Hydropower Rehabilitation Project - UkrHydroEnergo (UHE) and its consultants including UkrHydroProekt - Energy market and regulatory framework - NERC and its consultants

Bank funds expended to date on project preparation: 1. Bank resources: $262,965.1 1 2. Trust funds: $ 3. Total: $

Estimated Approval and Supervision costs ofthe Hydropower Rehabilitation Project: 1. Remaining costs to approval: $ 2. Estimated annual supervision cost: $100,000.00

Bank staff and consultants who worked on the Energy Program and the Hydropower Rehabilitation Project included: Table 23. The Bank staff and consultants involved

Name Title Unit Dejan Ostojic Sr. Energy Specialist - Program Team Leader ECSIE Claudia Pardinas Ocana Senior Counsel LEGEC Jonathan Pavluk Senior Counsel LEGEC Nikolay Chistakov Senior Finance Officer LOAG2 Carolyn Gochenour Consultant - Financial Analyst __ Dennis Creamer Consultant - Economist -- Permanand Gupta Consultant - Dam Safety Specialist -- Bernard Baratz Consultant - Environmental Specialist --

100 Ludmila Butenko Sr. Resource Management Officer I SFRRM Varadaraian Atur Sr Financial Analmt I ECSIE

101 Annex 12: Documents in the Project Files UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

1. Country Assistance Strategy for Ukraine, 2003

2. Decision of the Cabinet ofMinisters of Ukraine on the establishment of Commission for Energy Sector Refonn and Development, No.1091, August 25,2004.

3. Letter from Vice Prime Minister Andriy Kluyev to Country Director Paul Benningham requesting the Bank support in preparing and implementing the Energy APL, October 20,2004

4. Letter from Country Director Paul Benningham to Vice Prime Minister Kluyev on Energy APL Pre-Appraisal mission, and signing of the PHRD Grant Agreement, November 10,2004

5. Signed Letter ofAgreement on Japanese Grant No. 053330, November 18,2004

6. Decision of the Cabinet ofMinisters ofUkraine on the preparation ofHydropower Rehabilitation Project for possible financing under the Energy APL, December 29,2004.

7. Ukraine's Country Economic Memorandum, 2004

8. No Objection Letter from the Deputy Minister of Environmental Protection Sviatoslav Kurulenko, March 10,2005

9. Decision Package Review Meeting, March 24, 2005

10. Minutes ofDecision Meeting, April 2, 2005

11. Letter from the National Energy Regulatory Commission ofUkraine Acting Head Yuri Kyyashko with suggestions on the Project, April 13,2005

12. Invitation to Negotiate to the Government of Ukraine addressed to Prime Minister Yulia Tymochenko signed by Country Director Paul Benningham, April 11,2005

102 Annex 13: Statement of Loans and Credits UKRAINE: Hydropower Rehabilitation Project in Support of the Energy Sector Reform and Development Program

Table 24. Statement of loans and credits

- Difference I I between expected and Original Amount in US$ actual Millions disbursements Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Rev’d PO74972 2004 PAL 2 250.0 0.0 0.0 0.0 0.0 172.5 172.5 PO76338 -2004 DEVSTAT 32.0 0.0 0.0 0.0 0.0 32.0 15.9 PO57815 2003 ST TAX SERV MOD PROG (APL 40.0 0.0 0.0 0.0 0.0 38.4 #I> PO69857 2003 TBiAIDS CNTRL 60.0 0.0 0.0 0.0 0.0 59.1 PO35777 2003

~ PO74885 2003 PO69858 2002 PO54966 2002 PO48790 2002 AZOV-BLK SEA CORR BIODIV

PO3 5 7 86 2001 PO55739 -2000 PO44832 -1998 KYIV DISTRICT HEAT. I 200.0 I 0.0 I 0.0 I 0.0 I 40.0 I 101.1 I 141.1 I 16.4 Total: 1904.9 I 0.0 IO.0 1 6.9 I 42.0 I 701.1 I 388.4 I 29.5

103 Table 25. Ukraine Statement of IFC’s on Held Held and Disbursed Portfolio (In Millions of US Dollars)

Committed Disbursed FY Approval

I 2000 1994196 Total portfolio: 13.50 10.13 0.00 0.00 3.50 10.13 0.00 0.00

FY Approval Loan Equity Quasi Partic.

~ ~~~ 2004 First Lease 0.00 0.00 0.00 0.00 2004 MBU RI 0.00 0.00 0.00 0.00 Total pending commitment: 0.00 0.00 0.00 0.00

104 Annex 14. Ukraine at a Glance

Europe 8 Lower- POVERTY and SOCIAL Central middle- Ukraine Asia income Development diamond' 2003 Population,mid-year (millions) 48.4 473 2,655 Life expectancy GNI per capita (Atlas method, US$) 970 2,570 1,480 GN I (Atlas method, US$ billions) 46.9 1,217 3,934 - Average annual growth, 1997-03 Population (%) -0.8 0.0 0.9 GNI Gross Labor force (%J -0.4 0.2 1.2 per primary Most recent estimate (latest year available, 1997-03) captta enrollment Poverty (% of population below national poverly line) Urban population (% of total population) 67 63 50 Life expectancy at birth (years) 68 69 69 - Infant mortality (per 7,000 live births) 16 31 32 Child malnutrition (% of children under 5) 3 11 Access to improved water source Access to an improved water source I%of population) 98 91 81 Illiteracy (% ofpopulation age 75+) 0 3 10 Gross primary enrollment (% of school-age population) 90 103 112 -Ukraine

Male 91 104 113 ~ Lower-middl~ncomeamuD Female 90 102 111

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1983 1993 2002 2003 Economic ratios' GDP (US$ billions) 65.6 42.4 49.5 Gross domestic investmenffGDP 36.3 18.7 19.3 Trade Exports of goods and services/GDP 25.9 55.1 52.9 Gross domestic savingslGDP 36.0 23.0 24.0 Gross national savingslGDP 26.1 25.2

Current account balancelGDP -1.3 7.5 6.2 Domestic __ Investment Interest paymentslGDP 0.1 1.3 1.2 savings Total debffGDP 5.9 32.0 23.1 Total debt servicelexports 1.3 13.7 10.6 - Present value of debffGDP 29.8 Present value of debffexports 53.4 Indebtedness 1983-93 1993-03 2002 2003 200307 (average annual growth) GDP -5.6 -1.6 5.2 9.4 5.0 -Ukraine GDP per capita -5.9 -0.8 6.0 10.2 5.7 Lower-middleincome arom Exports of goods and services 5.3 9.1 5.0 4.8

STRUCTURE of the ECONOMY 1983 1993 2002 2003 Growth of investment and GDP (%) (% of GDP) 40 - Agriculture 21.7 15.3 14.1 Industry 37.7 38.2 40.3 20 - Manufacturing 29.9 23.2 25.0 0 Services 40.6 46.5 45.6 -20 Private consumption 48.0 57.0 60.2 -40 - General government consumption 16.0 20.0 15.8 -GDI *GDP Imports of goods and services 26.2 50.7 48.3

~~~~ ~ - 1983-93 1993-03 2002 2003 Growth of exports and imports (%) (average annual growth) I AQriCUltUre -2.5 3.6 -8.0 Industry -0.3 5.0 14.0 Manufacturing 1.0 7.0 16.0 Services -2.9 6.3 18.2 Private consumption -0.8 5.1 -15.7 General government consumption -2.0 -0.7 13.8 -30 - Gross domestic investment -5.1 -22.3 16.3 Exports *imports Imports of goods and services 3.6 3.7 10.4 - I

Note: 2003 data are preliminary estimates. This table was produced from the Development Economics central database. * The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.

105 Ukraine

PRICES and GOVERNMENT FINANCE 1983 1993 2002 2003 ___~- Inflation (Oh) Domestic prices I (% change) Consumer prices 10,125.0 0.8 1.1 Implicit GDP deflator 3,334.8 5.1 6.9 Government finance (% of GDP, includes current grants) Current revenue 42.8 35.3 34.2 gS 99 W 01 02 03 -25.4 Current budget balance 3.3 1.5 "-GDP deflator +CPI Overall sumlusldeficit -28.1 0.5 -0.4

TRADE 1993 2002 2003 1983 Export and import levels (US$ mill.) (US$ millions) Total exports (fob) 12,796 18,669 21,225 25m - Ferrous and non-precious metals 7,126 8,745 Mineral products 2,389 2,558 Manufactures 3,508 3,540 Total imports (cif) 15,315 17,959 20,029 Food 1,114 1,225 Fuel and energy 6,156 6,940 7,289 Capital goods 3,785 4,714 97 98 99 w 01 M M Export price index (7995=700) 99 107 Import price index (7995=100) 114 115 Exports w Imports Terms of trade (1995=700) 87 93

BALANCE of PAYMENTS 1983 1993 2002 2003 Current account balance to GDP (%) (US$ millions) Exports of goods and services 15,850 23,351 26,240 10 - imports of goods and services 16,755 21,494 23,922 -905 1,857 2,318 I Resource balance Net income -69 -606 -446 Net current transfers 1,922 1,187 Current account balance -854 3,173 3,059 Financing items (net) 817 -2.128 -406 , Changes in net reserves 37 -1,045 -2,653 -5 - Memo: Reserves including gold (US$ millions) 4,417 6,874 Conversion rate (DEC, local/US$) 2.26E-2 5.3 5.3

EXTERNAL DEBT and RESOURCE FLOWS ~- 1983 1993 2002 2003 (US$ millions) Composition of 2003 debt (US$ mill.) Total debt outstanding and disbursed 3,855 13,555 11,448 IBRD 0 2,233 2,121 578 IDA 0 0 0 Total debt service 202 3,243 2,817 IBRD 0 198 209 IDA 0 0 0 Composition of net resource flows Official grants 117 120 Official creditors 307 -272 -265 Private creditors 441 689 -1.578 Foreign direct investment 200 693 Portfolio equity 0 -1,958 World Bank program Commitments 27 82 0 A - IBRD E - Bilateral Disbunements 0 45 28 B - IDA D - Other mullilateral F - Pnvate Principal repayments 0 121 139 C - IMF G - Short-term Net flows 0 -76 -111 Interest payments 0 77 70 Net transfers 0 -153 -181

Note: This table was produced from the Development Economics central database 9/29/04

106 MAP SECTION

°

° 40 ° 50 45 MAY 2005 IBRD 34052

any judgment on the

status of any territory, ° 40 RUSSIAN This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information shown on this map do not imply, the part of The World Bank Group, legal or any endorsement acceptance of such boundaries. FEDERATION Luhansk Donbass Uglegorsk MILES Zuiv Slaviansk KILOMETERS Kurakhivsk of

Sea

Azov Starobesheve 0 50 100 150 0 50 100 150 Zaporizhia South Donbass RUSSIAN FEDERATION ° 35 Zmiiv Crimea (halted) Pridniprovsk Zaporizhia ° 35 Dniprovsk Dniprodzerzhinsk Zaporizhia North Ukraine Kremenchuk

Kakhivka

Inhulets

a

n s

Kryvyi Rih e

Dniprovsk D Kiev 6 South Ukraine

Kaniv B L A C K S E KIEV Kiev PS/Kiev Trypillia ° ° 30 30 Chernobyl Vinnitsa Ladyzhynsk

South Buh

MOLDOVA Dniester Danube

Khmelnytski Prut

Prypyat Rivne BELARUS

Dniester ° BULGARIA

Siret 45 ° 25 Dobrotvirsk Burshtynsk

Buh ° North 25 West Ukraine U K R A I N E ROMANIA TRANSMISSION LINES: 750 kV 330-500 kV SUBSTATIONS HYDROELECTRIC POWER PLANTS THERMAL POWER PLANTS NUCLEAR POWER PLANTS NATIONAL CAPITAL INTERNATIONAL BOUNDARIES RIVERS PROJECT

TRANSMISSION LINES Tisa Tisa MAIN POWER STATIONS AND POLAND ° HYDROPOWER REHABILITATION 20 SLOVAK

REPUBLIC

°

° 50 20 HUNGARY