Document of The World Bank Public Disclosure Authorized

Report No. 15378-AZ

STAFF APPRAISAL REPORT

AZERBAIJAN REPUBLIC Public Disclosure Authorized

GAS SYSTEM REHABILITATION PROJECT

August 2, 1996 Public Disclosure Authorized

Infrastructure, Energy and Environment Division

Public Disclosure Authorized Country Department III Europe and Central Asia Region CURRENCY EQUIVALENTS

Currency Unit = manat

EXCHANGE RATES Manats per US$I 1993 (Average) 92.6 1994 (Average) 1,456.9 1994 (End) 4,168.0 1995 (End) 4,580.0 1996 (April) 4,450.0

WEIGHTS AND MEASURES Metric System BCM - billion cubic meters toe - tonne of oil equivalent MCM - thousand cubic meters kWh - kilowatt hour

ABBREVIATIONS AND ACRONYMS CAS - Coimtrv Assistance Strategy CGS - City Gate Station CP - Cathodic Protection EBRD - European Bank for Reconstruction and Development EIRR - Economic Internal Rate of Return EU - European Union FIRR - Financial Internal Rate of Return FSU - Former Soviet Union GAAP - Generally Accepted Accounting Principles GPP - Gas Processing Plant IAS - International Auditing Standards ICB - InternationalCompetitive Bidding IS - International Shopping JSC - Joint Stock Company LIB - Limited International Bidding LPG - Liquid Petroleum Gas MOF - Ministry of Finance NPV - Net Present Value PEMS - Procurement, Engineering, Management and Supervision PIU - Project Implementation Unit PPF - Project Preparation Facility SA - Special Account SLA - Subsidiary Loan Agreement SOCAR - State Oil Company of Azerbaijan SOE - Statement of Expenditure TA - Technical Assistance TACIS - Technical Assistance - Commonwealth of Independent States VAT - Value Added Tax

AZERBAIJAN - FISCAL YEAR

January I - December 31 STAFF APPRAISAL REPORT

AZERBAIJAN REPUBLIC

Gas System Rehabilitation Project

CONTENTS

Credit and Project Summary ...... iii

I. INTRODUCTION ...... I A. Macroeconomic Setting ...... 1 B. The Energy Sector ...... 1 C. Government Strategy and Bank/IDA Role ...... 2

II. PROJECT CONTEXT AND STRATEGY ...... 3 A. Institutional Setting .3 B. Supply/Demand Outlook .4 C. Issues .6 D. Project Design Strategy .13 E. Rationale for Bank Involvement .13 F. Lessons Learned from Past Operations .14

III. THE PROJECT ...... 14 A. Project Origin and Formulation .14 B. Project Objectives .15 C. Project Description .15 D. Cost Estimate .17 E. Project Financing Arrangements .18 F. Environmental Aspects .19

IV. PROJECT IMPLEMENTATION ...... 20 A. Implementation Arrangements .20 B. Schedule .21 C. Procurement Arrangements .22 D. Disbursement .24 E. Supervision .26 F. Insurance .26

V. FINANCIAL ISSUES ...... 26 A. Financial Rates of Return .27 B. Financial Risks and Sensitivities .28 C. Pro-Forma Financial Projections .29 D. Sensitivity of Pro Forma Projections .31 E. Accounting and Auditing Arrangements .33 - ii -

VI. BENEFITS AND RISKS ...... 33 A. Benefits, Costs and Rate of Return ...... 33 B. Risk Analysis and Risk Mitigation Measures ...... 36

VII. AGREEMENTS REACHED AND RECOMMENDATIONS ...... 38 A. Agreements Reached .38

ANNEXES Annex 1.1 - Fuel and Energy Production and Consumption Annex 2.1 - Azerigaz Organization Chart Annex 2.2 - Comparison of Household Fuel Costs Annex 2.3 - Household Gas Price Increases - Assessment of Social Impacts Annex 2.4 - Structure of the LPG Industry Annex 2.5 - Action Plan on Gas Payments Annex 3.1 - Project Cost Estimates Annex 3.2 - Lending Arrangements, Legal Documents, and Flow of Funds Annex 3.3 - Summary of Environmental Assessment and Environmental Mitigation Plan Annex 4.1 - Terms of Reference - Procurement, Engineering, Management and Supervision Consultants Annex 4.2 - Project Implementation Schedule Annex 4.3 - Procurement Plan Annex 4.4 - Development Indicators Annex 4.5 - Proposed Supervision Program Annex 5.1 - Financial Rates of Return Annex 5.2 - Pro Forma Financial Projections Annex 5.3 - Sensitivity Analysis - Cash Flow Financial Projections Annex 6.1 - Economic Analysis Annex 7.1 - Policy Letter

MAPS: IBRD No. 24912, 27812, 27813

This report is basedon the findingsof Preappraisal(September, 1995) and Appraisal(January, 1996) missionsled by MichaelLevitsky and PeggyWilson, Task Managers(EC31V). The reportwas preparedby MichaelLevitsky and Peggy Wilson,with contributionsfrom YeldaGuven, PaulGallagher, (EC31V), Mohsen Shirazi (IENOG), and Steven Ward(Consultant). Pervaiz Rashid(EC3DR) provided operational guidance. Peter P. Pease(EC3IV) is the procurementspecialist for the project. The DivisionChief and DepartmentDirector are JonathanC. Brownand Yukon Huang. Johannes F. Linn is the Regional Vice President. - I11 -

AZERBAIJANREPUBLIC

Gas SystemRehabilitation Project

Credit and Project Summary

Borrower: Governmentof AzerbaijanRepublic

ImplementingAgency: Azerigaz

PovertyCategory: Not Applicable

Amount: SDR 14.1 million (US$20.2million equivalent)

Terms: 35 years maturitywith 10 years grace

CommitmentFee: 0.50 percent on undisbursedcredit balances,beginning 60 days after signing, less any waiver.

OnlendingTerms: The full amount of the Credit will be onlent by the Govemmentof Azerbaijan to Azerigazin dollar equivalentsat the IBRD's variable interestrate applicable to currency pool loans. Repaymentwill be over 20 years including 5 years grace. Azerigazwill bear the exchangerate risk in dollars,and the Government will bear the cross-currencyrisk.

FinancingPlan: (US$ million equivalent)

FinancingSource Local Foreign Total % of l______Total I.D.A. 20.2 20.2 82.3 Azerigaz 4.4 4.4 17.7 Total 4.4 20.2 24.6 100.0 Percentageof Total 17.7 82.3 100.0

EconomicRate of Return: 47%

EconomicNet PresentValue: US$73million

Staff AppraisalReport: 15378 AZ

Maps: IBRD 24912,27812, 27813

Project ID Number: AZ-PA-8287

I. INTRODUCTION

A. Macroeconomic Setting

1.1 Azerbaijan is one of the oldest petroleum producing regions in the world. The country is also well-endowed with various natural resources, including fertile agricultural land, a diversified industrial structure, and a well-educated work force. However, in addition to the problems it shares with other Former Soviet Union (FSU) countries, its transition to a market economy has been complicated by regional conflicts. The war with Armenia, which began in 1989, has led to nearly 20 percent of the national territory being under the control of occupation forces, and about 900,000 people (out of a total population of 7.5 million) are refugees or internally displaced persons. While a cease-fire has been in place since mid-1994, the conflict has been costly in terms of defense spending, the social and economic costs of occupation, and difficulties in accessing economic assistance.

1.2 Unprecedented shocks to the economy, stemming from the conflict with Armenia and its ensuing refugee problems and from the dislocation of trade links among the FSU countries, have resulted in a continuous decline in output, high inflation, and significant erosion of real wages. Severance of transport links to traditional markets, owing to the conflict in Chechnya and political problems with Iran, has compounded the deterioration in external trade and intensified output contraction. As a consequence, Azerbaijan's GDP was half its 1989 level by the end of 1993, and is estimated to have contracted by a further 22 percent in 1994. Although the official figures on output may fail to include some informal sector activities, there is no doubt that the declines have been particularly severe even relative to other FSU countries.

1.3 Since independence, Azerbaijan has experienced several changes in government and considerable political instability. However, since late 1994, the current President has appeared to be in firmer control of the country and government apparatus, to the extent that Parliamentary elections were held in mid-November of 1995. The Government has also taken a number of important steps to liberalize economic activity and promote the transition from a centrally managed to a market economy. A national currency has been introduced, most prices have been liberalized, some financial sector reforms have been initiated, and a buoyant and rapidly expanding private sector has emerged in trading activities. A more appropriate legal and institutional framework to support these reforms is being developed. However, structural reforms, such as privatization, have been relatively slow to take off.

B. The Energy Sector

1.4 The energy sector has played a key role in the development of Azerbaijan's economy. Azerbaijan's initial economic growth was largely driven by oil exports, and by the subsequent development of industries in support of oil and gas production. However, oil production has fallen sharply since 1970, and the growth of other industries has reduced the relative importance of the sector. Gas production has also declined rapidly in recent years, and the country is no longer self sufficient in energy, and relies on gas imports to meet its energy needs. -2 -

1.5 The structure of Azerbaijan's energy balance is relatively straight-forward with oil and gas accounting for about 97 percent of primary energy supply, and hydropower and biomass providing the remainder (see Annex 1.1). Most non-transport energy demands are met from natural gas or fuel oil. Power stations are largely designed to use gas, although they can (and currently do) use fuel oil. Industrial boilers are almost all designed to use gas, and households rely on natural gas for a significant proportion of their energy requirements - although gas-fired district heating also plays an important role in urban regions. Residential reliance on natural gas, especially in small towns and rural areas, is attributable in part to past policies to extend the natural gas network throughout the country irrespective of whether this was economically viable. However, the Government proposes in the future to rationalize the gas supply network, confining natural gas supply to major centers and customers and to meet the energy needs of less densely populated regions with Liquefied Petroleum Gas (LPG) and liquid fuels. Thus, the energy balance is expected, over time, to shift towards decreasing reliance on natural gas, at least for customers in rural areas.

1.6 The economy is highly energy intensive, even by the standards of the FSU. In 1990, its fuel use per unit of GDP was the third highest of the FSU countries. In addition, the severe economic contraction of recent years has not been accompanied by a proportional decline in energy use. While energy prices to industries have been steadily increased and now approach economic levels, industrial customers have generally failed to respond to price signals by improving their efficiency, choosing instead to accumulate arrears in the absence of actions on the part of energy companies to cut off supply to non-paying customers. Energy prices to households, at least for essential supplies such as electricity and gas, remain well below cost recovery, even on a short-run marginal cost basis. This imposes an additional financial burden on energy suppliers, and acts as a disincentive to improved efficiency in either supply or consumption.

1.7 Despite its long history of oil production, Azerbaijan could benefit from large remaining oil resources in newly discovered fields, and the oil sector could again dominate the country's future development. The Government attaches great importance to private sector involvement in this development, and has signed agreements with international oil companies regarding the development of large off-shore oil fields in the Caspian Sea. Initial production under these agreements is expected in late 1997, with full development after the year 2000. Further agreements are being considered and negotiated to develop additional fields and to rehabilitate existing oil and gas deposits. Large- scale development of oil, however, will also require construction of new export pipelines to reach world markets.

C. Government Strategy and Bank/IDA Role

1.8 The Government considers a combination of rapid price stabilization, restoration of external balance, and accelerated structural reform as the only viable route to stability and growth. The authorities have agreed a macroeconomic program with the IMF, focussing on controlling inflation, improving external reserves, and limiting accumulation of non-concessional debt. Efforts are under way to reduce the deficit, liberalize trade and prices, and reform the enterprise sector so as to foster greater competition and private sector development. A privatization bill has been passed which provides a framework for privatizing all small and medium-sized enterprises through a combination of cash-based and voucher-based programs, and also for corporatizing those enterprises which will remain, at least for some time, in the public sector. At the same time, the Government is taking steps - 3 - to reform the social protection system, with a view to better meeting the needs of poor and vulnerablesegments of the populationwithin the limitationsof the resourcesavailable.

1.9 The Bank is supporting the reform agenda through the extension of IDA Credits. A RehabilitationCredit of SDR 41.6 million has been concluded,which focussedon supportingthe programof structuralreform of the enterprisesector. A PetroleumTechnical Assistance Credit of SDR 14.3 million is in place to financestudies and advisory services in support of the on-going developmentof oil and natural gas resources. A Baku Water Supply Project Credit for SDR 38.8 million has been approved to finance, jointly with EBRD, urgently needed investments in rehabilitatingthe water supplysystem, and an InstitutionBuilding Technical Assistance Credit for SDR 11.5 million is in place to strengthenthe capabilitiesof governmentinstitutions.

II. PROJECT CONTEXT AND STRATEGY

A. InstitutionalSetting

2.1 The key agenciesinvolved in the supplyof gas withinAzerbaijan are the State Oil Company of the AzerbaijanRepublic (SOCAR),and the gas transmission/distributionenterprise, Azerigaz. SOCARis responsiblefor gas production,both from offshoreand onshorefields. Most of the gas comesfrom offshorefields, generally in the form of associatedgas; onshorefields account for only a smallfraction of production(0.2 BCM out of 6.7 BCM in 1995). SOCARuses approximately1 BCM in its ownoperations and deliversthe balanceeither to the Karadaggas processing plant (GPP) or directlyinto the Azerigaznetwork. Due to the poor conditionof the Karadagplant and inadequate pipeline infrastructure,less than half of the gas is currentlyprocessed; consequently, much of the gas deliveredto Azerigazis high in both water contentand heavierhydrocarbons. Feasibility studies on replacingthe existingGPP are currently underwayunder the PetroleumTechnical Assistance Project,and dehydrationfacilities are expectedto be installedon existinggas wells in conjunction withadditional compression which will be neededto maintaintheir output. Howeverin the interim, the water content in particular imposes a cost in terms of accelerateddeterioration of the gas transmissionand distributionfacilities.

2.2 Azerigazpurchases gas fromSOCAR and other sources,and distributesit to over 1 million customers(residential, industrial and communalservices) through a number of regionaloperating departments.'Until the early 1990's,gas from Turkmenistanwas also shippedthrough Azerbaijan from the North Caucasusto Georgia and Armenia;this flow has virtually ceased, however, as a result of boththe war withArmenia and the economicproblems in the region. Azerigazwas formed in 1992through the mergingof the gas transmissionoperations of Aztransgaswith the branchesof the State Fuel Committee responsiblefor gas and LPG distributionto customers. Azerbaijanis amongthe mostwidely gasified countries in the world,and the gastransmission/distribution network extendsto over 80 percentof the population,and comprises4,500 km of high pressuretransmission lines, 7 compressorstations and over 31,000km of mediumand low pressuredistribution lines. In additionto naturalgas supply,Azerigaz also has departmentsresponsible for gas storage (with sites at Kalmasand Karadag),supply of LPG, pipelineconstruction and maintenance,scientific research

I There are 18 regionaltransmission branches and 12regional distribution companies. - 4 - and planning, equipment production and banking. An organization chart for the Company is provided in Annex 2.1.

2.3 Considerable progress has been made in rationalizing the operations of the company. Total employment has been cut from 22,000 to its current level of approximately 16,000. In addition, the company has recently proposed further consolidation of some of its research and maintenance activities, and plans to devolve some of its non-core activities such as construction and LPG distribution. However. there is still room for further rationalization and improved efficiency. Operations are scattered among a number of offices, activities are extensively duplicated, and lines of communication and authority are weak. Furthermore, company staff have had little access to modem management tools and techniques (computers, training) to assist them in upgrading their operations.

2.4 The pipeline network itself is generally in a poor state of repair. Minimal funds have been available in recent years to carry out maintenance or to replace pipe that has passed its design life. Compression is inadequate, both offshore and onshore, and Azerigaz has used high pressure imports from Turkmenistan in order to maintain reasonable delivery pressures in the outlying regions. System losses are very high, averaging 15 percent. Of this, at least 10 percent is estimated to be non- technical losses - i.e. gas which is used by customers but not billed as a result of faulty or absent meters, meter tampering or illegal connections. The remaining 5 percent is believed to be technical losses from system leakage. However, the exact split between technical and non-technical losses is difficult to establish since metering of the system is incomplete. While city gate stations and most large customers are metered, the meters are old, and are often faulty, inappropriately sized or inaccurate. Smaller enterprises and almost all residential customers are not metered but are billed based on "norms" - consumption units which are linked to other indicators such as the size of the service pipe, number of occupants, types of equipment installed, etc.2 While generally the norms are substantially higher than the measured consumption of similar types of equipment in other countries, they are insufficient to account for the full amount of gas which is supplied.

B. Supply/Demand Outlook

2.5 Azerbaijan's gas production has declined precipitously in recent years, from a high of approximately 13 BCM in 1986to an estimated 6.7 BCM in 1995 (of which approximately 5.7 BCM was available for sale to customers). While demand has also declined steadily since 1990, imports have been restricted due to the rise in Turkmen gas prices to "world levels", and it has been necessary to curtail gas use in power generation through substitution with fuel oil. In 1994, imports accounted for 2.2 BCM, or 30 percent of Azerigaz's total gas supply. The decline in domestic supply was partially offset in 1994 with the installation (by the U.S. company Pennzoil) of a compressor at the Oil Rocks field to allow capture of up to 1.4 BCM/yr of gas from the Guneshli field which was previously vented. However, the outlook for domestic supply shows little likelihood of additional improvement until the new offshore oil fields approach full development (not expected until post-2000), and could in fact deteriorate further unless investments are undertaken to redress some of the major problems. While some of these investments are relatively modest (e.g.

2 "Norms" are used as a basis for residentialgas billing in muchof the FSU, includingthe Russian Federation. approximately US$6 million for piping systems to recapture 0.4 BCM of gas currently being vented), others, such as installation of additional compressor capacity at some of the declining fields, would require investments in excess of US$1 00 million.

2.6 Total gas consumption fell from 17 BCM in 1990 to approximately 7.5 BCM in 1994, but a large part of the reduction came from curtailment of supply to the power sector. Between 1992 and 1994, most of the remaining decline in sales was accounted for by industrial customers, whose consumption fell by 0.9 BCM or 25 percent in 1993 and by a further 0.3 BCM or 13 percent in 1994. Figures for 1995 show an additional 10 percent decline over the previous year. In part, however, this drop may be attributable to the Government decision to curtail imports in 1995 (see para 2.9). Communal sales have also declined over the period. However, demand by residential customers has remained relatively constant, and hence has increased as a share of total consumption.

2.7 Recent experience, together with the short-term outlook for weak industrial growth, suggests a continuing decline in industrial consumption which is unlikely to be reversed in the near future, particularly if payment discipline is imposed and supply is cut off to non-paying customers. The forecast therefore uses 1994 as a base year, and assumes that industrial consumption will fall by 25 percent through 1998 (when it is expected that offshore oil developments will begin to revitalize the economy), and increase by 1 percent per annum thereafter. Zero growth has been projected in residential and communal sales, on the basis that the positive effects of income and population growth and of cross-price elasticities would be offset by improved end-use efficiency, and by rationalization of the rural gas network and hence a reduction in the number of customers served.

2.8 Table 2.1 below shows the gas supply/demand balances from 1992 through to the year 2000. Supply projections assume that no large investments are undertaken during this period to increase domestic gas production, but include approximately 0.4 BCM per year of supply as a result of early oil development in 1999 and 2000. Generally, the projections indicate an increasing dependency on imported gas, despite the drop in consumption, with required imports almost doubling from 2.2 BCM in 1994 to 4 BCM in 2000. - 6 -

Table 2.1 Gas Supply/Demand Balances (million cubic meters)

------Actual------Projected------1992 1993 1994 1995* 1996 1997 1998 1999 2000

Domestic 7,844 7,005 6,143 6,665 5,217 4,524 4,271 4,093 3,830 production** SOCARUse 1,000 1,000 790 988 800 800 800 800 800 AvailableSupply 6,844 6,005 5,353 5,677 4,417 3,724 3,471 3,293 3,030

Consumption Industrial 3,437 2,579 2,248 2,049 1,833 1,758 1,686 1,703 1,720 Communal 1,941 1,525 1,552 1,226 1,552 1,552 1,552 1,552 1,552 Residential 2,450 2,871 2,686 2,447 2,686 2,686 2,686 2,686 2,686 Power Generation 1,621 1,455 Losses (15%) 1,445 854 1,050 712 1,071 1,058 1,045 1,048 1,051 Total Consumption"** 10,894 9,284 7,536 6,434 7,142 7,054 6,969 6,989 7,009

RequiredImports 4,050 3,279 2,183 594 2,725 3,330 3,498 3,696 3,979

* Whileprojected required imports were 1.6 BCMfor 1995,the Governmentlimited imports during the year to only 594 million m3. The shortfall of over I billioA m between planned (projected) and actual consumptionwas met by reductionsin residentialconsumption (240 million m3) and communalconsumption (300 million m3) relative to projections,by withdrawal of approximately 160 million m3 from storage, and by reduced losses and own use, partly as a result of lower volumes. ** Assuming no major new investment in gas production. *** Excluding net transfers to storage.

C. Issues

2.9 Gas Supply: As noted above, domestic gas supply has been dropping rapidly in recent years, and, unless substantial investment is undertaken in compression, collection systems and well rehabilitation, is likely to continue to decline over at least the next 5 years. In the past, Azerbaijan has filled the increasing gap between demand and supply with imports, both from Turkmenistan and from Iran. After the collapse of the Soviet Union, however, Turkmenistan increased prices for gas to world parity levels, while the Iranians increased their export prices to even higher levels. As a result of poor customer payments and inadequate margins, Azerigaz was unable in 1994 to pay for the Turkmen gas and incurred a debt of approximately $81 million. Agreement was reached with Turkmenistan for repayment of this debt in approximately equal installments over 4 years, and Azerigaz was meeting the proposed schedule.3 The Government, however, decided that it was

3 ByMay 1, 1996,Azerigaz had paid off over$40 millionof the debt,and expect to repaythe remaining outstandingbalance by the end of the year. - 7 - unacceptable to incur further foreign currency debts for gas supply, particularly when gas losses are high, and instructed that no further gas would be imported during the winter of 1995/96. Supply has been cut-off to most of the country and gas is being supplied in full only to Baku and Sumgait4 . Meanwhile, SOCAR has been ordered to increase gas production, although there does not appear to be a coordinated plan as to how this can be done either technically, economically or financially. The Government has not made any official statements with regard to its intentions beyond the 1995/96 winter. The projections of domestic supply suggest, however, that if the ban on imports is extended, more severe supply curtailments will be needed.

2.10 The Bank has questioned these decisions on a number of grounds. First, the restriction of supply does not, in itself, address the problem of losses. Non-technical losses (which are the major issue) can only be addressed through a comprehensive program of metering and a strong corporate effort to identify and prosecute fraudulent uses. Secondly, not providing gas to a significant segment of the population raises the demands for other forms of energy such as fuelwood, LPG and kerosene, whose economic costs could exceed the cost of gas imports.5 Generating additional electricity requires additional fuel oil, which could otherwise be exported or used in other domestic applications, and the stability of the electricity distribution system could be jeopardized if loads increase significantly. The relatively high prices of kerosene, LPG and fuelwood will stretch the budgets of the population, and may not be affordable to the poor. (Annex 2.2 provides a comparison of the unit cost of alternative household fuels). Use of fuelwood is also damaging to the environment. In addition, these substitute fuels may not be available in sufficient quantities to meet the increased demand. Filling the gap will require imports (official or unofficial) of LPG and liquid fuels, or changes in the pattern of domestic supply (changes in the refining mix, investments in additional distribution facilities, etc.). Lack of gas for fuel also affects industrial outputs. Some of these impacts were already being observed at the time of appraisal (January, 1996). The overall economic cost of curtailing gas supply probably exceeds the savings on gas imports.

2.11 The Governnent needs to take a more integrated, long-term view of the issue of gas supply, rather than continuing to manage supply on a "crisis" basis. Feasibility studies are needed on the options for increasing domestic supply, both to ensure that the options are economic and to attract necessary investment funds.6 In addition, the question of restrictions on imports needs to be re- assessed in the context of the impact on the total economy. If gas is being wasted, either through losses or through use by non-productive sectors of the economy, these problems should be addressed through appropriate metering and pricing. Denying supply to large segments of the country, while continuing to indiscriminately supply other regions does little to resolve the problem.

2.12 Gas Prices: The system of gas pricing in Azerbaijan is seriously distorted. These distortions directly contravene long-term objectives of increasing the supply of domestic gas, encouraging

4 The limitationin the areas suppliedis attributablein part to the fact that Azerigaz's compressionproblems have been aggravatedby the loss of high pressureTurkmen gas.

5 In the Surveyof LivingConditions carried out in November/December1995 in conjunctionwith the ongoingWorld Bank PovertyAssessment, over 40 percentof the populationreported using fuelwoodas their primary fuel for heatingand cooking.

6 Studieson rehabilitationof matureoffshore fields are being undertakenas part of the PetroleumTechnical AssistanceProject. -8 - efficient use of gas by customers, and preserving the financial viability of the gas company. Gas purchased from SOCAR is priced at US$10.80/MCM equivalent ($9.00/MCM to SOCAR, plus 20 percent royalty)7 . Gas imports from Turkmenistan are priced nominally at US$80.00/MCM, but payment is made in commodities and the effective price is estimated to be approximately US$43.00/MCM. Including 15 percent losses, the effective cost of gas sold is $12.40/MCM from SOCAR and $49.50/MCM from Turkmenistan. Selling prices to customers are similarly distorted, both across sectors and relative to gas purchase prices, with residential prices at $2.80/MCM8 , as compared with $23.60/MCM for communal and $53.30/MCM for industrial use.

2.13 With respect to stimulating domestic supply of gas, while the current price to SOCAR of $9.00/MCM is more realistic than the previous price of $3.50/MCM, it is unlikely to be sufficient in the long term to attract the funding needed to develop significant additional gas supplies.9 Consequently, the recent gas price increase must be viewed as first step in a longer term program which provides adequate incentives for increased gas production. This will also require suitable long term purchase contracts. The Government has confirmed its intention to undertake, within a reasonable time frame, a review of the producer pricing system for gas which addresses the investment needs of gas development and also the need to attract foreign investment to gas development projects. In addition, the arrears problem needs to be urgently addressed (see para 2.23). High prices will not be a sufficient incentive for development without corresponding assurances that the gas will be paid for.

2.14 As regards the financial viability of the gas company, while Azerigaz currently has a positive spread between average selling and purchase prices, the situation is tenuous. The positive balance could be quickly eradicated by small shifts in either the proportion of sales to the higher tariff customers (industrial and communal) or the proportion of imports to total gas supply. Furthermore, the spread or margin currently budgeted in the tariff to cover operating and maintenance costs and depreciation on the transmission and distribution systems is less than US$2.00/MCM, which is inadequate even given the relatively low cost of local inputs, and certainly does not leave a margin for capital expenditures.'" Based on the projected supply/demand balance shown in Table 2.1 (including essential imports in 1996) and the current pricing structure, Azerigaz's costs of gas supply would exceed revenues in 1996 by approximately US$27 million - equivalent to a loss of $4.40/MCM of sales."

7 Prior to November1, 1995,the price to SOCARwas equivalent to only US$3.50/MCM. 8 Theresidential price was increased from $1.40/MCM to $2.80/MCMfrom June 1, 1996as a conditionof ProjectNegotiations. 9 The compressorand pipelinesections which were constructedat Oil Rocks, for example,cost $160 million and yieldedincremental supplies of approximately1.4 BCMper year. At a 10%cost of capitaland 10 year amortization,this equates to a cost of roughly$18.50/MCM. 10 By contrast,average distribution margins on gas sales in Russiaare in excess of USS5.00/MCM.In addition,the Russianmargin excludesthe costsof transmissionto the city gate. I I If importcurtailment continues, the projectedsupply/demand balance, which preservescurrent market sharesfor each sector,would providean adequatemargin on 1996sales at currentprices. However,the economic and socialcosts of the curtailmentare viewedas unacceptablyhigh, and financialviability remains vulnerable to small shifts in sectoralshares of the market. - 9 -

2.15 In order to ensure the financialviability of the sector, gas prices to consumerswill have to increase. There is little scope for furtherincreases in industrialgas prices,which are already close to parity with the economic(and financial)costs of alternativefuels. Hence, price increaseswill have to focus on the residentialand communalsectors. Residentialprices in particularneed to be adjusted. Not only are they below the short run cost of supply, but they are only a fraction of the cost of alternativefuels, and are significantlyless thanprices in other FSU countries(see Annex2.2). The Governmenthas therefore agreedto maintainall prices at not less than their current levels in real terms, and to make quarterly upward adjustmentsto communaland residentialgas prices as necessaryso as to ensure Azerigazan averageannual operatingmargin of at least US$4.00/MCM equivalent(in constant 1996 dollars) based on reasonableprojections of gas sales and purchases. In addition,as an indicationof commitmentto price reform, the Governmentagreed to implement a two-timesincrease in residentialgas prices (to 12,700manats/MCM or US$2.80 equivalent),as a conditionof Creditnegotiations. The Governmenthas also agreed,by January31, 1997,to prepare a scheduleacceptable to IDA for furtherincreases in residentialgas pricesto equate them to at least the cost of gas purchases. This schedule would be coordinated with both the introductionof residentialmeters and the developmentof a mechanismto protect low-incomehouseholds from adverse impactsof price increases(see para 2.17 and 2.19).

2.16 Coordination of Energy Policy: Responsibilityfor the energy sector in Azerbaijanis divided among a number of governmentagencies (Ministryof Finance, Ministry of Economy, Cabinetof Ministers,Office of the President)and state-ownedenterprises (SOCAR, Azerigaz, the State Fuel Committee,Azerenerji, etc). In the absenceof a coordinatingunit, which can research issuesand advisethe Governmenton sector-wideimplications of policies, decisionsare sometimes taken to address a problemin one area which have substantialadverse impactsin other areas. An exampleis the recent decisionto terminategas importsfrom Turkmenistan. The implicationsof this decisionon the demandsfor electricityand other fuels,on the environment,on the socialwelfare of the populationoutside the majorurban centers, and on the financialviability of Azerigazdo not seem to have been fully takeninto accountin evaluatingthe net benefitsof the scheme. The Government has been strongly urged to establish, if not an energy ministry, at least an energy coordinating commissionwhich could prepare an integratedenergy strategyfor the country, and provide policy recommendationsto the Governnent for its consideration.

2.17 Gas Meters: A comprehensiveprogram of extendingmetering to all customersis an urgent priority in Azerbaijan,to reduce non-technicallosses attributableto inadequatenorms, to reduce opportunitiesfor fraudand illegal connections,and to provideAzerigaz with essential information on gas flows and technicallosses. Metersare also essentialif customersare to have an incentiveto use gas more efficiently.The proposedproject will financethe meteringof all major industrialand commercialcustomers, and will financeimproved instrumentation at city gate stations. However, the full benefits of metering will only be achievedonce meters are also installed at households. Householdmeters will also help to alleviatethe impactsof increasesin residentialgas prices, since householdswill be able to control their gas bills by opting to reduce their consumption. Azerigaz and the Governmenthave thereforeagreed to develop,by January 31, 1997,a programto extend meteringto coverall residentialcustomers, with priority assignedto the coverageof single-family - 10- dwellings and apartments which use gas for multiple purposes (e.g., cooking, heating, hot water)"2 . The program will include a timetable for completion, and a financing plan to cover the cost of the meters and of their installation.

2.18 Social Impacts of Gas Price Increases: Affordability of gas supply is an issue of major concern for a significant segment of the population, and care will have to be taken to ensure that relief is provided in cases of genuine hardship. However, affordability and the social impacts of price increases have also been used by the Government as an argument against any meaningful increase in residential prices. In fact, uniformly low prices result in a substantial transfer of welfare to the wealthy, who receive their gas at the same price as the poor, and may in fact consume larger volumes as they have larger dwellings and may use appliances more intensively. In addition, the concern over affordability may be exaggerated. Prior to the recent doubling of residential gas prices, a typical household using gas for heating, hot water and cooking was paying under 1 percent of monthly income for gas (approximately 2,000 manats or 45 cents per month, as compared with an average stated household income of $55.00'3). There is substantial scope to increase prices for households at average and above average incomes, and a 7 to 10 times increase should not be unreasonable. Moreover, the billing norms (i.e. the amounts of gas for which customers are charged) are significantly higher than the measured consumption of western households for similar applications.'4 This would suggest that, once meters are installed, many households may find that their gas costs decrease by virtue of proper measurement, while others will be able to decrease their costs by taking basic steps to conserve gas (such as turning off the cooker when it is not in use).

2.19 While households at and above average income levels would not be unduly affected by significant increases in residential gas prices, households in the lowest income deciles could have difficulty in accommodating higher gas costs. (A more detailed analysis of the distribution of incomes and expenditures is contained in Annex 2.3). With a 10-fold increase in prices, basic quantities of gas for cooking and heating would cost over 10 percent of income for low income households (defined as the average of the first 3 income deciles) in the winter months. Arguably, some of these households are already paying even higher proportions of income for energy, since the recent curtailment in gas supply has forced them to use higher cost fuels. Provision should be made for a targeted program of income support to ensure that lower income households can afford an adequate supply of energy. Proposals in this regard are currently being evaluated in consultation with the Poverty Assessment team, and the Government has agreed that a targeted mitigation program for low-income households from adverse impacts of higher energy prices will be initiated in conjunction with the proposed program of residential gas price increases. Some of the cost of

12 Meteringof individualapartments, particularly where gas is used only for cooking,may not be cost effective. In these cases, considerationcan be givento installingmeters either on risers or for the buildingas a whole,and allowingtenants to agree a basis for apportioningthe bill among individualunits. 13 Preliminarydata, AzerbaijanSurvey of LivingConditions, carried out in November/December1995 in conjunctionwith the ongoingWorld Bank PovertyAssessment. 14 For example,norms for cookingand waterheating are 31.5 m3/person/month- or 126 m3/monthfor a 4 personhousehold. By comparison,metered household consumption in Germanyfor cookingand water heatingis approximately33 m3/month. - I1 - such a programcould be coveredby eliminatingpoorly targeted gas subsidies,such as those now accordedto teachers and workingpensioners." 5

2.20 InstitutionalIssues: As noted above,Azerigaz was createdby the merger of a number of disparateentities. System-wide,it has some 16,000employees, operating in a numberof geographic regions. Notwithstandingthe decentralizationof many activities,strategic planning and decision- makingare tightly controlledat the seniormanagement level. As a state owned enterprise,Azerigaz has not been encouraged,or even allowedto operate on a commercialbasis. Prices, margins and service policies are set by the central government,and funds for capital expendituresare allotted from centralbudgets, often based on the availabilityof funds for particulartransactions rather than on the prioritizationof investmentrequirements and competitiveselection of the most cost-effective technology.

2.21 Azerigaz has put forward proposals for its conversion to an independent joint stock company, and has prepareda draft charterfor governmentreview. Any restructuringwill be carriedout within the contextof the Government'scurrent privatizationprogram. Given the lack of a legislativeor regulatoryframework for the gas sector,privatization would be prematureat this time. However, corporatizationshould move forward, initially with a view to introducing a more commercial orientation into the company's operations,including separate accountabilityon the part of the variousoperating divisions. Transparencyof transactionsbetween divisions is important,especially betweentransmission and distributionactivities. Ultimately,the objectivewould be the separation of transmission and distribution. Social services should be transferred to the public sector. Competitiveservice activities (e.g. construction)can be spun off. Private participationin some or all of the activities can be introduced once the proper regulatory framework is in place. This objectiveshould be taken intoaccount in definingthe corporatestructure, possibly through a holding company/subsidiarystructure which dividesoperating assets among the variousoperating divisions. The Governmenthas issueda PresidentialDecree orderingthe establishmentof Azerigasas a joint stock society,with shares held initially by the State Property Committee. The Governmentagreed to completethe corporatizationprocess by September30, 1996 under a charterwhich reflects the commercialfocus of the company,and also the ultimate separabilityof its variousactivities. The Governmenthas also expressedits commitmentto timelypassage of a gas legislation,based in part on work to be undertakenwith EU-TACISfinancing.

2.22 A related issue under the subject of institutionalreform is the immediateneed to address major problems in LPG supply. LPG bottling and distribution is currently handled by one of Azerigaz's operatingdepartments. While supply has declineddramatically in recent years, it is expectedto increaseas petroleum output rises and new gas processingfacilities are constructed. LPG demand is also expected to rise in conjunction with overall growth in incomes and rationalizationof the rural natural gas supply system. (Annex 2.4 providesadditional background detail on the current structureof the LPG industry.) However,in order to serve expectedmarket growth,substantial investments will be neededto acquirenew and replacementequipment, both for bottlingand transport. It has been proposedto meetthese investmentneeds by separatingAzerigaz's LPG operationfrom the rest of the company, and solicitingprivate participation(either whole or partial)in its operationsand development.The Governmenthas expressedits agreementto establish

15 About 50% of residential consumers benefit from concessions on gas tariffs, ranging from 10%to 100%. - 12-

LPG distribution as a separate company, and to privatize it in a manner which attracts significant investment from a qualified foreign company, while maintaining competitive conditions for LPG distribution. The Government plans to use funds available under the Institution Building Technical Assistance (TA) Project to support the privatization process, within the framework of the overall privatization program.

2.23 Accounts Receivable: Accounts receivable are a problem throughout the economy, but tend to focus ultimately in the energy sector because, for legal, political and often technical reasons, customerscontinue to be suppliedeven thoughthey are not payingfor the energy they receive. All of the energy enterprisesin Azerbaijanare running substantialarrears in collections. Enterprises which supply end users (Azerenerji,Azerigaz, the State Fuel Committeeand the district heating companies) are unable to collect in a timely manner, if at all. In turn, they are building up arrears among themselves and with SOCAR and the SOCAR refineries. Azerigaz's accounts receivable from customerstotal approximately 300 billion manats- of which approximately180 billion manats is due from Azerenerji- and Azerigazin turn owes correspondingamounts to SOCAR.

2.24 The buildup of arrears causes serious problems both for the enterprises and for the Government.Productive companies are unableto generatethe cash neededto purchasesupplies and equipment and to pay workers. They are also unable to reimburse the Government for taxes due. Those which can access commercialcredit are obliged to borrow, at high cost, to meet their obligations. The impact of price increases, in terms of encouraging increased production or more efficient use of resources, is weakened. In addition, enterprises which are no longer productive or economic continue to consume scarce resources, operating on the credit which is provided, involuntarily, by their suppliers. Finally, the real value of accounts receivable erodes over time with inflation.

2.25 Azerigazhas takena numberof actionsto managethe accountsreceivable problem, including arrangingmutual settlements, cutting off customerswhere possible, and acceptinggoods in lieu of cash settlements. However, they are still burdenedwith substantialand growing debts from the power company(Azerenerji), budget organizations,and some of the larger state-ownedindustrial enterprises,all of whom continueto be suppliedwith gas becauseit is either politicallyor legally impossible to cut off supply. The Government has been urged to take immediate action to address the issue of arrears at a national level, both to reduce existing arrears and prevent the accumulation of furtherdebts, and has passeda decree(No. 13, February7, 1996)which requires end-users to pay in advance for further supply of goods and services. However, in the case of the gas subsector, the Government has only allowed partial implementation of the decree. The right to refuse further supply to any customers who are not current on payments is essential if Azerigaz is to successfully manage its payment arrears. Additionalremedies, such as the right to attachassets of non-paying customers, to impose severepenalties for non-payment,to demandprepayment for supply, or to receive government compensation in the event that cut-offs are prohibited, could also be applied to supplement the right to curtail supply. The Government and Azerigaz have therefore agreed to a time-bound Action Plan to address arrears in the gas distribution sector. Specifically, the Plan specifies dates after which Azerigaz would be required to supply to all customers on a prepayment or letter of credit basis, with the exception of those agencies which are specifically exempted by the Government. Further, in the event that these exempted agencies fail to make timely payment for gas - 13 - received, the Government commits to making prompt payment on their behalf Details of the Action Plan are given in Annex 2.5.

D. Project Design Strategy

2.26 Given Azerbaijan's limited borrowing capacity and the constraints associated with IDA funding, it has been agreed to focus initial lending to the gas subsector on items which address the primary concerns of high gas losses, low efficiency of use, and high costs of maintaining the operating integrity of the network. Hence, the project focuses on metering, upgrading of the cathodic protection system, equipment for leak detection and gas quality analysis, and a limited amount of TA to assist in project implementation and support the corporatization of Azerigaz. Implementation of these initiatives should improve the cost-effectiveness of Azerigaz's operations, which in turn will increase the funds available for additional investments. Larger investments are required, in gas storage, the transmission system and in gas processing. However, these can only be initiated once considerable additional detailed preparatory work has been undertaken.6

2.27 From the policy perspective, agreements have been obtained which will further improve the financial position of Azerigaz (e.g. pricing, accounts receivable). In addition, initial steps will be undertaken to corporatize Azerigaz, with the longer term objective of enabling the company to operate on a commercial basis, enhancing its access to debt and equity financing, improving its operating efficiency, and increasing the value of the Government's interest in the enterprise.

E. Rationale for Bank Involvement

2.28 As noted in the Country Assistance Strategy (CAS) which is to be discussed by the Board concurrently with this project, the Bank's basic objective is to assist Azerbaijan in achieving a balanced transition to a market economy. With regardto energyand energy infrastructure,there is a need in the near term to maintain a basic provision of essential services to the population and to evolving enterprises,while at the same time minimizingbudgetary transfers. In the longterm, a reliable,efficient and financiallyself-sustaining system of energysupply is necessaryfor sustainabledevelopment. The proposed Projectpromotes these objectivesby supportingrehabilitation of existingfacilities, reduction of gas losses, and corporatizationof the gas distributionsector. The Projectwill also encouragemore efficient use of gas, whichwill help to reduceenergy costs, cut importrequirements and increaseforeign exchange available for other uses. Private sectorsupport for investmentsin naturalgas infrastructureis constrainedby the fact that no direct export revenues are available and returns are dependenton a still-evolvingregulatory system. However,the projectwill facilitateAzerigaz's transition to a commercially-basedoperation and will support development of a legal and regulatory framework for the sector, which are important first steps in introducinga market-basedsector organization, as well as attractingfuture private sector participation. The privatization of the LPG business, within the policy frameworkof the project, will assist in broadening private involvementin the energy sector.

16 A detailedfeasibility study of undergroundstorage investment is beingfunded by EU-TACISin parallel with this Project,at a cost of about $1.5 million. - 14-

F. Lessons Learned from Past Operations

2.29 Bank financed projects in Azerbaijan are only at the initial stages of implementation. However, experience to date with investment projects such as the Baku Water Supply Project and the Petroleum TA Project has shown that, as in other FSU countries, institutional capacity is limited, and responsibilities are often not well defined among government departments and enterprises. There is also a lack of local familiarity with Bank procedures, particularly as regards procurement, and the practical aspects of implementation, such as international communications and language difficulties, can create delays. Bank practice in other FSU countries has been to devote a considerable effort to general institution building and training among counterpart agencies and government departments, to provide for a substantial degree of support to the project implementation unit (PIU) within the project budget, and to allow for above-average levels of supervision effort. The establishment of a fully-staffed Resident Mission in early 1996 has helped to resolve some of the practical difficulties, and has improved coordination with and among government agencies.

2.30 The World Bank has financed a number of gas distribution and transmission projects. Among the most pertinent lessons which have been learned are: (a) the importance of defining fully the institutional framework for natural gas, including enterprise autonomy and regulation; (b) the need for clear targets for gas price reform and for financial viability of gas enterprises; (c) the importance of institutional strengthening of gas enterprises, coupled with the need for a long-term approach to the process; (d) the importance of strengthening the contractual and operating relations between the gas company, the gas suppliers, and the major gas consumers; and (e) the importance of integrating gas supply forecasts with gas system investments. Along with assurances of financial viability through appropriate pricing policies, it is also critical to ensure counterpart funding as required.

III. THE PROJECT

A. Project Origin and Formulation

3.1 The Energy Sector Review carried out in 1993' emphasized the importance of natural gas as a source of energy in Azerbaijan, but also recognized the need to improve the efficiency of gas production, transport and use. In September 1993, the Japanese Government provided a grant to the Government of Azerbaijan to finance a project preparation study, which would identify priority investment requirements in gas transmission and distribution, and serve as a basis for project lending by the World Bank and other international lending agencies. The consultants engaged to undertake the project preparatory work found that the gas transmission/distribution enterprise, Azerigaz, was suffering from a lack of investment in new capital equipment, replacement parts and modernization. Existing metering equipment was outdated and inaccurate, the network was in a poor state of repair, operations and maintenance of the pipeline systems were highly labor intensive and obsolete equipment was often not replaced. Losses, both technical and non-technical, were high, and there was little incentive to conserve energy. The consultants' report identified a number of necessary investments, and outlined a priority program with a foreign cost of approximately US$90 million.

17 World Bank, Azerbaijan Energy Sector Review, Report No. 12061-AZ, December 27, 1993. - 15 -

This included metering, pipe replacement, gas dehydration units, laboratory and testing equipment, construction equipment, detailed reservoir studies and essential maintenance for the storage facilities, equipment for LPG distribution, cathodic protection and planning studies for future network development. The total amount of investment which was identified as being required in the medium term is substantially higher (over $150 million), but further feasibility work is needed, particularly as regards development and rehabilitation of transmission, gas treatment and storage facilities.

3.2 As a result of the restricted borrowing capability of the Government, together with the need to allocate resources among a number of sectors, it was not possible to meet the full investment needs of the gas subsector in the first Credit. Accordingly, based on detailed analysis of the costs and benefits of various components, Azerigaz and the Bank defined a more limited project, consisting of priority investments which would address the most pressing problems of the sector, would yield high and early returns, and would contribute to long-term viability of the sector.

3.3 It was agreed that the proposed project would focus on the primary concerns of high gas losses, low efficiency of use, and high costs of maintaining the operating integrity of the network. Hence, the project includes metering, upgrading of the cathodic protection system, equipment for leak detection and gas quality analysis, and a limited amount of TA and equipment to support project implementation and the corporatization of Azerigaz. Implementation of these initiatives should improve the cost-effectiveness of Azerigaz's operations, which in turn will increase the funds available for additional investments.

B. Project Objectives

3.4 The principal objectives of the proposed project are to::

(a) promote more efficient use of gas and reduce non-technical losses by replacing obsolete and inaccurate metering, improving measurement instrumentation, installing meters where none presently exist, and establishing associated meter proving facilities;

(b) improve the physical accounting for gas and encourage an improved commercial basis for gas trading through the upgrading of metering and instrumentation;

(c) ensure the efficient operation and preserve the value of the existing pipeline assets through investments in cathodic protection, gas analysis and leak detection equipment; and,

(d) support the commercialization of Azerigaz and further development of the sector through technical assistance, training programs and the acquisition of modem office equipment. -16-

C. ProjectDescription

3.5 The project is divided into four main components, each of which has several sub- components. The componentsare: (a) metering; (b) cathodicprotection (CP) rehabilitation;(c) analyticalequipment; and (d) corporatizationsupport.

3.6 Metering: The metering component includes: (a) rehabilitationof the city gate meter stationsthroughout Azerbaijan by replacingthe existing instrumentationor by replacingthe entire meterat somestations; (b) installingnew metersat industrialand largecommercial consumers who currently have no meters; and (c) rehabilitating the metering at the industrial consumers who currentlyhave metersby eitherreplacing the meters or replacingthe measuringinstrumentation. In addition, financingwill be providedto acquire related meter proving equipment and equipment packagesto facilitatemeter installation.

3.7 City Gate Stations: Approximately 214 meter sets at the city gate stations will be rehabilitatedor replacedunder the project. Thisincludes all the city gate stationswhich are currently in operationin Azerbaijanand those industrieswhich are fed directlyfrom the main high pressure pipeline. The programcovers all of the locations where gas is currentlydelivered from the main transmissionpipelines. As a result, an improvedmeasurement accounting will be achievedfor the gas sectorwithin the country. Instrumentationrehabilitation will includeinstalling flow computers, transmittersand powersupplies on existingorifice flow meters. The feasibilitystudies have shown that the maincause of the existinginaccurate measurement is obsoleteand faulty instrumentation.

3.8 New and Replacement Meters: Approximately 465 industrial and large commercial consumers are currently operating without metering and these will have meters installed. Approximately690 industrialand large non-industrialconsumers are currentlyoperating with meters which are either not functioningor are obsoleteand inaccurate. The larger consumerswill have instrumentationreplaced and some consumerswill also have the meters replaced,where this is justified. Initially,the meterswill be procuredas pre-assembledskid mountedpackages to simplify installation.

3.9 MeterProving Equipment: Meter proving equipment will also be purchasedfor each meter type and housedin appropriatelyconstructed facilities that will meet internationalstandards. This would satisfy the requirementof the AzerbaijanState StandardsCommittee and would allow a metertesting program for Azerbaijancomparable to internationalnorms. A signed agreementto be initiatedbetween the State StandardCommittee and Azerigazon Project implementationprocedure was sent to the Bank on February21, 1996.

3.10 InstallationEquipment: This componentincludes three vehiclesequipped with lifting and weldingequipment and necessarytools to modernizeand facilitateinstallation of meter sets.

3.11 Cathodic ProtectionSystem Rehabilitation: The cathodic protection of the pipeline systemthroughout Azerbaijan is in poor conditionand in need of rehabilitation,largely as a result of a lack of funds for investment. The CP rehabilitationcomponent would focus on the Apsheron peninsulaand cover about 2,700km of pipelines servingthat area. This area was selectedbecause it is where most of the gas is currentlytransported and consumed,and for safetyreasons as this is - 17- the area of highest population density. The rehabilitation program would include electrically isolating the pipelines into discrete sections, designing the detailed CP requirements for each section and installing the required CP equipment. A specialized consultant would assist Azerigaz in the initial isolation of two sections, one on the transmission system and another one on the distribution network, carrying out the design, and training Azerigaz to continue the work. In addition to the CP equipment, an allowance for approximately 900 tons of large diameter pipe has been included in the cost estimate. This would be used to replace seriously corroded pipe which is discovered during implementation.

3.12 Analytical Equipment: This component consists of three sub-components: (a) gas quality test equipment; (b) leak detection equipment; and (c) computer software and hardware to undertake network modeling. The gas quality test equipment would upgrade Azerigaz's gas analysis capability, and would include gas sampling and analysis equipment to verify gas quality and heat content, and improve gas accounting. The equipment would be used for on-site testing of gas supply by SOCAR to Azerigaz, and housed in Karadag in a suitably constructed building in line with international norms. The operational procedures for this gas testing center will be included in the supply agreement to be signed between Azerigaz and SOCAR (para. 4.3). Leak detection equipment would replace the existing equipment which is obsolete and in many cases not working; and network modeling tools would assist Azerigaz in carrying out engineering analysis for system capacity and design.

3.13 Corporatization Support: The Corporatization Support component of the project includes: (a) assistance in project implementation; (b) training for Azerigaz staff; and (c) upgrading of office equipment. Implementation assistance, which will be provided by consultants, would include assistance in procurement, engineering, project management and accounting, and implementation supervision (PEMS). Training would include assistance with company organization and management and training in modern procedures for commercial operation (planning, budgeting, finance, accounting, marketing, human resources management). Office equipment includes the purchase of computer hardware and software to assist gas accounting, financial accounting, and technical groups. An allowance has also been made for items of equipment and technical assistance to support commercialization of Azerigaz, which will be identified as the process of corporatization moves forward.

D. Cost Estimate

3.14 The total project cost including physical and price contingencies is estimated at US$24.6 million equivalent, of which US$20.2 million, or about 82 percent, is the foreign exchange cost. Physical contingencies were estimated at 15 percent of base cost on all items. Price contingencies were estimated using the standard MUV index and the average price contingency is about 8 percent. Since Azerigaz will not be subject to Value Added Tax (VAT) and import duties, these costs have been excluded from the total project costs. Interest during construction will be borne by Azerigaz. Local costs include the costs of establishing and maintaining the PIU, the costs of personnel and equipment which will be involved in installation of new equipment, and the costs of facilities to house items such as gas analysis and meter proving equipment. Summary project costs are shown in Table 3.1. The cost estimate is shown in more detail in Annex 3.1. - 18 -

Table 3.1 Estimated Project Cost

---(in MillionUSS)--- Foreign Component Local Foreign Total as % of % of Total Total Metering 1.5 9.6 11.0 87 45

CathodicProtection 1.1 3.8 4.8 79 20

Analytical Equipment 0.4 1.0 1.4 73 6

Corporatization Support

- PEMS, Training 0.5 1.1 1.6 69 7

- Office Equipment 0.3 0.3 83

- Other 0.1 0.4 0.5 80 2

BaseCost 3.5 16.1 19.6 82 80

PhysicalContingency 0.5 2.4 2.9 83 12

PriceContingency 0.4 1.7 2.1 81 9

Total ProjectCost 4.4 20.2 24.6 82 100 Note: Figures may not add due to rounding.

E. Project Financing Arrangements

3.15 An IDA Credit would be extended to the Government of Azerbaijan in the amount of SDR 14.1 million (US$20.2 million equivalent), and would cover the foreign currency portion of the project. Azerigaz would finance US$4.4 million equivalent from internal cash generation to cover local costs. The IDA Credit would be on standard IDA terms of 35 years repayment, including 10 years grace, a service charge of 0.75 percent and a commitment fee not to exceed 0.5 percent. The Government would on-lend the full IDA Credit in dollar equivalents to Azerigaz at an interest rate equal to the IBRD variable rate on currency pool loans, adjusted every six months.'8 Repayment terms would be over 20 years, including 5 years grace. The proposed financing plan for the project is summarized in Table 3.2.

3.16 Funds from the IDA Credit would be available to finance equipment, materials and technical assistance for Azerigaz. A Credit Agreement has been concluded between IDA and the Government of Azerbaijan. A Subsidiary Loan Agreement (SLA) will be concluded between the Governrnent of Azerbaijan and Azerigaz. The execution of a SLA satisfactory to IDA would be a condition of

18 The proposed onlending rate reflects a number of considerations, including the role of Azerigaz as a public utility, and the financial constraints that it must operate under until residential gas prices can be adjusted to levels that more fully reflect full operating costs. - 19-

Credit effectiveness. A Project Agreement between IDA and Azerigaz will facilitate the achievement of project objectives and utilization of loan proceeds as intended. The Ministry of Finance will represent the Government of Azerbaijan. A chart of lending arrangements, legal agreements, and flow of funds is shown in Annex 3.2.

Table 3.2 - Proposed Financing Plan (US$ million equivalent)

Financing Source Local Foreign Total % of Total

I.D.A. 20.2 20.2 82 Azerigaz 4.4 4.4 18

Total 4.4 20.2 24.6 100

F. Environmental Aspects

3.17 In accordance with Annex E of OD 4.01, the proposed project has been assigned Category B classification. The project involves only rehabilitation and maintenance, and has no significant or irreversible environmental impacts. The natural gas savings generated by the introduction of gas meters would provide both direct and indirect environmental benefits. Direct benefits would include reduction in acid and greenhouse gas emissions (NOXand C02 ) associated with lower consumption of natural gas. In addition, reduction in natural gas leakages represents a significant benefit, since methane emissions produce a greenhouse effect that is 20 to 50 times greater than carbon dioxide for equivalent emissions. Indirect benefits would stem from the greater availability of natural gas and LPG and their potential substitution for more polluting fuels such as wood and petroleum products.

3.18 An environmental mitigation plan has been prepared to address potentially adverse project impacts, and is described in Annex 3.3. Only two components of the system rehabilitation may have a measurable impact on the physical environment: (a) replacement of degraded pipe; and (b) cathodic protection. The impacts of these components would depend on the specific characteristics of the locations involved which would only be determined during implementation. Mitigation measures to be taken are described in the environmental mitigation plan, and include the appointment of an environmental coordinator to work with the PIU and ensure that provisions in the plan are carried out. During negotiations, Azerigaz agreed to adhere to the proposed mitigation plan in implementing the project. Necessary preparation and training will be provided by the Procurement Engineering Management and Supervision (PEMS) consultant during the project implementation phase. - 20 -

IV. PROJECT IMPLEMENTATION

A. Implementation Arrangements

4.1 The existing project preparation unit within Azerigaz, which has worked closely with the consultants and the World Bank preparation missions in defining and analyzing proposed investments, will form the core of the PIU, supplemented by additional staff possessing relevant qualifications. A project director would lead the team and will be supported by a technical manager, a procurement specialist, finance manager and a logistics/administrative officer. An environmental coordinator will also be appointed to ensure that the environmental mitigation plan is implemented. Considering the substantial technical qualifications and experience of Azerigaz senior staff and their understanding of the problems faced by the company, the suggested procedure will be to assign existing senior staff to the key positions. Azerigaz has agreed, prior to Credit effectiveness, to formally establish a PIU, and to appoint managerial, operational and support staff sufficient to initiate project implementation.

4.2 Considering Azerigaz's lack of experience with international and Bank procedures, especially with regard to financing and procurement, it is proposed that consultant support services be provided for project implementation. The selected consultants would be conversant with World Bank practices and would have the backing or support capabilities to carry out their work effectively. The consultants will establish a nucleus project team in Azerigaz (resident in Baku). Specialists will be provided as needed under the implementation schedule, traveling to Baku on a regular and on an as required basis. In discussions with Azerigaz, terms of reference has been prepared (Annex 4. 1). The Letter of Invitation for the PEMS consultants will be issued under a Project Preparation Facility (PPF) advance. The PEMS consultants will be asked to bid based on a two-phase assignment, with the first phase to cover finalization of technical specifications and bidding documents for initial metering and leak detection packages. The second phase, which will commence following Credit effectiveness, will cover the balance of the implementation period.

4.3 The PEMS consultants will be expected to provide the following consultant skill mix:

(a) A Project Managerwill be provided to serve as a counterpart to the manager of the PIU and to manage and co-ordinate the activities of other members of the PEMS consulting team. This individual would be a specialist with expertise in design and management of gas network projects. He/she would assist the PIU to finalize the technical specifications, and would set up a project management system and train Azerigaz in its use.

(b) A Metering Specialist would be required in the early stages of the project to finalize metering designs, specifications and installation programs. Further assistance from this individual may be required on a short-term basis when additional metering packages are being prepared.

(c) A Procurement Specialist will advise and assist with the procurement process including the preparation of tender documents, bid evaluations and contracts with suppliers of equipment and services in accordance with Bank guidelines. The procurement specialist will also recommend institutional changes to strengthen the capability to procure goods and services from local and international sources. - 21 -

(d) A Financial Analvst will assist the financial manager in establishingproject accounting systems and procedures, in engaging auditors, and in preparing financial statements that conform to international standards and IDA requirements.

(e) A specialized sub-consultant for Cathodic Protection will be hired to carry out the initial detailed designs and implementation, train Azerigaz staff, set up a program for the survey of the entire pipeline system and monitor the implementation of this component. The consultant would also establish procedures for the definition and implementation of the emergency pipe replacement program.

(f) A Gas Sales and Purchase Contract Specialist will be provided on a short-term basis to assist Azerigaz in: (a) supplementing the existing contracts with industrial and commercial customers to provide for security, maintenance and operation of the new meter sets to be installed at the customer sites; and (b) concluding a gas supply contract with SOCAR in line with the industry norms providing particularly for operation of the new gas measurement center to be installed in Karadag.

B. Schedule

4.4 The project will be implemented over four years, starting in the third quarter of 1996 through the fourth quarter of 2000. All components will be launched in the first two years of the project. The proposed implementation schedule is shown in Annex 4.2. As noted above, it is expected that the PEMS consultant contract would be signed prior to Credit effectiveness (with the second phase subject to satisfactory performance during the PPF phase). It is anticipated that the PEMS consultants will be in place by the end of the 3rd quarter of 1996.

4.5 During 1996, Azerigaz will, with the assistance of the PEMS consultants, complete a detailed customer survey for the proposed metering of large consumers and for the meter upgrading at the city gate stations. This survey will confirm the need for metering at each premises, confirm whether new or upgraded metering is required, determine the detailed design requirements, and determine installation details for each consumer.

4.6 The Procurement process for the first package of the metering component, which will include major city gate stations, will begin in the 4th quarter of 1996, and the first deliveries of equipment will begin in approximately the 4th quarter of 1997. Procurement of industrial and commercial meters will begin in the 3rd quarter of 1997, with subsequent packages to follow as detailed specifications of individual customer requirements are finalized. Procurement of leak detection equipment will also be initiated in the 4th quarter of 1996, with the first deliveries expected in the 2nd quarter of 1997. Implementation of the cathodic protection component will begin in early 1997, with the consultants completing the initial surveys, implementation and training by the 3rd quarter of 1997. Procurement of the gas quality equipment will be started in early 1998 following design and specification studies. Including installation and commissioning, this component will be completed by mid-1999. - 22 -

C. Procurement Arrangements

4.7 Table 4.1 summarizes the procurement approaches to be used for the project. All Bank financed goods and equipment will be procured in accordance with the "Guidelines: Procurement under IBRD Loans and IDA Credits," published in January 1995 and revised in January 1996. Consultant services will be procured in accordance with the "Guidelines: Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency", August 1981. The equipment and services to be financed by IDA mostly consist of standard, conventional items available from numerous suppliers worldwide. The project consists of 19 packages of which 10 packages with a total estimated cost of US$18.2 million would be procured under International Competitive Bidding (ICB). It is proposed that 5 contracts for specialized goods such as test equipment and network modeling, with an aggregate value of about US$2.3 million, would be procured under limited international bidding (LIB) using IDA's standard bidding documents for goods. The remaining four packages with total estimated value of about US$4.1 million for items such as PEMS, training and office equipment will be procured in accordance with IDA Guidelines for selection of consultants and through International Shopping (IS).

4.8 The first general procurement notice has been published in the UN Development Business in the summer of 1996, and thereafter notices will be published annually about the same time throughout the implementation period for all outstanding procurement. For the ICB packages, specific procurement notices will be published both in local papers and UN Development Business.

4.9 Equipment installation will be performed primarily by the Construction Department of Azerigaz (Azerigaz Glastroi) and by local contractors, hired using local procurement rules, and financed by Azerigaz. Quotations will be obtained from local contractors and the contract will be awarded to the lowest evaluated bidder. Azerigaz has recently established a transaction committee to ensure proper implementation of these procedures as well as review of all the bids for management approval. Constructionworks associated with equipment installation will be supervised jointly by local construction management teams and equipment supplier representatives, as well as by the PEMS consultant.

4.10 Consultants to provide implementation assistance and other technical assistance will be selected in accordance with the "Guidelines: Use of Consultants by World Bank Borrowers and by The World Bank as Executing Agency," August 1981. Azerigaz will select and manage the Consultants and the selection procedure will be on a competitive basis using a short list of firms proposed by Azerigaz and agreed by IDA. The Consultants would be employed under the World Bank's "Standard Form of Contract for Consultants' Services for Complex Time-Based Assignments - June 1995." - 23 -

Table 4.1 - Summary of Proposed Procurement Arrangements (US$ million equivalent)'

Project Element Procurement Total Costs Method ICB Other2 1. Goods: 1.1 Metering 1.1. I City Gate Meters 2.9 2.9 (2.4) (2.4) 1.1.2 Industrial Meters 10.2 10.2 (9.0) (9.0) 1.1.3 Proving and Installation Equipment 0.8 0.8 (0.6) (0.6) 1.2 CathodicProtection 5.1 5.1 (3.9) (3.9) 1.3 Analytical Equipment 1.5 1.5 (1.2) (1.2) 1.4 Office Equipment 0.2 0.2 (0.2) (0.2) 2. Consultant Services: 2.1 ImplementationAssistance (PEMS) 2.7 2.7 (1.8) (1.8) 2.2 Training 0.3 0.3 (0.3) (0.3) 2.3 CorporatizationSupport 0.5 0. 5 (0.4) (0.4) 3. Miscellaneous: 0.4 0.4 3.1 RefinancingPPF (0.4) (0.4) Total 18.2 6.4 24.6 IDA Financed (15.4) (4.8) (20.2)

Notes: Figures in ( ) are the amountsfinanced by the IDA Credit. Discrepanciesmay occur due to rounding. I. Costsinclude contingencies. 2. Office equipmentwould be procuredby IntemationalShopping (IS). Goodsof a specializednature (analytical equipment and metertesting equipment)would be procuredby Limited IntemationalBidding (LIB). Consultingservices would be procuredin accordancewith BankGuidelines for the Useof Consultantsby World Bank Borrowers(August 1981) 4.11 Qualified suppliers from Azerbaijan will be encouraged to bid on procurement packages. The bidding documents for ICB procurement will include the domestic preference, as per the Bank's Guidelines, for goods manufactured locally, of 15 percent of the CIF price or the value of import duties and charges, whichever is less. Considering the separable nature of most of the project components, procurement arrangements will be structured so as to be sufficiently flexible to accommodate adjustments in the work program during project implementation. - 24 -

4.12 Azerigaz staff, assisted by the PEMS consultants, will be responsible for preparing and maintaining detailed procurement plans. These plans will contain a list of bidding documents to be issued and a schedule for each proposed contract, giving the date when the draft will be ready for Bank review, when bid documents would be released, the bid opening date, the date the bid evaluation report will be given to IDA for its review, the contract signing date, and the dates when equipment will be delivered or services rendered. Equipment procurement will be structured in a phased manner to minimize the financial risks for the borrower. This is feasible because of the divisible nature of the project. Periodic reviews of the financial viability of the project components and of Azerigaz will be undertaken in close concert with procurement reviews, to ensure that the individual project subcomponents remain feasible, and the procurement plan will be adjusted accordingly. Annex 4.3 shows the procurement plan for the project.

4.13 All contracts for goods procured under ICB, LIB and IS will be subject to IDA's prior review procedure. The terms of reference for all consulting assignments will be subject to prior review by IDA. All consulting contracts in excess of US$100,000 for firms and US$50,000 for individuals will be subject to IDA's prior review procedure. This relatively extensive review of the procurement packages is considered necessary because of the inexperience of Azerigaz. In addition to IDA's review procedure, a procurement specialist, contracted under the implementation assistance component of the Project, would assist Azerigaz to implement the procurement according to IDA's Guidelines.

D. Disbursement

4.14 The profile of yearly expenditures for the IDA Credit is given in Table 4.2. The distribution over the implementation period (spread over five Bank fiscal years) is uneven, with 11 percent to be disbursed in fiscal year 1997, 29 percent in 1998, 33 percent in 1999, 21 percent in 2000 and 6 percent in 2001. This distribution is consistent with the borrowers' ability to implement the project and is based on the preparation work done on the terms of reference for implementation assistance and technical specifications. In the first year, the disbursements will be for consultants to assist in project implementation and launching the first procurement package for metering (CGS). In the second, third and fourth years, the engineered materials, equipment and remaining TA would be disbursed.

4.15 Disbursements will be made against Statement of Expenditures (SOEs) for goods and consultants' services up to US$50,000 equivalent for which detailed documents evidencing expenditures will be reviewed and kept by Azerigaz and made available for the required audit as well as to Bank supervision missions. Disbursements against contracts for goods and consultants' services exceeding US$50,000 equivalent will be made against normal documentation. - 25 -

Table 4.2 - Disbursement Schedule of the IDA Credit (US$ million equivalent)

| FY97 FY98 FY99 FY00 FY01 Total

Annual 2.3 5.8 6.6 4.2 1.3 20.2

Percent of Total 11.4 28.7 32.6 20.8 6.4 100.0

CumulativeTotal 2.3 8.1 14.7 18.9 20.2 _

4.16 To facilitate payments of small and medium size amounts in foreign currency and all payments in local currency, the Borrower will open a separate Special Account (SA) in a commercial bank acceptable to IDA. The maximum authorized allocation of the SA will be US$200,000. The initial amount to be deposited at the beginning of disbursement will be US$100,000. This amount will be increased to the maximum authorized allocation once the level of disbursement under the Credit reaches US$1,000,000 equivalent. Each disbursement from this account will require documentation from the Project Manager at Azerigaz to ensure that it is being used exclusively for eligible expenditures. Replenishment applications should be submitted at least every three months, and must include reconciled bank statements as well as other appropriate supporting documents.

4.17 Table 4.3 itemizes the withdrawal of the proceeds of the IDA Credit.

Table 4.3: Withdrawal of the Proceeds of the Credit

Category Amount % of Expenditures to be (US$ million) Financed Goods 17.2 100% of foreign expenditures, 100% of local expenditures (ex-factory cost), and 85% of local expenditures for other items procured locally Consultant Services 1.5 100% Project Preparation Advance 0.4 100% Unallocated 1.1 Total 20.2 - 26 -

E. Supervision

4.18 Owing to the nature of the project, the relative lack of experience on Bank projects in Azerbaijan and Azerigaz's lack of experience with Bank procedures, reporting arrangements are particularly important. Frequent adjustment of the work program is expected, in order to compensate for changing conditions during project implementation. To facilitate increased focus on the project objectives during implementation, a set of key development and performance monitoring indicators have been developed that will be specifically addressed in supervision missions and periodic reports by the borrower (Annex 4.4).

4.19 A project launch mission will take place early on to accelerate Credit effectiveness and project implementation. It is proposed that Azerigaz prepare monthly progress reports during the first year of implementation, and bi-monthly progress reports thereafter. These reports will be furnished to IDA and will present the physical progress of the project, procurement status, costs incurred and anticipated, disbursements made, administrative aspects and institutional performance. A mid-term review will take place towards the end of the second year and Azerigaz will be required to prepare a report describing the physical progress and an assessment of how well the project meets the overall project objectives and benefits.

4.20 Because of the borrower's inexperience and the fact that the project is broken into a number of components, project supervision will require more resources than normal Bank projects. Project supervision will entail two supervision missions annually. Requirements in terms of staff weeks are expected to be high (24 weeks) in the first year, but should decline to 20 staff weeks in the second year, and to 18 in the third and fourth years of the project. Annex 4.5 details the proposed supervision program.

4.21 During the implementation phase of the project, Azerigaz will be asked to agree to furnish the following financial reports to IDA: (a) financial statements, within three and one-half months of the end of each fiscal year, beginning with fiscal year 1996; (b) audited project accounts, beginning with the account for year 1996, within six months of the end of each year; and (c) audited financial statements within six months of the end of each year, beginning with fiscal year 1996. Azerigaz will also prepare and furnish to IDA, within six months of project completion, a completion report including a reassessment of proiect costs and benefits.

F. Insurance

4.22 Insurance on equipment procured under the project will be provided during shipment under terms of the purchase contract. Azerigaz is obliged to maintain insurance on all of its assets, and once installed, the new equipment will be covered in the same fashion. - 27 -

V. FINANCIAL ISSUES

A. Financial Rates of Return

5.1 Projected financial returns on the project are fully satisfactory. The overall financial internal rate of return (FIRR), at currently prevailing prices for inputs and outputs, is 51.6 percent after tax. Returns on the main subcomponents are: 46.3 percent for the asset preservation components of the project (cathodic protection, leak detection equipment, and analytical equipment and models); 33.6 percent for new meters for large industrial and commercial customers; 70.9 percent for replacement meters; and 108.9 percent for the upgrading of instrumentation at the city gate stations.

5.2 Details of the financial rate of return analysis are contained in Annex 5.1. The level and timing of capital costs is based on the cost estimate and implementation schedule outlined in Sections 3 and 4. Financial benefits associated with the asset preservation components of the project derive mainly from the gradual extension in the life of the pipe network and the consequent reduction in annual pipe replacement costs. Average annual requirements for pipe replacement were assumed to be 5 percent without the project (20 year life). With the implementation of cathodic protection, they are assumed to decline from 5 percent to 3 percent per annum over the first 5 years and to 2.5 percent per annum by the end of 15 years.19 Financial benefits also accrue through reduced gas leakages within the area where the project is being implemented, as a result of both cathodic protection and acquisition of leak detection equipment, and from savings in electricity consumption as compared with the existing, poorly isolated cathodic protection system.

5.3 Positive financial returs from the installation of new and replacement meters at large industrial and commercial customers accrue primarily from reductions in non-technical losses. Approximately 10 percent of existing meters are not functioning at all, and the remainder are judged to be under-reading by between 8 and 15 percent. Customers which currently have no meters are billed based on estimated consumption "norms" associated with the types of equipment installed. Together, these factors lead to system-wide non-technical losses of approximately 10 percent per year. These losses are expected to be virtually eliminated where new/replacement meters are installed. Conservatively, the loss reduction associated with replacement meters has been taken at 8 percent of sales, while the loss reduction associated with new meters has been assumed at 10 percent of sales. This latter figure almost certainly understates the likely degree of loss reduction, since unmetered industrial customers are likely to account for higher than "average" losses - particularly since the high norms for residential consumption may, in many cases, exceed actual consumption (which would imply greater use in industry than estimated by Azerigaz). The "recaptured" sales have been valued at the current industrial/commercial selling price of 240,000 manats/MCM (US$53.33/MCM). These gains will be offset, however, to the extent that customers are willing or able to respond to higher gas bills by using gas more efficiently. The same conservation impacts were assumed in both the financial and economic analyses: that is, 15 percent for unmetered industrial customers and 3 percent for customers receiving replacement meters. Azerigaz will lose the revenue which would have been associated with the sale of this gas (valued as above), and, since their distribution costs are largely fixed, will save only the cost of purchasing

19 With cathodicprotection, pipe life shouldincrease to between40 and 60 years. However,because of the relativelypoor stateof existing pipes, full realizationof these benefits is assumedto be deferred. - 28 - the gas from the supplier. This cost has been assumed, at the margin, to be equivalent to imports from Turkmenistan and valued at the current price of approximately US$43.00/MCM.20

5.4 Financial returns from the upgrading of the city gate metering stations were valued on the samnebasis. A more conservative estimate of the reduction in non-technical losses was used, since the meters are more distant from the end-users and it will therefore be more difficult to track down instances of under-billing. It was therefore assumed that improved city-gate metering will , where installed, lead to a reduction in non-technical losses from 10 percent to 8 percent. As with customer metering, some of this gain will be offset by customer efforts to use gas more efficiently. Customers were assumed to respond to higher gas bills by reducing their consumption by 1.5 percent. The recapture of non-technical losses was valued at the system weighted average selling price of $23.16/MCM. Reductions in sales due to induced efficiency gains were valued at the difference between the average selling price and the marginal cost of imports.

B. Financial Risks and Sensitivities

5.5 The primary risks which might affect the financial rates of return on the project relate to: (a) failure to actually capture the full potential benefits; (b) failure by Azerigaz to implement the project in a timely manner; and (c) unexpectedly high capital costs of the procured equipment. These risks, and their potential impacts on the project's rate of return, are discussed below.

5.6 A variety of technical and institutional factors may jeopardize the ability to capture potential financial benefits of the project. As regards the asset preservation components, the existing pipeline may be in worse condition than expected and hence expected savings in replacement costs may not materialize as early as expected. As regards metering, the benefits associated with projected reductions in unbilled consumption are based on system average figures for non-technical losses; however, actual reductions will depend on the specific loss characteristics of customers who receive the new meters, which may be less than expected. In the case of city-gate instrumentation, reductions in losses would be jeopardized if Azerigaz fails to follow up on and eliminate residual unbilled consumption. In addition, the estimates of financial return assume that, at the margin, the value of gas saved is equivalent to the price of imports from Turkmenistan. If the decision not to import gas in 1995/96 is extended indefinitely, and if there are no further increases in the price paid to SOCAR, then the value of gas saved will, at the margin, be equal to the current price of domestic gas - that is, US$10.80/MCM rather US$43.00. However, an indefinite ban on imports is neither expected nor recommended.

5.7 The impacts of lowered benefits on the project FIRR's have been quantified under a relatively pessimistic set of assumptions. Delays in realizing the benefits of investments in asset preservation do not seriously alter the financial viability of this component. Even if no reductions in pipe replacement were realized until 5 years after the project was completed, the FIRR would remain high at 27.5 percent. In terms of metering, however, the viability of new industrial meters

20 While the price of domesticgas supply is currently less than that of importedgas, importswill be needed for someyears to balancesupply and demand. In addition,while new offshorepetroleum developments should increasethe longer-termsupply of domesticgas, financialprices for this gas are expectedto rise to at leastat fuel- oil parity (currently$45/MCM equivalent) in order to ensure economicallocation and efficientuse of fuel resources. - 29 - could be jeopardized if benefits fail to meet expectations. A 50 percent drop in the recaptureof unbilled consumptionwould reduce the FIRR to 10.3 percent on new meters21. For replacement meters and instrumentationof the city gate stations,however, a 50 percentdrop in recapturewould reducethe FIRR's to a still robust 35.6 percent and 73.9 percent respectively. In the eventthat the ban on irnportsof gas is maintained,and that the price of domesticgas staysat $10.80/MCM,returns decline on all componentsof the project. Returns would be negativeon new meters, and would decline to 60.1 percent on replacementmeters and to 64.1 percent on city gate instrumentation. Returnson assetpreservation components would fall marginallyto 44.7 percent,and the overallrate of return on the project would drop to 39.6 percent. However, the lower level of gas supplies resultingfrom the absenceof imports would allow some scaling back of project investments.

5.8 As regards the risks associated with the capabilities of the implementingagency and associatedpotential delays in projectimplementation, a 2-year delay in the realizationof benefits as a result of delays in equipment installation would reduce the FIRR on the project from 51.6 percent to 33.3 percent. Finally,as regardscapital cost relatedrisks, a 35 percent increase in the estimated capital costs (an extreme scenario which would include VAT being applied on all componentsand full absorptionof the physicalcontingencies) reduces the expectedFIRR to 42.0 percent.

5.9 While the project is financially robust even under a pessimistic set of assumptions,the sensitivity analysis highlightsthe importanceof three main factors: (a) careful planning of the meteringprogram, giving priority to installingmeters where there are strongreasons to believethat current billingsunder-represent actual consumption;(b) institutionalstrengthening of Azerigazto maximizerecapture of unbilledgasuse; and (c) planningand supportfor the overallimplementation programto ensurethat the availabilityand capacityof local resources(both physical and financial) are sufficientto ensurethat equipmentis installedin a timely manner. Thesefactors are addressed in the project design through early work on the preparationof tender documentsfor the PEMS consultantto ensure that assistanceis in place at the earliest stages of projectimplementation, and through a policy agenda which focuses on the corporatizationand financialviability of Azerigaz.

C. Pro-Forma Financial Projections

5.10 Price reformis an integralfactor inthe successof the project. If the status quo is naintained withregard to pricingpolicies, the futurefinancial position of Azerigazwill be precarious,and the companywill be unableto financeeither the localcosts of the projector the initialdebt servicefrom internally generated funds. Pro-forma financial projections indicate that, with or without the proposedproject, Azerigaz will have a fundingshortfall of approximatelyUS$70 million over each of the-next3 years - of which approximately$40 millionper year is attributableto priority and/or committedinvestments in networkrehabilitation. A substantialportion of these investmentsare for pipe replacement(approximately $35.5 million per year is estimated as necessary based on an average pipe life of 20 years). Other planned investmentsinclude purchase and installationof residentialmeters, and purchaseof replacementcompressors for the gas storage facility at Kalmas.

21 This assumesno correspondingdecline in the conservationimpacts of newmeters. If conservationimpacts also fill by 50percent (to 7.5 percent),the FIRRwould be 20.0 percent. -30-

Even if these investmentsare deferred,the enterprisewill still be in an annual cash deficitposition of approximatelyUS$30 million.

5.11 In this context,price increasesare regardedas essentialto preservethe company'sfinancial viability. Theaverage margin of $4.00/MCMequivalent agreed as a conditionof Boardpresentation (pam 2.15) would reduce the cash deficitby approximatelyUS$34 million per year over the next four years(1996-1999 average), which wouldprovide full coverageof operatingcosts and of local costs of the project,and providepartial financing (on averageapproxinately $8 millionper year out of the proposed $40 million) for non-projectrelated capital investments. Table 5.1 shows the projections of cash flow and selected performanceratios assumingthat margins are increasedto $4.00/MCMequivalent in 1996and held at that level in real terms thereafter. A more completeset of pro formafinancial statementsis providedin Annex 5.2.

5.12 The remainingfinancing gap, however, will have to be met by additionalprice increasesfor residentialand communalcustomers, improved operating efficiency and/or further deferralof other investmentsin the network. Azerigazwill prepare,by the first of Novemberfor each year, financial projectionsand an actionplan acceptableto IDA whichdemonstrates how they proposeto meettheir finacial obligations under the project, including coverage of operating costs, contributionsto project-relatedexpenditures, debt service coverage, financingof other capital expenditures,and adequatereturn on investment. Possiblemeasures in the action plan includebut are not limited to price increases,rescheduling of capital investment,and improvementsin operatingefficiency. In addition, to ensure that sufficient funds are available to meet the financial requirementsof the proposed project, Azerigaz will submit its annual capital investmentprogram to IDA for prior review and approval.

5.13 Over the longer term, Azerigaz is expectedto operateon a commerciallyviable basis, and earn a reasonablerate of return for its owners. To this end, Azerigazand the Governmenthave agreed to meet the followingfinancial conditions:

- to implement a time-boundAction Plan to address arrearsin the gas distributionsector. The plan specifies dates, after which Azerigaz will be requiredto refuse furthersupply to customersin the absenceof prepaymentor Letterof Credit,and includesprovision that if the Government exempts certain agencies from prepayment,the Governmentwill guarantee timely payment on their behalf;

by June 30, 1997,to improvemonthly collection rates from customersto equal seventy-five (75) percentof the invoicevalue of gas delivered,and by December31, 1997to equalninety (90) percent of the value of gas delivered,and to maintaincollection rates at or above that level thereafter;

not to incur additionaldebt unlessprojections indicate that a debt-servicecoverage ratio of at least 1.5 can be maintained;and

following completion of the project (i.e. from 2001 onwards), to earn an annual return equivalentto 10 percentof net revalued fixed assets. - 31 -

Table 5.1 Summary of Cash Flow Projections (million USS)

--- W:419^M 1999 2000 2001

Total Sales (million m3) 6,071 5,996 5,924 5,941 5,958 5,975 Total Purchases (million m3) 7,124 7,017 6,915 6,917 6,937 6,957 SOCAR 4,400 3,700 3,500 3,200 3,200 3,520

Imports 2,724 3,317 3,415 3,717 3,737 3,437 Sources of Funds: (S million)

Net Profit from Operations 7.0 5.4 3.6 2.2 0.3 (2.7) Depreciation 1.5 3.3 5.2 6.9 8.7 11.A Borrowing (includingInterest) 0.1 4.4 8.0 7.0 4.1 1.5

Total Sources 8.6 13.1 16.8 16.1 13.1 10.2 Application of Funds: (S million)

CapitalExpenditure - Project 0.2 5.3 9.1 6.9 3.2

Capital Expenditure - Other 43.7 43.8 40.9 41.0 35.5 32.7 Debt Service 0.2 0.6 1.2 1.5 2.8 Total Applications 43.9 49.3 50.6 49.1 40.2 35.5

Net Cash Surplus/(Shortfall) (35.3) (36.2) (33.8) (33.0) (27.1) (25.3)

Net Surplus/(Shortfall) excluding 8.4 7.6 7.1 8.0 8.4 7.4 "Other" Capital Expenditures

Debt Service Coverage 49.2 13.6 7.6 6.0 3.0

Average Tariff per MCM (current S) $31.76 $36.05 S37.71 $39.74 $39.85 $38.42

D. Sensitivity of Pro Forma Projections

5.14 Becausethe above cash flow projectionsare based on a fixed minimummargin per unit of gas delivered,operating revenues are directlyrelated to volumessold. In the eventthat gas imports are not resumed,Azerigaz will be obligedto meet their fixed operatingcosts, as well as the costs associatedwith the project, out of a potentiallysmaller revenue base. An alternativescenario was thereforeexamined based on the followingassunption set: (a) gas importsare not resumed; (b) gas supply from domesticfields declines in line with the projectionsshown in Table 2.1; (c) supply shortfallsare spreadover all customerclasses in proportionto their demand;(d) pricesto consumers wouldbe held constantin real terms, apart from the doublingof residentialprices agreed prior to - 32 -

Creditnegotiations; and (e) a minimum$4.00/MCM (1996 price levels) averagemargin would be maintained.

Table 5.2 Summary of Cash Flow Projections -No Imports Scenario (million USS)

1996 1997 1998 1999 2000 2001

Total Sales (million m3) 3,750 3,162 2,999 2,758 2,824 3,171 Total Purchases (million m3) 4,400 3,700 3,500 3,200 3,200 3,520

Unmet Demand (million m3) 2,321 2,834 2,925 3,183 3,134 2,804

Sources of Funds: (S million) Net Profit from Operations 18.5 12.8 9.5 8.6 6.6 5.1 Depreciation 1.5 3.3 5.2 6.9 8.7 11.4

Borrowing (including interest) 0.1 4.4 8.0 7.0 4.1 1.5

TotalSources 20.1 20.5 22.7 22.5 19.4 18.0

Application of Funds: (S million)

CapitalExpenditure - Project 0.2 5.3 9.1 6.9 3.2 Capital Expenditure - Other 43.7 43.8 40.9 41.0 35.5 32.7

Debt Service 0.2 0.6 1.2 1.5 2.8 Total Applications 43.9 49.3 50.6 49.1 40.2 35.5 Net Cash Surplus/(Shortfall) (23.8) (28.8) (27.9) (26.6) (20.8) (17.5)

Net Surplus/(Shortfall)excluding 19.9 15.0 13.0 14.4 14.7 15.2 "Other" Capital Expenditures

Debt Service Coverage 90.9 22.8 13.2 10.2 5.8

Average Tariff per MCM (current S) $23.85 $24.29 S24.52 $25.67 $26.05 $26.06

5.15 The resultant pro forma financialprojections are summarizedin Table 5.2, and detailedin Annex 5.3. Table5.2 demonstratesthat, at least in the short term, Azerigazis in a moderatelybetter financialposition as a result of continuedcurtailment of imports,provided that currentpurchase and selling prices are maintained in real terms, and that the curtailment in supply is spread proportionately across all customer classes. If, however, as a result of political or social considerations,curtailments are focussed on industrialcustomers in order to maintain supply to residential and communalcustomers, there would be a rapid deteriorationin Azerigaz's average margin at currentprices. Furthermore,unless domesticproduction could be maintainedat or near current levels, the curtailmentof imports would entail as much as a 50 percentdrop in Azerigaz's - 33 - sales, and the companywould be unable to cover its full operatingcosts eyen with a $4.00/MCM averagemargin.

E. Accounting and Auditing Arrangements

5.16 Virtually all of Azerigaz's financial and accountingactivities are carried out manually. Billings, accounts receivable, payments and fixed asset management are handled regionally. Financialresults, in terms of profitsand balancesheets, are reportedquarterly to head office where they are "consolidated"(i.e. added together without adjustment)to generate corporatefinancial statements."Surplus" cash fromthe regions(i.e. the differencebetween their collectionsand their expenses)is also transferredto head office. Internalfinancial controls are weak, in part becauseof the poor informationon gas flows to and within the regions, but also because of the substantial autonomyallowed at the locallevel. Whileannual audits are carriedout on bothregional and central financial records, these are conductedby the taxation departmentand are focussed primarily on assessingtax liabilityand compliance.A corporateaudit based on InternationalAuditing Standards ([AS) would be problematicat this stage. Accounting systems are not fully in accord with intemationalaccounting standards,' localaccounting finns are not qualifiedto undertakea full audit in accordance with international standards, and the cost of retaining an international firm to undertake such an audit would be prohibitive at the present time given the poor state of the company's finances,and of the economyas a whole.

5.17 Bankrequirements for the maintenanceand auditingof projectaccounts have been discussed with senior management,who have agreed to comply with Bank standards in terms of record- keepingand reporting. Theconmpanyhas agreedto appoint an independentauditor, acceptableto IDA,to reviewproject accounts, SA's and SOE's on an annualbasis. In addition,in order to assist Azerigazin developingtheir own accountingcapabilities, a substantialproportion of both the office equipmentand trainingbudgets under the projectwill be directedtowards the financialdepartments. For the corporateaccounts, it is proposed that the requirementfor a full LASaudit be introduced once the corporationhas had an opportunityto upgrade and strengthenits accountingand financial mnanagementsystems. Beginningwith the fiscal year endedDecember 31, 1999,Azerigaz will be asked to engage internationalauditors, under terms of engagementsatisfactory to IDA, to review corporatefinancial statements, and to assess internalrecording and control procedures.

VI. BENEFITS AND RISKS

A. Benefits, Costs and Rate of Return

6.1 Theproposed project consists primarily of investmentswhich constitutea part of a longer- term programto upgrade,rehabilitate and preservethe gas transmissionand distributionnetwork.

22 Inconsistencieswith international accounting standards include the following:(i) incomeand expenditure accountsare maintainedon a cash,rather than an accrual basis;(ii) reservesfor uncollectibleaccounts are prohibited;(iii) write-offof bad debts and obsoleteassets and inventoriesrequires prior governmentapproval; (iv) revaluationof assets is based on generalindexes dictatedby the government;and (v) consolidatedaccounts do not includeadjustments for internaltransactions. - 34 -

Least-costprinciples have been adhered to in the selection of technologies,the choices between replacementand upgrading,and the specificationsof materials quality.

6.2 The principaleconomic benefits of the project,which have been used to assessthe Economic InternalRate of Return (EIRR), are as follows:

- reduced expenditureon pipeline replacementdue to rehabilitationof the cathodic protectionsystem;

- increasedefficiency in the use of gas due to the incentivescreated by the introduction of effectivemetering; and

- reductionin gas leakagedue to replacementof corrodedor damagedpipe.

6.3 The economiccosts of the projecthave been assessedat the same level as the financialcosts (excludingtaxes and duties), since the bulk of the costs are for importedequipment procured on international markets. The value of the benefits for pipelines is the cost of replacement at internationalparity prices. Gas savings have been valued at the economicvalue of gas, which has beentaken at fuel oil exportparity, or US$45.00/MCMbased on a fueloil exportprice of US$50/ton (f.o.b. Baku).

6.4 In the short run, given the volume of requiredgas imports, it could be arguedthat the cost of gas imports would be a more appropriatemeasure of the economicvalue of gas. However,this has not been used for two_easons:firstly, it is extremelydifficult to arrive at a realisticeconomic (as opposedto financial)value of importsof gas (especiallythose fromTurkmenistan), due to the distortednature of the FSU gas marketand the lack of adequatedata; and, secondly,in the medium term,as Azerbaijan'sgas productionstabilizes and eventuallyrecovers, it will be possible to supply all of the "non-substitutable"gas marketfrom domesticgas, leaving gas to displace fuel oil at the nargin in the powermarket. The projectwill savea total of about 215 million cubic meters of gas per year (3% of consumption)within five years of completionthrough improvedefficiency of use and reducedleakage. The annual economicvalue of this gas is about US$10million.

6.5 Based upon these assessmentsthe EIRR for the projectas a whole is fully satisfactory(46.9 percent). The EIRR's for the individual components are presented below (additionaldetail is providedin Annex 6.1):

- Asset Preservation:53.4 percent,based upon extensionof the lifetimeof the pipeline assets and consequentreduction in annual maintenancecost, reducedgas leakages, and reducedelectricity costs.

- New Gas Meters: 43.0 percent, based upon an assumption of an improvement in efficiency of use of gas of 15 percent after 3 years. This is a fairly conservative figure,since it is often observedthat meteringcan lead to irnprovementsin efficiency of 25 percentor more. - 35 -

lacement Gas Meters:21.1 percent,based upon an assumptionthat there will be a 3.0 percent improvementin gas use efficiency since, firstly, current meters are estimated to under-readconsumption by about 10 percent, and secondly,about 10 percentof metersare not working. In the first case there will be a demandresponse to the increase in billed gas, in the second there will be a substantialresponse as meteringis restored and consumptionis rationalized.

UUpgradingof Metering at City Gate Stations: 74.3 percent, based upon an assumptionthat there will be a 1.5percent improvement in gas use efficiencydue to the eliminationof large scale gas theft in certainareas, which in turn will lead to a rationalizationof gas use. In addition, there will be some benefit in reduced gas leakagesince accurate metering at key points in the systemwill allow lossesthrough leakageto be identifiedmore rapidly.

6.6 The main economicrisks faced by the project arise from:

- possible over-estimationof the demandresponse to improvementsin the metering system;

- possibleover-estimation of the benefitsfrom cathodicprotection (due to the existing pipeline being in poorer conditionthan assumed);

- lower benefits from gas savings due to lower international oil prices and consequentlylower economicvalue of naturalgas saved; and

- higher capital costs than expected.

6.7 The outcomesof key sensitivitiestaking account of these risks are shownin Table6.1. It can be seen that all of the componentsare robust to downsideassumptions, and that the project as a whole is robust to both lower energyprices and substantiallyhigher capital costs. - 36 -

Table 6.1 Economic Rates of Return - Sensitivities (percent)

Asset New Meters Replacement City Gate Total Preservation Meters Instruments Project

Base Case 53.4 43.0 21.1 74.3 46.9

Demand response 50 percent 53.4 23.7 10.4 44.9 39.8 lower than base case

Effect of cathodic protection 30.5 43.0 21.1 74.3 34.9 delayed 5 years

Low international oil prices - 52.5 30.7 14.4 55.6 41.7 gas value $30/MCM

Capital costs 20 percent above 49.1 37.1 17.9 65.4 42.1 base case

6.8 The only exception to economic robustness is the Replacement Metering component, which yields 10.4 percent when a 50 percent lower efficiency response is assumed. While this may be unacceptable on a stand-alone basis, it should be noted that the upgrading of all meters may well be necessary in order to create the appropriate climate of accurate and equitable metering that will lead to improved gas use measurement and revenue collection. If only new meters and the most obsolete and inaccurate existing meters were replaced, this would create two classes of customer - those with "old" and less reliable Soviet-era meters, and those with new and more reliable foreign meters. There would tend to be resistance among those with newer meters to paying for perceived under-reading and cheating by "old" meter customers.

B. Risk Analysis and Risk Mitigation Measures

6.9 There are a number of risks attached to undertaking the proposed project, both at the macroeconomic level and at the project level. The financial and economic sensitivity analyses have examined several of the project risks, with a view to testing the robustness of the predicted rates of retum. While the sensitivity analyses have indicated that the project remains economically and financially viable under a wide range of assumptions, the degree of uncertainty regarding returns can be reduced by anticipating the risks and incorporating mitigation measures into the project design.

6.10 The key project risks can be summarized under the following headings:

* Government policy risks, in terms of failure to enact the necessary reforns and/or failure to take steps necessary to ensure the viability of the gas enterprises; * risks related to the capital and operating costs of the project; * risks related to the borrower's implementation capability; * risks regarding the timely availability of counterpart funding, to meet both local costs of the project and debt service obligations; * risks that loss reduction will fall below targets; and * risks that energy conservation impacts will be less than predicted. - 37 -

6.11 Macroeconomicrisks include:

* continuingarrears problems throughout the economy,which jeopardize the financial viabilityof the gas company,its suppliers,and its customers; * further contraction/stagnationof the industrial and commercial sectors, and consequentloss of relevanceof part of the meteringprogram; * failure or delay of macroeconomicstabilization programs, with consequenthigh domestic inflationand deteriorationin the exchangerate.

6.12 The projecthas been designedto minimizethe potential impactof these risks in a number of ways. Risks of Governmentfailure to enact requiredreforms are being dealt with by requiring specificactions to be takenprior to negotiations,Board presentationand Credit effectiveness,and by havingcritical items (pricing, corporatization) addressed prior to Boardpresentation. In addition, ongoing dialogue will be maintainedwith regard to the long term developmentof the gas sector. At present,the gas sectoris at the center of politicalfocus due to the problemsof gas supplyand the central role which the fuel plays in the economy. Hence it is likely that gas policy will receive increasedattention from the Governmentin future,and that with suitabledialogue between IDA and the Government,necessary policies will be enacted.

6.13 Risks relatedto the costs and relevanceof projectcomponents are being addressedthrough a combinationof detailed surveywork prior to initial procurement,provision of substantialexpert assistance to the PIU, and a mid-term review at approximately the mid-point of project disbursements.Implementation risks are being addressedthrough technicalassistance to the PIU, as well as throughon-going country-wide seminars and trainingon Bank procedures. In any event, the EIRRand FIRR of the projectare robusteven underfairly pessimistic scenarios relating to costs and timing. Financial risks are being addressedthrough pricing conditionalities,including the requirement for initial price increases which was met prior to Credit negotiations. In addition, financialcovenants will require that actions be taken in advanceto ensure that Azerigazis able to meet its financial obligationsunder the loan. The risks attachedto failure to capture expected benefits from the project are being addressedthrough supportingthe corporatizationof Azerigaz, and providingtechnical assistance in support of institutionaldevelopment. Again, the project is fairly robust under more pessimisticassumptions regarding benefits capture.

6.14 The problemof arrears is being addressedat the macroeconomiclevel in conjunctionwith discussionswith the IMF, and additionalprovision against these risks is incorporatedin the covenant whichrequires implementation of a time bound Action Plan to reduce accountsreceivable to more satisfactorylevels, and a covenantwhich requires that they be maintainedat these levels over time. The Bank continuesto reinforcethe need for measuresto reducearrears in its discussionswith the Government. Nonetheless,arrears remain one of the more serious risks potentiallyaffecting the project. - 38 -

VUI. AGREEMENTS REACHED AND RECOMMENDATIONS

A. Agreements Reached

7.1 Prior to Creditnegotiations the Governmentimplemented a two-timesincrease in residential gas prices, to 12,700manats/MCM (US$2.80 equivalent) (para 2.15).

7.2 During Credit negotiations,the followingagreements were reached:

a) The Governmentwill maintainall gas pricesat not less than their currentlevels in real terns and will make quarterly upward adjustmentsto communal and residentialgas prices as necessaryso as to ensure Azerigaz an averageoperating margin of at least US$4.00/MCM equivalent (in constant 1996 dollars) based on reasonable projections of gas sales and purchases(para 2.15).

b) The Governmentwill establishAzerigaz as a joint stock company,by September30, 1996 with sharesheld initiallyby the StateProperty Committee, under a charterwhich reflectsthe commercialfocus of the company,and also the ultimateseparability of its variousactivities (para 2.2 1).

c) The Governmentwill implementan Action Plan to address arrears in the gas distribution sector. The Plan specifiesdates after which Azerigazwould be requiredto refuse further supplyto Azerenerjiand other revenue-earningcustomers in the absenceof timelypayments. (para 2.25).

d) The Governmenthas expressedits intention,through a policy letter to IDA, to implement the followingactions (see Annex 7.1):

to undertaketimely passage of gas legislation,based in part on work to be carriedout with EU-TACISfinancing (para 2.21);

to establishthe LPG distributiondepartnent of Azerigazas a separatecompany, and to privatize it in a manner which attracts significantinvestment from a qualified foreign company, while maintainingcompetitive conditions for LPG distribution (para 2.22);

- to carry out a review of the producerpricing and contract system for gas which addresses the investmentneeds of gas developmentand also the need to attract foreign investmentto gas developmentprojects (para 2.13).

e) The Governmentwill prepare, by December31, 1996,a schedule acceptableto IDA for furtherincreases in residentialgas pricesto equatethem to at least the cost of gas purchases. This schedulewill be coordinatedwith both the introductionof residentialmeters and the developmentof a mechanismto protect low-incomehouseholds from adverse impacts of price increases(para 2.15). - 39 - f) The Government agreed that a targeted mitigation program to protect low-income householdsfrom adverseimpacts of higher energy priceswould be initiatedin conjunction with the proposedprogram of residentialgas price increases(para 2.19). g) Azerigaz and the Governmentwill develop,by December31, 1996, a programto extend meteringto cover all residentialcustomers, with priorityassigned to the coverageof single- family dwellingsand apartmentswhich use gas for multiplepurposes (e.g., cooking, heating, hot water). The programwill includea timetablefor completion,and a financingplan to cover the cost of the meters and of their installation.(para 2.17). h) Azerigazand the Governmentwill meet the followingfinancial conditions (para 5.13):

by June 30, 1997, to improve monthly collection rates from customers to equal seventy-five(75) percentof the invoicevalue of gas delivered,and by December31, 1997 to equal ninety (90) percent of the value of gas delivered,and to maintain collectionrates at or abovethat levelthereafter;

not to incur additionaldebt unlessprojections indicate that a debt-servicecoverage ratio of at least 1.5 can be maintained;and

following completion of the project (i.e. from 2001 onwards),to earn an annual returnequivalent to 10 percent of net revalued fixed assets. i) Azerigazwill prepare,by the first of Novemberfor each year, financialprojections and an actionplan acceptableto IDA which demonstrateshow they proposeto meet their financial obligationsunder the project,including coverage of operatingcosts, contributions to project- related expenditures,debt service coverage, financingof other capital expenditures,and adequate return on investment. Possible measures in the action plan include but are not limitedto price increases,rescheduling of capitalinvestment, and improvementsin operating efficiency.Azerigaz will also submitits annualcapital investment program to IDA for prior review and approval(para 5.12). j) Azerigazwill meet the followingrequirements for financialreporting (para 4.21):

- financialstatements, within three and one-halfmonths of the end of each fiscal year, beginningwith fiscal year 1996;

audited projectaccounts, beginning with the accounts for 1996,within six months of the end of each year; and

audited financialstatements within six months of the end of each year, beginning with 1996. k) Azerigazwill appointan independentauditor, acceptable to IDA,-toreview project accounts, SA's and SOE's on an annual basis (parm5.17). - 40 -

1) Azerigaz,beginning with the fiscalyear endedDecember 31, 1999,will engageintemational auditors, under terms of engagementsatisfactory to IDA, to review corporate financial statements,and to assess internalrecording and control procedures(para 5.17).

7.3 The followingconditions for Credit effectivenesshave been stipulated: a) The Governmentwill completea subsidiaryloan agreementwith Azerigazunder the terms and conditionsoutlined in the financingplan (para 3.16). b) Azerigaz will formally establish a Project ImplementationUnit (PIU), and appoint managerial,operational and support staff sufficientto initiateproject implementation (pam 4.1). - 41 - Annex 1.1 Page 1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT FUEL AND ENERGY PRODUCTION AND CONSUMPTION

1990 1991 1992 1993 1994 Coal (milliontonnes) . Production 0.0 0.0 0.0 0.0 0.0 Consunption 0.2 0.1 0.0 0.0 0.0 Net Exports (0.2) (0.1) 0.0 0.0 0.0 CrudeOil (milliontonnes) Production 12.5 11.7 11.2 10.3 9.6 Consumption(refinery) 16.3 15.8 11.8 10.0 9.4 Net Exports (3.8) (4.1) (0.6) 0.3 0.2 Oil Products(million tonnes) Production 16.3 15.8 11.8 10.0 9.4 Consumption 8.8 8.8 8.7 8.4 7.8 Net Exports 7.5 7.0 3.1 1.6 1.61 Natural Gas (billionm3) l Production 9.9 8.6 7.8 6.8 6.4 Consumption 17.5 17.0 14.8 12.2 11.7 Net Exports (7.6) (8.4) (7.0) (5.4) (5.3) Electricity (billionkWh) Production 23.2 23.3 19.7 19.0 17.5 Hydro 0.7 0.6 0.6 0.5 0.5 Nuclear 0.0 0.0 0.0 0.0 0.0 Consumption 22.7 22.9 19.6 19.0 17.9 Net Exports 0.5 0.4 0.1 0.0 (0.4) Source:PlanEcon Inc., EnergyOutlook for the FormerSoviet Republics - 42 - Annex 1.1 Page 2

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT PRIMARY ENERGY CONSUMPTION (percent)

i______| 1990 1991 1992 1993 1994 Coal 0.4% 0.2% 0.0% 0.0% 0.0% RefmedOil Products 37.3% 38.2% 4.1.0% 44.7% 43.7% NaturalGas 60.6% 60.2% 57.1% 53.2% 53.6% Primaryelecticity 0.2% 0.2% 0.5% 0.6% 1.2% OtherFuel (peat,wood) 1.5% 1.2% 1.3% 1.5% 1.6% Total PrimaryConsumption 100.0% 100.0% 100.0%/.. 100.0% 100.0% Source:PlanEcon Inc., Energy Outlook for the FormerSoviet Republics AZRBAIANGASSYTEM REHABITAllON PROJET AzegOrganbaton Chart

AkerigaztaeCmpary President

SteGas ControlDepartment

Gasindruy| MaorCity ConlrudionScientiic Research Machinery Other DiMson stbutionDivisons &Manning Bulding seefolbwing - Sumgal LowNMedumPressure-kengaz Instute Gazmashzav -SoialSppo AImBayramlPipeline Construdion -Azerigaz Projed Balgazmash plantTechnial Suppor -Mingechevir8Regonal Depaitmies Institute GanjaMachinery Azengazbank -Leram Rant

Annex 2.1 Page I AzerigazOrganization Chart (continued)

[ President I Azerigaz I

[Gas Industry Division

MainPipeline NakhchivanGas LPGControl BakuGas MainPipeline LocalDistribution Operations Producation Department Production Operations Departments (Azerigaztajhizat) Department Department (Azerigaznagl)

- 8 regional - 7 regional L 11district - 10 regional L50 regional departments depatments departments departments depaIti1ents staffand services pipelineoperation maintenanceand t staffand services - wellworkover department construction department - corrosionprotection - highpressure department pipelineconstruction L construction communications department statefarm

Annex 2.1 Page 2 - 45 -

Annex 2.2 Page 1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT COMPARISON OF HOUSEHOLD FUEL COSTS

Fuel Unit Household Energy/ Costper Efficiency Costper Index Price Unit nmmBTU (House- Effective Relativeto (manats) (BTU) (manats) holdUse) mmBTU Gas NaturalGas M3 6.35 35,300 180 70% 257 1.0 Electricity kWh 18 3,412 5,276 90% 5,862 22.8 Petrol liter 1,100 30,950 35,541 30% 118,469 461.0 Kerosene liter 420 32,934 12,753 30% 42,509 165.4 LPG kg 750 42,854 1,750 70% 25,002 97.3 Fuelwood 20 11 904 1 680 20% 8,401 32.7

Source: Mission estimates - 46 - Annex 2.2 Pap2

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT Comparison of Reidentfal Gas Prices - FSU (USS/Mcm)

Moldova Uzbekistan Russia Kyrgyz Rep. Kazakhstan Ukraine Latvia' Lithuania' Azbajuan US $/Mcm 61.7 2.0 21.7 87.0 67.4 48.0 142.8 121.0 1.4

ResldentlalGas Price (FSU) (USSMcm) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0

1Gas used for cooking. - 47 - Annex 2.3 Page 1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT HOUSEHOLD GAS PRICE INCREASES ASSESSMENT OF SOCIAL IMPACTS Introduction

1. Significant increases in residential gas prices are required in Azerbaijan if the gas company is to achieve financial viability. Current prices to households are a small fraction of the purchase price of gas, even at the relatively low prices charged by SOCAR. However, given the relatively low wage levels in the country, concern has been expressed about the affordability of household gas price increases - particularly when increases of ten times or greater are contemplated. A special review was therefore carried out by London Economics, together with consultants working with the Bank's Poverty Assessment, as part of the preparation of the Gas Rehabilitation Project. The consultants examined the affordability of various levels of gas price increases for households across the range of income levels, and considered alternative mechanisms for protecting vulnerable low-income households from adverse impacts of an overall increase in tariffs. This Annex describes the key findings of that review and presents preliminary options for alleviating potential impacts on low-income households.

2. A primary source of data for the review was the household survey carried out by the Government of Azerbaijan and the World Bank during November and December of 1995 as part of the Bank's Poverty Assessment work'. The primary focus of the survey was to examine living standards, incomes and expenditures across a broad sample of households. Over 2,000 households were surveyed, including both established households in urban and rural areas and also refugee families living in either cities or tented camps. While the survey was not primarily directed at establishing patterns of usage or expenditure on energy, it provided useful information which could be used to draw some representative outlines of the role of energy in household budgets and of observed willingness to pay for energy supplies.

Characteristics of Energy Use

3. Because the survey was carried out during the period when gas supply was being restricted to only a limited number of regions in the country due to a government policy of banning gas imports, only 38 percent of households reported using gas for either cooking or heating - despite the fact that at one time network gas was available to over 80 percent of the population. Figures I and 2 below show the breakdowns of primary fuel use based on the survey responses.

4. One of the more notable findings on fuel use is the dominance of fuelwood. Fuelwood was reported as the primary fuel both for cooking and heating in over 40 percent of the households surveyed. This suggests that many households have responded to the cutting off of gas supply by using wood, despite its high price when transport costs are included.

5. Of the 38 percent of households which reported using gas, 20 percent said that they used gas for cooking only, 1 percent used gas for heating only, 9 percent used gas cookers and heaters, and the remaining 8 percent reported using their gas cookers for both cooking and as a primary source of heating.

The analysisin this paper was carriedout priorto the final reviewof survey findingsby the Poverty Assessmentteam. While the surveyresults convey an accuratepicture of reportedhousehold incomes and expenditures,the precisedefinitions of some of the categoriesmay be adjustedupon further review. - 48 - Annex 2.3 Page 2

The prevalenceof this latter group can be explainedby the structure of the tariff, where the charge for a gas cooker is a fixed amount per person per month (based on norms for cookingusage, as gas use in householdsis not metered). Hence, while the cooker may not be an efficient sourceof heat, using it in this manner carries no additionalcost to the household.

Figure 1 Energy use for cooking, November/December1995 45%

235%

30%4

10%

I 10% .5%

Gas Bectryicit Wood Coal Kerosene Ubnure LPG Othr Don'tcook

ource: HouseholdSurvey

Figure 2 Energy use for heating, November/December 1995 45%1

30%,

*25%, I20% 15%I r~~~hr10%I

0% DItrict Gas BeCtrlclty WVood coal Kerosene Other heat

Source:Household Survey

6. Table I shows the distributionof householdgas use by decile of the population,where decile I is the poorestin terms of total householdexpenditure and decile 10 the wealthiest. Gas is most widely used by the poorest 20 percentand the richest 10 percentof the population. The distributionalpattern of gas use is in large part due to the shortageof gas and the restrictionof suppliesto only half the country, includingBaku, duringthe survey period. 94 percentof householdsin Baku use gas against the national averageof 38 percent; in addition,the poorestand richest householdsare concentratedin Baku. - 49 - Annex 2.3 Page 3

Table 1 Household Gas Use by Expenditure Decile

Decile Do not use Cook only Heat Only Cook and Cookand gas . heat heat with gas -*--- ' ' cooker

I------53.7% 26.9% 0.7% 8.3% ', 10.5% 2 55.0% 20.3% 1.9% 11.2% 11.6% 3 63.6% 18.1% 0.9% 10.4% 7.0% ------r------r ------r ------r ------r ------4 62.5% 17.8% 0.9% 10.6% 8.1% 5 63.0% 19.2% 1.5% 12.8% 3.5% 6 66.5% 18.4% 0.0% 9.3% 5.8% ______------_ _ __------7 73.2% 9.0% 0.9% 8.8% 8.1% 8 65.2% 19.5% 0.5% 4.4% 10.5% 9 60.5% 19.5% 1.7% 9.1% 9.3% 10 49.3% 30.7% 0.5% 9.7% 9.9% Average 61.2% 19.9% 0.9% 9.5% 8.4% Note: Decile I represents the poorest 10% of the population. Source: Household Survey, November/December 1995

Current Energy Tariffs

7. Gas tariffs for householdconsumers are very low. While they have risen significantlyin real terms during 1995- see Table 2 - increasesare less than the increases in the prices of other fuels. Currenttariffs are M6350 per MCM, approximately$1.40 per MCM. Despitethe increase,gas tariffs for householdconsumers are far below industrialand commercialtariffs. Current tariffs for the latter categoryare M240,000per MCM,approximately $53 per MCM. Gas tariffs are uniformfor each consumercategory across Azerbaijan.

8. Householdgas consumersare not metered in Azerbaijan. Bills are based on consumptionnorms for appliancesand householdsize. While these norms overestimateindividual appliance consumption, they underestimateactual householdconsumption due to inefficientuse, wastageand non-technical losses. The recent introductionof meters to about 700 householdsin Baku has shownsignificant variation,both positiveand negative,in actual gas consumptionaround that based on norms.

9. In principle, gas bills are issued monthly,and gas inspectorsvisit householdsonce a month to verify appliance use, householdsize, and to service appliancesand connections. In practice,bills are issued quarterlyin some districts,and many householdsare inspectedonly once a year. Bills are payable within a month. Failure to pay on time leads to a 0.1 percent penaltyin the first instance,and is followed by disconnectionif the bill remains unsettledfor three months. In practice, few householdspay on time, and the sanctionsavailable are never applied. Indeed,officials at Bakgaz,the distributioncompany serving Baku, believethat current legislationdoes not empowerthem to disconnecthouseholds. - 50 - Annex 2.3 Page 4

Strongerlegislation, however, may not help greatlyas it is technicallydifficult to disconnectmany individualhouseholds due to the absence of service or metervalves.

Table2 Householdenergy tariffsin nominaland real terms

Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 ------F------F------F------F------Gas tariff (manat 144 432 1,210 6,350 6,350 per MCM) ------F------F------F------F------F------Index in realterms 100 91 59 192 168 Electricitytariff 0.26 I 2.7' 18' 18 (manat per kWh) Index in realterms 100 117 73 302 264 Kerosene (manat 5 16 90 420 420

-eper ------liter) ------F------F------'------Index,- - - - in- -real- - terms------100- - -- I - - - - - 97- -- I------,-.----.-.-----126 I - - - - -367------320- - Gasoline (manat 17 100 500 1,100 1,100 per liter) ------.------Indexin real terms 100 180 207, 283, 247

Costs of HouseholdEnergy

Costs of Gas Use

10. The first column of Table 3 below sets out estimated gas bills by decile. These estimatesare based on gas consumptionnorms, the current gas tariff for householdconsumers, and data on household size and applianceuse for cooking and heatingfrom the HouseholdSurvey. 2 The averagecooking bill is estimatedto be some M600 per month. The average space heatingand water heating bills (weighted for alternativeappliances) are estimatedat M2,440 and M I, 150 per month, respectively. However,not all gas consuminghouseholds use gas for all three services. The total gas bill could be as low as M600 for those usinggas cookers alone, and as high as M4,190 for householdsusing all three services. Using HouseholdSurvey data on the use of gas, the averagegas bill is estimatedto be Ml,877 per winter month. The distributionof estimatedbills across the income deciles is relativelyeven. In other words, the variationin appliance use across the deciles is counter-actedby the larger family sizes of poorer deciles.

2 The estimationassumes that 50 percentof householdsusing gas for either cookingor heatinguse gas-firedappliances for water heating. This is based on estimatesby Sofregaz. Specificappliances used for water heating are based on appliancesregistered with Azerigazfor the rayons receivinggas supplies. - 51 - Annex2.3 Page 5

11. It should be noted that, because of the structureof the norms, gas bills for householdswith gas heat are higher in the winter months,since the heatingcharge is not applied duringthe other seasons. In order to provide a basis for comparisonwith total householdexpenditures and also for comparisonwith the survey (which was carriedout during the winter),the estimatesbelow are based on winter month billings. However,if heatingtariffs were levellizedover the year (i.e. payable,but at a lower rate, in each month),the monthlycost of heating with gas would be significantlylower than is impliedin the Table 3.

Table 3 Average Gas Bills (manat per winter month)

Decile Estimatedbill Bill Bill Surveyed Surveyed based on discounted discounted heatingbills heating bills household for at 50 for gas for all characteristics pensioners percent consumers consumers ------_-____-__-__ ------__-__-__ - ---_ _------.------I 1,746 1,067 873 516 2,505 ------.------2 1,983 1,238 992 1,141 9,355 ------t------r------r------3 1,934 1,212 967 1,512 11,056 ------r------T------r------4 2,043 1,304 1,021 1,058 14,841 ------v ------5 2,347 1,621 1,173 5,683 20,991 ------t------I- - -- r------r------6 1,930 1,324 965 2,888 25,768 7 2,206 1,592 1,103 2,981 24,406

8------t------r------1,499 1,151 ------749 r------r------2,008 34,401 9 1,725 1,320 863 4,909 31,771 10 1,565 1,194 782 2,050 30,955 ------r------Average 1,877 1,284 939 2,380 20,454 Source: LE estimates and Household Survey

12. At present,many consumersare eligible for discounts,ranging between 10 percentand 100 percent,on their gas bills. Table 4 below sets out the consumercategories and the discount available. Consumersclaiming these concessionsare asked to submit documentsto verify their claims. There appearedto be someconfusion both within the gas companyand among the generalpopulation over these categories,which suggeststhat there is considerableleeway for interpretation. For example, conflictingreports were receivedas to whether pensionerswere eligible for concessions. There was also confusionover the definitionof families,and whether it comprisesall members livingtogether or only immediatefamily. Furthermore,some of the categoriesmay be inconsistent. For example, it is unclear whether invalidsof the Karabakhwar are entitled to a 100 percent or 50 percentdiscount.

13. These concessionscover a substantialnumber of consumers. Both Bakgaz and Azerigazbelieve that some 50 percentof householdconsumers enjoy concessionson their gas bills. Sofregaz'srecent work identifiedthat of the 3,326 MCM supplied in September1995 in Sabahel district:

- 35 percentwas supplied free of charge; - 8 percentwas sold at a 90 percent discount; - 52 - Annex 2.3 Page 6

- 8 percent was sold at a 50 percentdiscount; and - only 49 percentwas charged at the full tariff.

14. Sofregazestimate a weighteddiscount to householdsof 53 percentarising from these concessions. The second and third columns of Table 3 above show the sharp impactof these concessionson gas bills. The discountoffered to householdswith a pensionerreduces the averagebill by almost 30 percent. An effectivediscount to all householdsof 50 percentreduces the estimatedbill to M939.

15. The cost of these exemptions and discount is borne by the State budget. However, there are substantialarrears in disbursementsfrom the State Budget for these subsidies. In other words, the de facto cost of these exemptionsis borne by the gas distributioncompanies. It should be emphasizedthat any increase in gas tariffs increasesthe cost of these subsidiesto the State Budget.

Table 4 Concessionary Consumer Categories

Concession Consumer Groups 100 percent Teachers War veterans and invalids Elderly people over 70 years old, living alone

------r------Refugees 90 percent SOCARpersonnel (both active and retired)granted concessionsbefore 1983 - _- - _- __--- - r------~~~~~------50 percent Pensioners :Labor veterans with more than 25 years of service, unemployedand living

------F------alone Householdswho sufferedbereavement in the January 20th 1990 uprising Households who suffered injury or bereavementin the Chernobyl nuclear accident I.------:Households who sufferedbereavement in December I Ith 1988 air battle Householdswith members servingon the front line, woundedor bereavedin

...... ------. ------the Karabakhwar

, ...... --...... --'Category -r ------I or--- 2-- invalids ------25 percent Category3 invalids Source: Bakgazand Sofregaz

16. The final two columns of Table 3 show the average householdexpenditure quoted for heating in the HouseholdSurvey. For householdsconsuming gas, the quoted heating bills are not significantlyout of line with the estimatedthe gas bill (column 1) - except at the lower-incomelevels, where concessionarytariffs may be more prevalent. In some instances,the quoted heatingbills may be higher than the estimatedgas bill, since not all gas consuminghouseholds use gas for heating,and other heating fuels are typically higher cost. - 53 - Annex 2.3 Page 7

17. Quoted heatingbills for householdsnot using gas are significantlyhigher at an averageM20,454. In other words,the cost of heating with fuels other than gas rapidly increasesenergy bills. The variation in energy bills across incomedeciles is shownin Figure 3.

Figure 3 Average heating costs and estimated gas bills

35 0 0 .0...... , ...

30000

25000

120000. .Heating costs

-I15000S= . . Heatingcosts - gas consuminghouseholds

E00stimtedgasbill

1 2 3 4 5 6 7 8 9 10

- poor rich ----

Source:LE estimatesand HouseiioT& Survey

Costs of Other Energy

18. Residentialelectricity tariffs are also heavilysubsidized in Azerbaijan. The current household tariff is MI 8 per kWh for monthlyconsumption under 200 kWh. Higher consumptionattracts a higher tariff - M45 per kWh up to 300 kWh and M70 thereafter. Householdsregistered to use electricityfor cooking are allowed 300 kWh at the M 18 tariff, and M45 per kWh thereafter. The M 18 per kWh tariff is estimated to be less than 20 percentof productioncost by Azerenerji,and compares with an industrial tariff of M184 per kWh.

19. The averageelectricity bill basedon an averageconsumption of 294 kWh would be M7,830 per month. This is considerablyhigher than electricitybills quoted in the HouseholdSurvey. The average bill quoted in the survey was M3,940,dropping to M3,300 for householdsthat use gas. Part of the discrepancymay be attributableto the fact that concessionssimilar to those affordedto gas users are also granted to electricityconsumers.

20. District heat services are also heavily subsidized. In Baku, the householdtariff is M81 per m2 giving an averagewinter bill of M3,645for a 45m dwelling.3 As with gas, there are significant weaknessesin the billingand collectionsystems, and a long list of consumerdiscounts for both electricity and districtheat consumers. In consequence,there are heavy arrears amongst household

3 The average size of dwelling is basedon the HouseholdSurvey. - 54 - Annex 2.3 Page 8 consumers. Bakteploset, the district heating company in Baku, estimates that only 10 percent to 15 percent of households pay for the energy consumed. Similarly, cash receipts at Azerenerji amount to less than 10 percent of billings.

21. While electricity and gas prices for households are heavily subsidized, wood, petroleum products, and other non-network fuels in Azerbaijan increasingly reflect market prices. The price gap between market and subsidized fuels is significant. For example, it is estimated that households in northern Azerbaijan may spend up to M40,000 per winter month on wood fuel. Similarly, one month's supply of LPG for cooking can cost Ml 5,000 for a 20 kg cylinder (excluding the capital cost of the cylinder).

22. The imbalance of relative prices ensures that network fuels are the preferred energy source, if available. The cheapest heating fuel is natural gas, followed by district heat, and electricity.4 The differential access to network fuels under the Government's policy of banning gas imports suggests that distorted relative prices for energy products are giving rise to significant income re-distribution between Baku and households outside Baku. This is strongly corroborated by the Household Survey. Average heating bills for households using gas are only 11 percent of bills for all households.

Household Income and Expenditure - Survey Results

23. Household expenditure in Azerbaijan for all households and gas consuming households are shown in Table 5. Average consumption for all households is just under $200 per month. Food comprises over half of total consumption for all households, and bread is the most important food product consumed.

24. Expenditures of gas consuming households are broadly similar to those of average households, except that:

- heating bills for gas consuming households are a fraction of the national average; - gas consuming households have much higher housing costs; and - gas consuming households consume less food, mainly due to lower household production.

These observations hold across all income deciles, and in large part reflect the urban location of gas consuming households.

4 This ranking is partially re-enforced by the capital cost of switching from gas to electricity - electricity heaters in Baku retail for between US $20 (M90,000) and $100 (M450,000). - 55 - Annex 2.3 Page 9

Table 5 Average Household Expenditure (manat per month)

All Households Gas Consuming Households

______-----_------+------F------Total Expenditure 880,552 871,432 Electricity 3,939 . 3,326 Heating 20,454 2,380 Housing 93,461 188,654 Food 541,469 | 467,015 …4.…I.…------Bought food 419,122 414,661 ------Own Consumption 89,275 18,850 Gifts received 33,072 33,504 o/w Bread 138,913 96,101 Cigarettesand alcohol 21,079 21,930 Transfers 27,082 23,949 Memo Items: ______---_------T------Total Expenditure(US$) 198.32 196.27 Cash Expenditure(US$) 170.77 1184.48 Cash Food/CashExpenditure 55.3% 50.6% Source: HouseholdSurvey

25. The distributionof total householdexpenditure by decile is shownin Figure4. It is of interestto note that even the householdsin the lowest expendituredecile report monthlyexpenditures of approximatelyUS$ 50 per month.

Figure 4 Householdexpenditure by decile

2500000

2000000 t 15s00000t

I1000000- _--- Al households 500000 - Gasconsuting households

1 2 3 4 5 8 7 8 9 10

- poor rich - 56 - Annex 2.3 Page 10

26. The reported average household incomes for all households and for gas consuming households are shown in Table 6. Average household income is well over $50 per month including salaries and allowances but only a quarter of the expenditures reported. The average value of the first salary is roughly in line with the national averages produced by Goskomstat. Again, there are significant differences between gas consuming households and the national average:

gas consuming households have a higher income; gas consuming households earn higher salaries and receive somewhat higher transfers and allowances; and gas consuming households earn far less from the sale of agricultural produce than the average.

Table 6 Average household income (manat per month)

All Households Gas Consuming Households Total Income 244,26&d. 283,727 ------+------Salary I 79,225 141,657 Salary 2 42,546 50,141 Sale of produce 35,398 5,876 Transfers 17,966 20,612 Pensions 17,201 18,329 Bread allowances 5,813 5,537 Other state allowances 9,934 12,792 Memo items: Total Income (US$) I 55.02 63.90 Salary I (US$) 17.84 31.90 Salary/Total income 49.9%' 67.6% Allowances/Total Income 6.4% 6.5%

Source:Household Survey

27. Again, these conclusions hold across all income deciles. The distribution of reported income across expenditure deciles is shown in Figure 5. - 57- Annex 2.3 Page 1I

Figure 5 Household income by expenditure decile

700000

600000

500000 i 4 t 1t 300000it A !+Gas consuming. 200000E e ; households ---- ANhouseholds

0 --- ;,- |---- I I .,I 1 2 3 4 5 6 7 8 9 10 <-..-- poor rich ---- >

28. Whilethe three- to four-folddiscrepancy between reported incomesand expendituresis significant,it is typical in householdsurveys to find that incomesare under-reportedwhile expenditures are over-reported. In additionr,the-inclusionof non-cashexpenditures such as imputedrent and the value of own production in the expenditurefigures, without also includingthem in income,distorts the normally-expectedbalance betweenthe two. This discrepancyis not viewedas discreditingthe survey findings,although it can create some problemsin establishinga reliable basis for assessingthe impacts of price increaseson householdbudgets. The Poverty Assessmentteam is currentlyreviewing the survey data with a view to developingan agreed measure of income/expenditurewhich will give a reasonable basis for evaluatingthe well-beingof the population. Once this work is completed,the assessmentof the affordabilityof householdgas price increaseswill be reviewed. One noteworthyobservation which can be made by comparingFigures 4 and 5 is that the discrepancybetween reported expendituresand incomes is less in the lowerexpenditure deciles (less than 2 times) that in the highest deciles (approximately4 times), particularlyfor gas consuminghouseholds. Hence, the problem of selectinga base for affordabilityassessments is of less concernat these incomelevels.

Impacts of Higher Gas Tariffs

29. Figure 6 shows current householdexpenditure on gas as a proportionof householdincome across all deciles. In order to err on the side of caution,income for gas consuminghouseholds rather than expenditurehas been used as the comparatorfor gas bills. In addition,current discountswere excluded from the estimates,and bills were based on the higher tariffs applicableduring the winter months. The Figure shows the proportionof incomewhich would be spent on gas consumptionat three differenttariff levels:

at current tariffs; followinga three-fold increasein tariffs, assumingno reductionin gas consumption;and - 58 - Annex 2.3 Page 12

- followinga ten-fold increasein gas tariffs over current levels. A ten-fold increase,together with a 50 percentincrease in communaltariffs, would be sufficientto provide an averagemargin of US$4.00per MCMon projected 1996 gas sales.5

The figure also shows the heatingbills reportedby all householdsacross Azerbaijanfor comparison. This can be roughly interpretedas the revealedability of householdsto pay for energy.

30. At current tariff levels, householdexpenditure on gas is around I percent of incomefor the poorest households. A three-foldincrease in tariffs would raise average gas spendingto around3 percent for the poorestdeciles. Nevertheless,this remainsgenerally below the expenditureon heat reportedby all consumersin the HouseholdSurvey. Furthernore, even at the three-foldtariff, expenditureon gas would be smallerthan that on alcoholand cigarettesand most other expenditureitems in the household budget.

Figure 6 Gas expenditure as a proportion of household income (winter month 1995/96)

_ 0 ______

12%

- I%~~~~~~~T.W Wof h-

31. A I 0-fold increase in tariffs, however, would be more problematic, at least at the lower income levels. Following such a tariff increase, expenditure on gas during the winter months would be pushed over IO percent of income for the poorest 30 percent of households. For the poorest 50 percent of gas consumers, this would be bigher than their counterparts are currently spending on alternative energy sources. For the poorest 30 percent, expenditure on gas would come second only to food, and would in all likelihood necessitate cuts in non-luxury consumption.

32. Consequently, a ten-fold increase in gas tariffs is likely to require compensatory measures in order to protect low-income households. A number of options are available, some of which are discussed in the following section.

s TheS4.00/MCM margins is viewed as necessaryto provideAzerigaz with anacceptable net income. - 59 - Annex 2.3 Page 13

Mitigation Options to Protect the Poor

33. The key factors which need to be consideredin assessingalternative mechanisms for protecting low incomehouseholds from impactsof higher energy prices include:(i) the overall cost of the program, which in turn relates to the degree to which supportcan be targetedspecifically to those households where it is most needed;and (ii) the availabilityof an effective deliverymechanism.

34. At present, gas consumersenjoy protectionagainst the full cost of gas supplythrough three channels:

- a subsidizedprice availableto all householdconsumers, financed by higher tariffs for industrial and commercialconsumers and by financial losses for the gas company;

- exemptionsand exclusionsfor specific categoriesof consumers,financed by the State budget; and

- a notionalenergy allowancebundled with the bread compensationscheme to all non working pensioners,children of poor families,students and refugees.The bread compensationscheme covers almost 50 percent of the population,and is financedby the State budget.

35. Raising householdgas prices in the first instancewill reduce the direct tariff subsidy,which is currently borneby non-residentialgas users and by the financial losses of the gas company. However, there will continueto be a substantialdegree of cross-subsidywhich benefits all householdconsumers in direct proportionto the amount of gas which they use. Since the volumesof gas consumedare not significantlydifferent amongexpenditure deciles (Table 3), this cross subsidyaffords benefits to householdsat above-averageincome levels as well as to the poorer households.

36. Higher householdgas prices will also increasethe burden on the State Budget arising from tariff exemptions.Assuming that concessionarytariffs are equivalentto 50 percentof householdgas charges, the subsidy at current prices amountsto approximately$1.9 million per year. Increases in gas tariffs would lead to a proportionateincrease in this subsidy burden. The increasingburden on the budget cannot be lightlydismissed. Indeed, it is suggestedthat these exemptionsbe eliminatedfor the following reasons:

- there is little evidenceto suggestthat exemptionsare well-targetedto protectvulnerable groups; - the financingburden of these subsidiesis confused as fiscal pressures have led to substantial arrears from the State Budgetto the gas companies;and - the exemptionscomplicate the social safety net provision.

In short, these resourceswould be better allocatedthrough the generalsafety net on a means tested or targeted basis.

37. Targetedoptions to protect the poor from an increasein gas tariffs can be either internal to the gas tariff and billing system or part of the generalsocial safety net. As an example of optionswhich are internalto the gas tariff system, carefulrefinement of the system of norms, pendingthe introductionof metering,could reduce gas bills for the poorestwhile allowingoverall increases in householdgas tariffs. At present gas bills are based on the size of household,and the appliancesused. Data from the HouseholdSurvey indicatesthat poorer groups have larger households,and use cookersfor both heating as well as for cooking. Hence, for example,a social gas tariff could: - 60 - Annex 2.3 Page 14

- place an upper limit on householdsize of 4 for the purpose of calculatingbills; and 3 3 - reduce consumptionnorms to, say, 5 m per month (from the current 20 mi) per person for cooking with gas.

38. The impactof such a tariff policy is illustratedin Figure 7. Gas bills as a proportionof householdincome would fall to just over 7 percent (from around 10 percent underthe ten-foldtariff increaseproposal) for poorer households. Whilst such a tariff structurewould benefit all households,it would benefitthe poorestmore than the richest.

Figure 7 Protecting Poorer Gas Consumers: Tariff Restructuring

I0%

39. Such a gas-specific scheme would be simple and quick to introduce and would facilitate an increase in the average residential tariff. Furthermore, it could be considered a short term measureo pending the introduction of meters and the redesign of the tariff structure. At that point in time, a lifeline block with a preferential tariff could be considered. The principle drawback of such a scheme, however, is that it distorts relative prices further, and reinforces incentives to use gas inefficiently - namely, using cookers for heating. In addition, while low-income households are the primary beneficiaries of the change, the preferential tariff continues to confer a substantial monetary beniefiton high-income households. Perhaps more importantly, while the reduction in gas bills is significant, the poorest 40 percent of gas consuming households would spend more on heat than is presently the case across Azerbaijan.

40. Including support for gas costs as part of the general social safety net eliminates some of the problems associated with fuirther manipulations of the gas tariff. In this case, however, a delivery mechanism to handle the targeting and transfer of the subsidy is needed. One option would be to utilize the existing bread compensation scheme as a basis for delivering a targeted subsidy for gas supply.

41. The Social Protection Fund's bread compensation scheme attempts to target benefits exclusively to the poor. Compensation under the bread scheme is available to:

-non-working pensioners - M8,500 per month; and - 61 - Annex 2.3 Page 15

children of poor families - M6,000 per child - where poverty is specifiedas three times the minimum wage for each memberof the household. At the presentminimum wageof M5,500, the averagethreshold in Azerbaijanwould be M80,850.

42. In addition,the Ministry of Educationand the RefugeeCommittee make similar compensatory paymentsto studentsand refugees.The latter are meanstested in the sameway as the SPF's poor family allowance. Thesesocial welfare paymentsare financeddirectly by the StateBudget.

43. The breadcompensation scheme has been criticized as poorly targetedon the basisthat:

- non-working pensionersare not meanstested; - the meanstest for poor families considersonly formal sectoremployment to assessincome. All informal sectoractivity and most privateemployment is not captured;and - the incomethresholds and the incomeperiod usedto assessclaims are distortedby Azerbaijan's rapid inflation.

44. Resultsfrom the HouseholdSurvey show that, while householdsin all decilesare receiving benefitsunder the breadcompensation scheme, the breadallowances are generallyprogressively targeted. In absoluteterms, the poorestdecile receivesan averageM7,200 per householdagainst M2,900 in the wealthiestdecile. In relative terms,of course,the allowanceis much more important to poorer households.In short,the schemeis progressiveand reasonablywell targetedto the poor. Non-working pensionersare moreheavily concentratedamongst poorer households;and the averageincome threshold of M80,850 does not appearto be fundamentallyout of line. The problem appearsto be one of implementationrather than design. For example,all gas consuminghouseholds earn salariesabove the incomethreshold, yet most are receivingbenefits. Similarly, the SPFreport that some 1.1million non- working pensionersreceived payments under the schemein 1995. However,the HouseholdSurvey suggeststhat, at most,there are 700,000non-working pensionersin Azerbaijan. Theseissues of design and implementationwill be consideredfurther by the Azeri authoritiesand the World Bankunder the PovertyAssessment over the coming months.

45. A schemeof providing fuel couponsalong with breadallowances through the bread compensationscheme would provide a convenientand relatively well targetedmechanism for delivering protectionagainst gas price increasesto low-income households.Whether these coupons should be focussedstrictly on gas users,however, raises broader issues of equity. The presentpolicy of gas shortagesand selectivesupply is highly inequitable. As seenabove, gas consumersspend less on energy and have higher incomes. Introducing a gas-specificsafety net would simply reinforce theseinequalities. Indeed,even if gas suppliesare restoredto the restof the country, it is not at all clear that gasconsumers should receivepreferential treatment as comparedto consumersof other network fuels or market-priced fuels.

46. Instead,it would be preferableto introduceenergy coupons which would be distributed alongsidethe breadcompensation scheme. It would be moreefficient if thesecoupons could beto meet energybills for a rangeof network fuels; however,they could equally be restrictedinitially to gas consumption. Suchcoupons would:

be targetedto the poor ratherthan all households; not discriminatebetween energy products consumed; supporta moregeneral realignment of tariffs for all network fuels; and - 62 - Annex 2.3 Page 16

- reduce the risk and level of arrears followingan increasein energy tariffs, and pending strengtheningof the billingand collectionsystems.

47. The targetingof these couponswould mirror the bread compensationscheme. In other words, benefits would be progressivelydistributed across income groups,and the targeting would improveas the bread compensationscheme is reviewed. Furthermore,given that the bread compensationscheme is alreadyup and running,the energy couponscould be introducedquickly and withoutgreat administrative expense. The potential impact on gas consumersof such a proposal is illustratedin Figure 8. The figure illustratesthe impact of a M12500energy couponto non-workingpensioners only. (It does not consider the means tested child benefit). As can be seen, the incidenceof gas bills on the poorest 20 percent of gas consuminghouseholds is sharplyreduced.

Figure 8 Protecting Poor Consumers: Energy Coupons

1 2 0 4 6 a 7 a I 10 *- FM -~

48. As the figure shows,the energy couponscheme directs the total costs of the subsidytowards low incomehouseholds more effectivelythan adjustmentsto the gas tariff. While the example tested (i.e. a couponof M12,500only to non-workingpensioners) would still leave the average cost of heatingwell above the revealedwillingness to pay (i.e. the current level of householdheating costs), additional refinementof the coupon schemeto include other householdsat low income levels wouldhelp to rectify this problem.

FiscalImpacts of Alternative Subsidy Mechanisms

49. At present, gas consumersare subsidisedthrough the subsidisedtariff availableto all household consumers,and discountsavailable to specific consumercategories. The former subsidy is financedby high industrial and commercial tariffs, and the financial losses and arrears of the gas distribution company. The latter subsidy, in principle, is financed by the Government. In practice, there are substantialarrears in budgetarydisbursements. - 63 - Annex2.3 Page 17

50. Table7 showsgas subsidies per annum under different tariff optionsand by sourceof finance.6 At currenttariffs andassuming that gas suppliesare restoredhouseholds are subsidisedby over $36 million. Thiscomprises the discounts offered to specificconsumer groups, and the costof holdingtariffs belowcost recovery levels. The overwhelming proportion of this subsidyis financedby Azerigazitself. This ensuresthat without tariff reform,the gas distributioncompany is highly unlikely to become financiallyviable.

Table7 GasSubsidies under Different Tariffs (US$m)

Tariff Option Azerigaz State Total Financed Financed

Currenttariff : 34.12 1.90 : 36.02

Threefold 26.54 5.69 32.23 tariff

------Tenfold tariff :r------g-- 0.00 : ------18.96 :------18.96 SocialTariff 14.51 0.00 14.51

------I------4-..... Energy 0.00 14.51 14.51 Coupon

51. As tariffs areincreased, the costof the subsidydeclines and the financingburden shifts between Azerigazand the Government.In short,as tariffs rise, the costof exemptionsto specificconsumer categoriesrises rapidly. Undera M63,500tariff, the costof theseexemptions to the Governmentwould bealmost $19 million. Exemptionsare not only poorlytargeted but are expensive.

52. Table7 also showsthe costof the Socialtariff andthe costof the energycoupon described earlier. Thecost of boththese schemes is lessthan the costof exemptionsunder a 10fold tariff increase. In formulatingthe Social Tariff andenergy coupon options discussed above, effort wastaken to keepthe over all subsidycost the same.The analysistherefore strongly suggests that the most cost-effective optionavailable to deliverassistance to poorhouseholds is the energycoupon. At the samecost as the SocialTariff, the energycoupon scheme makes a 10fold tariff increasefeasible.

53. Nevertheless,increasing tariffs to M63,500and introducing an energy coupon will increasethe costof subsidiesto theGovernment (but notto theeconomy) by $12.5million. The resourcesrequired, however,are relatively small - the breadcompensation scheme was budgeted at almost$60 million for 1995.In return,Government will achievebetter targeted assistance to poorhouseholds than is currently providedthrough Azerigaz's financial losses and exemptions.

6 Thesubsidy is estimatedas the difference between revenues under current tariffs and the M63,500per MCMtariff (assumedto bethe cost recovery tariff). Hence,at currenttariffs, this comprises a subsidy on gas purchasedfrom SOCAR and Turkmenistan, and on distribution costs. - 64 - Annex 2.4 Page I

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT DESCRIPTION OF THE LPG INDUSTRY

1. Production

1. LPG is supplied from four different plants in Azerbaijan: (a) Aznefteyanacak (New Baku) Refinery with a maximum yearly LPG production capacity of 90,000 tons, (b) Karadag natural gas processing plant of SOCAR with a maximum yearly LPG production capacity of 30,000 tons, (c) Azerigaz NGL processing unit operated by the LPG Branch with a maximum yearly LPG production capacity of 1,100 tons, and (d) Sumgait (40 km. from Baku) Sythetic Rubber Factory owned by Azerkimya, where propane and butane which are by-products of this chemical industry are retained by the LPG Branch of Azerigaz .

2. Production, however, is constrained by inputs to these plants which are not sufficient to produce the maximum output. Particularly due to the decline in oil production and consequently the crude input to the Aznefteyanacak Refinery and the limited amount of local gas production, the LPG production has declined in 1994 and 1995.2 The Karadag - SOCAR Gas Plant has worked at only 50% of capacity due largely to inadequate compression of domestic gas supplies. The plant (built in the 1960's) is now obsolete.

II. Consumption

3. Local distribution peaked in 1989 with around 62,000 tons supplied by imports from Russia to 450,000 customers, but declined steadily to some 24,000 tons in 1994 supplied to 240,000 customers. The sharp price increases beginning 1993 have caused a decline in demand particularly in households but also industries (Tables I and 2). Table 1 shows a more slowly declining market for LPG use in cars in 1994 and 1995.

4. In terms of demand outlook, the dependence on natural gas imports, the occasional shortages of supply due to regional disruption in gas production, and the shortages in the remote regions of the country not suitable for network distribution of natural gas could justify the expansion of LPG use for cooking in the medium-term. It must be noted that the natural gas network is extended beyond the maximum possible limits and the regions at the periphery and those that are beyond the network are good candidates for expanding the LPG market. Particularly, following the Presidential Decree banning all natural gas imports from Turkmenistan for the rest of 19953,the areas where gas is cut off will have relatively higher demand for LPG. At the same time, it is envisaged that LPG usage for cooking will be limited within this framework in areas where natural gas is available since LPG prices compare quite

The propane-butanefraction of this productis around70-80% which is too high qualityfor the purposesof cooking.Moreover, the Sumgaitplant sells this high qualityproduct at 1,500,000manats/ton while the other LPG producingplants sell at 467,000manats/ton. Note that the retailprice is 750,000manats/ton. There is demandfor this productin Russiabut the roads are closed. 2 The productionplan by the Ministryof Economyfor 1994was 70,000 tons, howeveronly 22,000 tons were suppliedto the LPG Branchof Azerigazfor distributionduring this year. The plan set by the Ministryfor 1995is 102,000tons (70,000 tons fromthe AznefteyanacakRefinery and 30,000tons fromthe KaradagPlant), however the actualdistribution by the LPG Branchof Azerigazfor the first 8 monthswas limitedto 10,005tons. 3The decreewas issuedfollowing balance of paymentsproblems which to a largeextent werecaused by naturalgas importsfrom Turkmenistan. Virtually all the countryoutside the three largestcities was withoutgas in the second half of 1995. - 65 - Annex2.4 Page 2

4 unfavorably to natural gas which is heavily subsidized4.Regarding LPG use in cars,the currenthigh demandseems transitory dueto price distortions betweenLPG andgasoline. No further expansionis envisagedin the medium-term when the gapbetween these prices dissappears.

Table 1: Distribution of Liquefied Petroleum Gas (ton) 1993 1994 1995 (8 months) Population 16,145 17,501 6,325 Industry 2,930 1,213 519 Transportation 5,671 4,910 3,161 Other - 1,304 1,153 TOTAL 24,746 23,625 10,005

III. Distribution

5. Thereare eight LPG bottling plantsin Azerbaijan:Ali-Bayramli, Yevlak, Berde,Horadiz, Sumgait, Siyazan, Nakhchevan,and Baku. LPG is carriedby rail tankers with 25 ton capacity from the producingplants to the first five of thesebottling plants.The LPG Branch owns some360-390 rail tankers for this purpose. The lastthree bottling plantsare suppliedby roadtankers, although supply to the bottling plant in Nakhchevan is handicappedby the political situation in Nagorno-Karabag. Distribution throughcylinders/road tankerscompares unfavorably to rail-based distributionin termsof capacity, i.e cylinders can handle only five tons while the capacityof rail tankersranges between 20-25 tons. Moreover, the roadtankers are ratherold andlack adequatemetering sytems. They should eventually bereplaced with larger capacitytankers.

6. From the bottling plantsto end-users, the shipment is againmade by road tankers/cylinders to householdsand car filling stations.Most of the LPG providedto householdsis suppliedin customer- ownedbottles. (Some 477,000 bottles are ownedby householdswhile the LPGBranch owns some 29,000bottles). Every year some80,000 bottles are testedand about 5,000 are consideredout of order. There is a bottle producingplant in Bakuand the currentprice of onebottle is around100,000-120,000 manats(around $US20) which is not affordableto a largepart of the population.

7. Transportationcosts vary dependingon the distance.The railway costsare particularlyhigh. This is mainly dueto the high maintenanceand operational costs of the rail tankers,which are about40 yearsold . Moreover,there is no local capacityin the countryto fully repairthe railtankers.In some cases,the costof providingLPG to certainregions exceeds the sellingprice for that regiondue to the decline in salesand the high fixed costsof operations.In remoteregions where railroadsdo not exist, distributionof LPGthrough road tankers is carriedout at a lossto the company.On the otherhand, distributionexpenses to filling stationsfor carsare much lessthan those distributed to householdsfor cooking i.e. around30,000-40,000 manats/ton to filling stationsas opposedto averageregional distributioncosts of 87,000manats to Berde(remotest region supplied) and 60,000 manats/ton to Ali- Bayramli (nearerregion).

4 Thecurrent price of LPGis 750,000manats/ton or $US169.1 /ton at thecurrent exchange rate. This is the equivalentof SUS62.7/1000cm of naturalgas. Gas to householdsis sold at a muchlower price of SUSI.41/1000 cm. 5 Every10 years there is a needof totalcapital repair which currently costs a total of around10 million manats (SUS2,222). Every two years containers inside the rail tankersneed to berepaired which costs 350,000 manats/railtanker ($US 77). -66- Annex 2.4 Page 3

IV. LPG Utilization in Cars

8. Demandfor LPG in the transport sector has been quite stable (see Table 1) despite the sharp price increases.This is the result of a faster increasein gasoline prices than LPG prices for cars. Currentlygasoline is 1,000 manats/It.as opposedto 425 manats/It.of LPG. The conversionkits that are installed in cars were previouslyimported from Ukraineand due to the disruptionof this trade currently there is a shortage.The value of these kits is reported to be around$100-120. LPG usage in transportationis not widespreadin the countryand the number of filling stations are limitedand concentratedin the Baku area: (a) between Baku- Karadag(8-10 km. from Baku),(b) Nizami Neighborhood- Baku, (c) Binagadi Neighborhood- Baku,(d) Sumgait(40 km. from Baku),(e) Lenkaran,and (f) Ali-Bayramli(recent and not yet in operation). In additionto these, there are 12 road tankers that are used as mobile fillingstations. The averagestorage capacity of filling stations is 100 m3 or 20 to 45 days of sales which is oversized.Due to the shortageof LPG in the country, as opposedto the ready availabilityof gasoline from domesticoil production,it is unlikelythat LPG use in transportation is economic.

V. Trade

9. Currently,there is a limitedregional market for exports.-LPGwas previously supplied to the region (also to Azerbaijan)by the Grozny Refineryin Chechnia-Russiaand due to the war in this region these supplieshave been disrupted.Therefore, currently there is demand in Armenia,Dagestan (Russia), Ukraine,and also Belorussia.However, all routes to these markets are closed due to the political situationeven though railroadsexist to realize the shipments.

10. The LPG Branchexported 2,000 tons of LPG to Georgia in 1994 and has a new contractto ship 2,000 tons in 1995.The shipmentis made by rail to the Georgianborder. The contracted price is $200/ton fob Tblisi in hard currency which includes a transport cost of 113,680manats to the Georgian border (about $US25).Products for export are boughtfrom the LPG plants at a pre-tax price (similar to exported petroleumproducts). However, the contractbetween the LPG Branchof Azerigazand the AznefteyanacakRefinery requiresthe approvalof the contractedprice by the Refineryand by the Ministryof ForeignEconomic Relations, which adds a bureaucraticburden on the companyand regional trade. On the other hand, export revenuesare actually collected,and in the mediumterm, the regional market could expand as politicalstability is.reached.

VI. Pricing and Taxation

I1. Sincethe beginningof 1993, LPG prices have sharply increased.Currently, the ex-refineryprice of LPG is 467,712 manats/ton(around $104/ton)while the wholesale price for all types of consumersis 750,000manats/ton ($169/ton). The LPG retail business is subject to nine differenttaxes includingVAT, Income Tax, Road Fund. However,despite the sharp fall in sales in 1994and 1995,Azerigaz claims that the LPG Branchhas made a net profit of 169 million manats in 1994 ($US 116,000at the averageannual exchangerate) and 300 million manats for the 8 monthsof 1995(around $US 60,000).The mode of immediatepayment at the sale point makes collectionmore reliable comparedto natural gas and the company seems to follow a strict policy of paymentcollection. - 67 - Annex 2.4 Page 4

Table 1: LAquefledPetroleum Gas Pricing (manhts/ton- USS/ton)

Jai-93 N*v-93 Jud-94 OCt-94 lk,v-94 Feb-95 Ar-95 (nuautsbtn) 2,800 15,667 34,537 115,622 156,100 400,000 750,000 (aUSiron) 58.0 79.0 35.2 51.4 45.7 90.2 169.1

Table2: Ditributlo of LPG

1. Tonrm Handxd 2. Sk SsmDlvto dhe Mid of Tr.uI 3 Numberof Co _nnim (nit) (incuded in 1) 1985 54,000 1969 16,800 1960 9,800 1986 52,500 1990 14,00 1965 41,300 1987 53,400 1991 11,430 1970 88,900 1988 58,300 1992 9,501 1975 245,100 1989 61,900 1993 2,194 1980 441,500 1990 54,400 1994 4,300* 1993 248,000* 1991 50,000 1992 35,600 1993 24,746 1994 41,800

"esimaus 2,863towns or villags Sowrce: AzerbaijanGo Tnnmmso SWdDisuibutou Systam RPoo nWniionmnd Metering Study and ProjecRPwpmt_Sofrep - 68 - Annex 2.5 Page 1

AZERBAIJANREPUBLIC GAS SYSTEMREHABILITATION PROJECT

ACTION PLANON GAS PAYMENTS

ThisAction Plan is basedupon the rightsand obligationsof Azerigazunder Decrees of the Cabinetof MinistersNo. 156 (April20, 1994 ) and No. 13 (February7, 1996)to requirepre-payment for gas and to cut off non-payingcustomers.

TheAction Plan includesthe followingprovisions:

I. For revenue-earningcustomers

(a) As of September1, 1996,Azerigaz is requiredto supplygas only on receiptof Pre-payment or Letterof Creditto all revenueearning customers with the exceptionof Azerenerjiand otherenterprises which are providingservices essential to the survivalof the population(e.g. districtheating, bread production,water supply).

(b) EffectiveDecember 1, 1996,the exceptiongranted above to Azerenerjiand other"essential" enterpriseswill be withdrawnand theywill be suppliedon the same Pre-paymentbasis as otherrevenue earning customers.

II. For non-revenue-earningcustomers:

(c) The list of agenciesand entities to be exemptedfrom using the Pre-paymentor Letterof Creditforms of paymentshould be finalizedby the Governmentby August23, 1996. Exemptionswill be basedupon the importanceof enterprisesor entitiesto the socialwelfare of the populationor upon specificsecurity and safetyconsiderations.

(d) In the eventthat exemptedagencies fail to maketimely payment for gas supply,the Governmentwill, beginningfrom January 1, 1997,take responsibilityfor theirpayment obligationsand will makeprompt payment to Azerigazon their behalf. Annex 3.1 - 69 - PPage1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT SUMMARY OF COST ESTIMATE (thousand US$) Azerigaz Year 1 Year 2 Year 3 Year 4 Year 5 Total 1996 1997 1998 1999 2000 1. CATHODIC PROTECTION Foreign Engineering 0 400 100 100 600 Test Equipment 0 50 50 Materials 0 700 900 900 550 3050 Freight 0 18 23 23 14 76 Sub-total 0 1168 1023 1023 564 3776 Local Engineering 0 38 48 38 20 144 Materials 0 153 213 156 80 602 Freight 0 3 4 3 2 12 Installation 0 76 106 77 40 299 Sub-total 0 270 371 274 142 1057 Total 0 1438 1394 1297 705 4833 2. ANALYTICAL EQUIPMENT Foreign Gas Quality Equip. 0 110 100 210 Leak Detection 0 300 100 400 Network Modelling 0 200 100 300 Freight 0 15 9 24 Training 0 60 30 90 Sub-total 0 575 349 100 0 1024 Local Engineering 0 30 30 60 Materials 0 100 50 150 Freight 0 2 1 3 Installation 0 100 50 150 Sub-total 0 232 131 0 0 363 Total 0 807 480 100 0 1387 3. METERING Foreign Materials 0 876 3745 3240 1412 9273 Freight 0 26 112 97 42 278 Sub-total 0 902 3857 3337 1454 9551 Local Engineering 0 45 85 70 50 250 Procurement 0 38 42 35 25 140 Materials 0 62 228 120 40 450 Freight 0 1 2 2 1 6 Installation 0 55 255 210 130 650 Sub-total 0 201 612 437 246 1496 Total 0 1104 4470 3774 1700 11047 4. IMPLEMENTATION Foreign Implementation Assist. 100 400 300 100 900 Sub-total 100 400 300 100 0 900 Local Implementation 50 130 130 100 40 450 Sub-total 50 130 130 100 40 450 Total 150 530 430 200 40 1350 Annex 3.1 Page 2

Azeigax Year 1 Year 2 Year 3 Year 4 Year 5 Total _ 1996 1997 1998 1999 2000 5. CORPORATIZATIONSUPPORT Foreign Office Equipment 0 100 150 250 Training 0 100 100 200 Other 0 200 200 400 Sub-total 0 400 450 0 0 850 Local Training 0 20 20 10 50 Other 0 30 30 60 Sub-total 0 50 50 10 0 110 Total 0 450 500 10 0 960 PROJECTTOTAL Foreign Total Basecost 100 3445 5979 4560 2018 16102 PhysicalContingency 15 517 897 684 303 2415 Price Contingency 4 225 572 578 320 1699 Sub-total 119 4786 7448 5822 2641 20216 Local Total Base cost 50 883 1294 821 427 3476 PhysicalContingency 8 132 194 123 64 521 Price Contingency 2 58 124 104 68 355 Sub-total 59 1073 1612 1048 559 4353 Total Total Base cost 150 4328 7274 5381 2446 19578 PhysicalContingency 23 649 1091 807 367 2937 Price Contingency 6 283 696 682 388 2054 TOTAL PROJECT 178 5260 9060 6870 3200 24569

SUMMARY Component Local Foreign Total 1. CathodicProtection 1057 3776 4833 2. Testing Equipment 363 1024 1387 3. Metering 1496 9551 11047 4. Implementation 450 900 1350 5. CorporatizationSupport 110 850 960 Total Base Cost 3476 16102 19578 PhysicalContingency 521 2415 2937 Price Contingency 355 1699 2054 Project Total 4353 20216 24569 Annex 3.1 -71 -Page 3

Azwigaz Year 1 Year 2 Year 3 Year 4 Year 5 Total 1996 1997 1998 1999 2000 3a. CITY GATEMETERING Foreign Materials 0 700 600 600 1900 Freight 0 21 18 18 0 57 Sub-total 0 721 618 618 0 1957 Local Engineering 0 15 25 20 60 Procurement 0 8 12 5 25 Materials 0 22 38 20 80 Freight 0 0 1 0 2 Installation 0 55 95 60 210 Sub-total 0 100 171 105 0 377 Total 0 821 789 723 0 2334 3b. NEWINDUSTRIAL METERING Foreign Materials 0 15 1435 1300 2750 Freight 0 0 43 39 0 83 Sub-total 0 15 1478 1339 0 2833 Local Engineering 0 20 20 20 20 80 Procurement 0 15 10 10 10 45 Materials 0 20 30 30 20 100 Freight 0 0 1 1 0 2 Installation 0 70 70 60 200 Sub-total 0 55 131 131 110 427 Total 0 71 1609 1470 110 3260 3c. REPLACEMENTINDUSTRIAL METERING Fofeign Materials 0 8 1650 1300 1192 4150 Freight Q 0 50 39 36 125 Sub-total 0 8 1700 1339 1228 4275 Local Engineering 0 10 40 30 30 110 Procurement 0 15 20 20 15 70 Materials 0 20 40 40 20 120 Freight 0 0 1 1 0 2 Installation 0 90 80 70 240 Sub-total 0 45 191 171 135 542 Total 0 54 1890 1510 1363 4817 3d. METERTESTING AND INSTALLATIONEQUIPMENT Foreign Materials 0 153 60 40 220 473 Freight 0 5 2 1 7 14 Sub-total 0 158 62 41 227 487 Local Engineering 0 0 Procurement 0 0 Buildingfor test equip. 0 120 30 150 Freight 0 0 Installation 0 0 Sub-total 0 0 120 30 0 150 Total 0 158 182 71 227 637 Annex 3.1 Page 4

Azerlgaz Year 1 Year 2 Year 3 Year 4 Year 5 Total 1996 1997 1998 1999 2000 3. TOTAL METERING Foreign Materials 0 876 3745 3240 1412 9273 Freight 0 26 112 97 42 278 Sub-total 0 902 3857 3337 1454 9551 Local Engineering 0 45 85 70 50 250 Procurement 0 38 42 35 25 140 Materials 0 62 228 120 40 450 Freight 0 1 2 2 1 6 Installation 0 55 255 210 130 650 Sub-total 0 201 612 437 246 1496 Total 0 1104 4470 3774 1700 11047 -73 - Annex3.1 Page 5

CATHODICPROTECTION MATERIALPRICE SUMMARY

Item Size Total Unit Cost Total Cost

______mm Quantity USD USD Isolating joint 50 22,000 60 1,320,000 Isolating joint 100 1,200 80 96,000 Isolating joint 150 400 300 120,000 Isolating joint 300 200 770 154,000 Isolating joint 400 35 1,094 38,276 Isolating joint 500 6 5,904 35,424 Isolating joint 700 6 17,856 107,136 Isolating joint 1,000 6 20,000 120,000 Isolating joint 1,200 2 20,000 40,000 CP stations units 100 3,000 300,000 Steel pipe tonnes 900 800 720,000 Total 3,050,836 Annex3.1 Page6

ANALYTICAL EQUIPMENT

Number Unit Cost Total USD Gas Quality Equipment Pressure Gauge Calibration 1 10,000 10,000 Gas Chromatograph 2 50,000 100,000 Hydrogen Sulphide H2S Analyser 1 15,000 15,000 Sulphur / Mercaptan Analyser 1 15,000 15,000 Water Dew Point Analyser 1 20,000 20,000 Hydrocarbon Dew Point Analyser 1 20,000 20,000 Analyser Calibration device 1 30,000 30,000 Gas Sampling, 10 kits & 40 bottles 1 60,000 60,000 Computer for storing and reporting data package 30,000 30,000

Sub-total 300,000

Leak Detection Mobile leak detection units 3 20,000 60,000 Hand held, solid state type 68 5,000 340,000

Sub-total 400,000

Network Modelling 2 PC based systems, 1 for transmission and 1 for distribution. Hardware computers, printers, digitizers, plotters etc. 2 25,000 50,000 Software, licences and initial programming. 2 125,000 250,000

Sub-total 300,000 - 75 - METERINGCOST ESTIMATES Annex3.1 Pagc 7

Maximum Type of Upstream Downstream Quantity Unit Total Capacity Meter Pressure Pressure Cost Cost Nm3/hr min/max.MBar) Bar USD USD Vow Industrial Meters 16 G10 0.7 - 4 0.019 or 0.300 15 940 14,100 25 G16 0.7 - 4 0.019 or 0.300 16 1,600 25,600 40 G25 0.7 - 4 0.019 - 0.3 - 1 58 2,480 143,840 65 G40 0.7 - 4 0.019 - 0.3 - 1 56 3,050 170,800

100 G65 0.7 - 4 0.019 - 0.3 - 1 51 3,910 199,410 160 G100 0.7 - 4 0.019 - 0.3 - 1 81 4,365 353,565 250 G160 0.7 - 4 0.019 - 0.3 - 1 77 7,605 585,585 400 G250 0.7 - 4 0.019 - 0.3 - 1 43 9,180 394,740

650 G400 0.7 - 4 0.019 - 0.3 - 1 39 11,070 431,730 1000 G650 0.7 -4 0.019 - 0.3 - 1 17 13,050 221,850 1600 G1000 0.7 - 25 0.019 - 16 8 20,520 164,160 2500 G1600 0.7 - 25 0.019 - 16 2 23,850 47,700 4000 G2500 0.7 - 25 0.019 -16 0 25,650 0 5000 G4000 0.7 - 25 0.019- 16 2 27,900 55,800

L______Sub-total 465 2,808,880

Maximum Type of Upstream Downstream Quantity Unit Total Capacity Meter Pressure Pressure Cost Cost Nm3/hr min/max. (Bar) Bar USD USD Replacement Industrial Meters 16 G10 0.7 - 4 0.019 or 0.300 21 940 19,740 25 G16 0.7 - 4 0.019 or 0.300 38 1,600 60,800 40 G25 0.7 - 4 0.019 - 0.3 - 1 50 2,480 124,000 65 G40 0.7 - 4 0.019 - 0.3 - 1 81 3,050 247,050

100 G65 0.7 - 4 0.019 - 0.3 - 1 86 3,910 336,260 160 G100 0.7 - 4 0.019 - 0.3 - 1 99 4,365 432,135 250 G160 0.7 - 4 0.019 - 0.3 - 1 71 7,605 539,955 400 G250 0.7 - 4 0.019 - 0.3 - 1 68 9,180 624,240

650 G400 0.7 - 4 0.019 - 0.3 - 1 74 11,070 819,180 1000 instr. pkge 0.7 - 4 0.019 - 0.3 - 1 37 9,200 340,400 1600 instr. pkge 0.7 - 25 0.019 - 16 28 9,200 257,600 2500 instr. pkge 0.7 - 25 0.019 - 16 17 9,200 156,400 4000 instr. pkge 0.7 - 25 0.019 - 16 8 9,200 73,600 5000 instr. pkge 0.7 - 25 0.019 - 16 12 9,200 110,400

Sub-total 690 4,141,760

Maximum Type of Upstream Downstream Quantity Unit Total Capacity Meter Pressure Pressure Cost Cost Nrn3/hr J _____mini/max. (Bar) Bar ______USO USO New Cornmmrcial Metors 1N6 610 0.7-4 0.019or0.300 100 940 94,000 25 G16 0.7 - 4 0.019 or 0.300 100 1,600 160,000

I__ _ _ _ I___ Sub total 200 254000

Sumnmary______Ouantity Cost Consumption 000 USD E6M3/yr City Gate Stations 214 1,906 7,437 New Industrial Meters 465 2,809 413 Replacement Meters 690 4,142 1,302 New Commercial Meters 200, 254, est. 11 TOTAL 1,5691 9,111 - 76 - Annex 3.2 Page 1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT LENDING ARRANGEMENTS, LEGAL DOCUMENTS AND FLOW OF FUNDS

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SuppliersG & S - 77 - Annex 3.3 Page I

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT SUMMARY OF ENVIRONMENTAL ASSESSMENT AND ENVIRONMENTAL MITIGATION PLAN

I. SignificantImpacts on the Environment

No significant impacts are anticipated to result from the project. For the purpose of full documentation and disclosure, the impacts which have been considered are described below and mitigation measures for them are proposed:

A. Potential Adverse Impacts

Implementationof cathodic protection systems, purchase of new equipment for maintenance and operation, and installation of new and replacement meters are not expected to result in adverse impacts. The origin and specifications for the new equipment will not be known until vendors are selected after competitive bids are received. Pipeline replacement will result in short term construction related impacts. This would include traffic circulation, air quality, odor, soil erosion, water quality, noise and public safety risks.

Traffic Circulation and Other Public Activities: There will be a potential temporary disruption of traffic movement, consisting of delays due to increased traffic on local roads and detours due to excavation at road intersections. Disruption of recreational activities may also occur, for example, if the pipe replacement area coincides with a public park or recreation area, a school or another public use.

Air Quality: Construction activities will create dust during clearing and grading activities, during trench digging and while moving soil. However,dust will result in only localized air quality impacts because most of the particulate matter will settle out immediately downwind of the source. Localizeddust emission impacts can be mitigated by applying water sprays to the construction area. The exhausts from construction vehicles will emit chemicals that are precursors to photochemical smog formation. These emissions will have a more regional impact because of the long atmospheric reaction times to form smog. However,these emissions will be very small when compared to other mobile and industrial source emissions of the region. There, the impacts will not be significant. Old pipe segments will be purged of gas after new sections of main are installed. Blowdownsrelease natural gas to the atmosphere. Because natural gas is lighter than air, it will rise quickly, mix, and be diluted to a level at which it would not be a concern to human health.

Odor: Gas venting will result in odor at blowdown sites. Under certain climatic conditions, the vented gas may drift in sufficient concentrations to be detected over a substantial distance. The duration of detectability in these cases is usually from a few minutes to an hour. Odors can also be emitted from exhausts on the diesel construction equipment. However,these impacts will only be localized and temporary, usually occurring during vehicle acceleration.

Soil Erosion: In hilly areas, there would be a potential for increased soil erosion as a result of pipe replacement activities.

Water Quality: Some of the pipe replacement locations may be in areas of rivers, streams and reservoirs. If old degraded pipes are not removed and disposed of properly, this could result in degradation of water quality. The release of hydrostatic test wastewater could also result in an impact on water quality.

Construction Noise: There will be a temporary increase in noise levels during construction. Trucks, bulldozers and welding equipment will be required for grading, trenching, pipe laying and backfilling. These - 78 - Annex 3.3 Page 2 piecesof equipmentproduce noise levels of 70 - 95 dBA at a distanceof about 15 meters. Thesenoise levels are not higherthan ambientlevels in urbanlocations in daytime,and thereforethe temporaryincremental increasein noiselevels is not consideredto be significant.Gas ventingusually take about an hour. Venting is requiredat bothends of the replacedpipe section. Ventingwill take placeoccasionally over the term of the pipe replacementprogram. Becausethe durationof the noiseis onlyone hour,this is not consideredto be a significantimpact. Nevertheless,mitigation measures are proposedto informnearby residents and commercialestablishments of the time of ventingin advance.

PublicSafety Risks: The old pipesthat will be removedwill be purgedof gas andthen removed. The pipesthat are abandonedin placewill be cut, cappedand filledwith inert nitrogengas to eliminatefuture risks. Thereforeno potentialfor increasedpublic safetyrisks is foreseen.

B. PotentialBeneficial Impacts

ReducedMethane Leak Potential: Replacementof deterioratedpipes, installationof cathodic protection,and new testingequipment will substantiallyeliminate gas leaks andresult in two impacts:

* improvedpublic safety through reduced risk of explosiondue to undetectedleaks;

a cumulativebeneficial impact resulting from the reducedpotential for releaseof methaneto the atmosphere,thus reducingthe greenhouseeffect. Sincemethane emissions produce a greenhousesignal that is 20 to 50 timesgreater than carbondioxide for equivalent emissions,it is the secondmost significantgreenhouse gas beingemitted by man's activities.

Potentialfor Gas Conservation:The installationof upgradedand new metering,together with proposedgas pricereforms, is expectedto promotemore efficient use of gas by industrialand commercial customers.This in turn will reducethe amountof gas consumptionassociated with givenlevels of output, therebyproviding a benefitin termsof reducedC02 and particulateemissions.

Substitutionof Gasfor Other Fuels:The combinationof conservationand loss reductionresulting fromthe projectwill, at least duringperiods of supplyconstraint and import curtailment, increase the amount of gas availableto consumers.The recentSurvey of LivingConditions (November/December 1995) showed that, in responseto gas supplyshortages, over 40 percentof the populationwere using fuelwood as their primaryfuel for heatingand cooking- eventhough the gas networkitself extendsto 80 percentof the country. Reducingfuelwood use by increasingthe availablegas supplywill reducedeforestation, which is reportedto be occuringat a rapid rate.

II. MitigationMeasures

Threetypes of mitigationmeasures are proposed:construction mitigation measures for pipe replacement;enhancement of environmentalmanagement capability; and, publicinvolvement during the constructionprocess.

A. ConstructionMitigation Measures for Pipe Replacement

Protectionof Other Utilities:Prior to construction,the locationof other utilitiesunderground and aboveground in the vicinityof the pipe will be identifiedand anynecessary permits from local authorities obtained. Duringconstruction all the other utilitysteel structureswill be protected.Each utilitywould remainin full operationduring construction. All ditcheswill be returnedto their originalcondition or better. - 79 - Annex 3.3 Page 3

Construction Safety: Pertinent information on safety procedures will be disseminated to all levels of personnel involved in the project. Safety hazards of concern include: dangerous machines with moving parts, electricity, ergonomic factors such as physiological and psychologicalstresses on the human body, eye protection, falls, fires and explosions, heat or cold stresses, moving and lifting equipment, noise, vibrations, and combinations of several of these hazards which can exacerbate danger and injury.

Research of Pipelines: No excavation will be undertaken until detailed research on the existing underground structures is completed by qualified pipeline engineers. All underground structures, their sizes, locations, depths, material carried and ownership will be identified, in order to prevent damage from external sources and damage from construction activities to existing underground facilities.

Pot Holing: Pot holing, or advance digging in the area to locate the position of underground structures, will be performed carefully by hand if necessary when a pipeline is near. Pot holing will be used whenever it is necessary to locate the position of undergroundstructures.

Protection of Existing Draining Patterns: At stream or river crossings, pipeline will be buried at least 3 meters under the scour line.

Erosion Control: In hilly areas where there is a potential for erosion, an erosion control plan will be prepared to keep stripping of vegetation to a minimum, control the velocity and direction of the runoff, protect slopes, stabilize soil, and reestablish native vegetation in natural areas.

Dust Control: The construction area would be sprayed with water to control dust.

Construction Noise: Prior to venting of gas, notice would be given to surrounding area residents and commercial and industrial establishments. The approximate time for venting and the anticipated noise level would be disclosed at that time. Insofar as possible, construction activities would take place only during the daytime, and would conform to city noise ordinances and regulations as applicable.

Treatment of Removed Pipes: Old pipes that are removed would be purged of all gas. Pipes that are abandoned in place would be cut, capped and filled with inert nitrogen gas to eliminate future risks.

Water Quality: Hydrostatic test water would be drawn from nearby sources, pressured in the pipe, tested for contamination and discharged to an existing waterway.

Solid Waste: All solid waste generated at the construction site would be removed and deposited at an approved solid waste disposal facility.

Construction Inspection: Inspectors would be designated by Azerigaz to perform regular inspections of construction activities to ensure that contractors are following the proper procedures and that they are taking precautions in conformance with local occupational health and safety provisions.

Fire Protection and Emergency Response: An EmergencyResponse Plan would be prepared for the project prior to construction. The EnvironmentalCoordinator within Azerigaz would be responsible for preparing the plan, managing its implementation, and reviewing it as necessary. Proper safety and fire fighting equipment would be provided at the construction sites and arrangements made in advance with emergencyresponse teams in the area. Personnel would be trained in the use of safety equipment and periodic drills would be given in emergency procedures. Safety reminders would be issued to all staff periodically, and visitors to construction sites would be briefed on potential hazards and necessary safety - 80 - Annex 3.3 Page 4 precautions. The EnvironmentalCoordinator unit wouldalso be responsiblefor informingthe local populationabout potential emergencies which could arise eitherduring or subsequentto construction,and for ensuringthat they are familiarwith appropriateresponses to ensuretheir safety.

Continuation of Vehicular Circulation: Steps would be taken to minimize disruption of vehicular circulationaround the constructionsite. Thesewould include detouring of traffic aroundthe construction area, directingtraffic along one half of the roadway,and routingtraffic over temporary trench bridging. Detourswould be properlysigned, and personneldeployed to directtraffic if necessary.

VehicularSafety duringConstruction: All laws dealingwith vehiclesafety would be adheredto to avoidvehicular accidents as a resultof addedheavy traffic on the road. The constructionarea wouldbe appropriatelysigned to alertmotorists and pedestrians. Temporarylighting and personnelwould be deployed to directtraffic if necessaryto ensuresafe movementin the constructionareas.

MitigationMonitoring: Monitoring of the implementationof mitigationmeasures would occur before,during and after the pipe replacementhas takenplace. Monitoringwould encompass all mitigation measuresrequired as conditionsof the projectto ensurethat they have beenproperly executed. Monitoring wouldbe the responsibilityof the EnvironmentalCoordinator of the project.

B. Enhancementof EnvironmentalManagement Capability

In orderto ensurethat the projectmitigation plan is executedeffectively, the environmental managementcapability of Azenrgazneeds to be enhanced.A new positionof EnvironmentalCoordinator shouldbe establishedwithin the ProjectImplementation Unit. The positionwould include responsibility for ensuringthat the mitigationmeasures are carriedout accordingto the technicaldetails, descriptions and operationsprocedures specified, that monitoringof mitigationand reportingprocedures are carriedout properly,and that funds allocationfor implementationof mitigationare used for their intendedpurpose.

C. PublicInvolvement

Publicinvolvement would be solicitedas part of the projectfor the generalpublic and enterprises that wouldbe affectedby short termconstruction impacts of the project. The programwould be plannedto informthe publicabout the purposeof the project,the short-termadverse impacts that maybe anticipated, the mitigationmeasures that will be undertaken,and the longterm benefitsof the project. The program wouldbegin prior to constructionand continueuntil the completionof the constructionperiod. Theprogram wouldinclude notices in the localpress, distributionof hand-outs,and site tours in areas to be disturbed. Citizenconcems and suggestionsfor addedmitigation measures would be incorporatedin projectprocedures as appropriate.

III. Implementationand Cost of MitigationMeasures

A. ImplementationResponsibility

Implementationof the constructionmitigation measures will be the responsibilityof the engineering contractorfor the project,and subsequentlyof the constructioncontractor. Adherenceto the mitigationswill be specifiedin bid documentsfor these contractors,and Azerigazwill assign inspectors for the durationof the activityto ensurethat they are carriedout. The designationof an EnvironmentalCoordinator should take placeat projectinception. - 81 - Annex 3.3 Page 5 B. Cost of MitigationMeasures

No additionalcosts are expectedfor constructionmitigation measures because best engineeringand constructionpractices would incorporateall of the measuresrecommended above as part of the projectcost. - 82 - Annex 4.1 Page I

AZERBAIJANGAS SYSTEM REHABILITATIONPROJECT TERMS OF REFERENCE PROCUREMENTENGINEERING MANAGEMENT AND SUPERVISION (PEMS)

GENERAL BACKGROUND

1. Azerigaz is a national gas company whollyowned by the Governmentof Azerbaijan.Its principal activitiesinclude purchaseof indigenous natural gas producedby SOCAR (State Oil Companyof Azerbaijan Republic);gas import,primarily from Turkmenistan;transmission of natural gas to domestic markets as well as transit to other countries of the region; operation of two undergroundgas storage; and distribution of natural gas to end users in Azerbaijan.Azerigaz is also in charge of transporting, bottling and distributing LPG to end users. These activitieswhich were previouslyconducted as part of a centralizedministry of the FSU, have been vested to Azerigaz since 1992. The companyemploys approximately 16 000 people and is managed as an autonomousentity.

2. The Governmentof Azerbaijan(GOA) has applied for a credit from the InternationalDevelopment Association, (IDA, a memberof the World Bank Group) for the implementationof the proposed Gas System RehabilitationProject. Part of this loan would be used to finance the cost of this consultancyassignment.

3. Azerigaz's transmissionsystem includes some 5,000 km high pressure pipelines and 224 MW in- stalled compressorcapacity. It is capable of transportingthe gas producedby SOCAR and also imports from Turkmenistanand Iran. Currently,the gas transmissionnetwork receives gas from offshore Caspian fields, from onshore fields and from undergroundstorage. The transmissionsystem delivers gas to approximately 120 points includingunderground storage sites, major industrial consumers,and city gate stations. It also has the capabilityto transit gas to other countries;however, at present there is no re-export through Azerbaijan.

4. Until April of 1995, gas was also imported from Turkmenistanand, occasionally,Iran, in order to meet full domesticrequirements. While these imports previouslyconstituted approximately30 percent of gas supply,the Governmenthas barred gas imports since April, 1995 owing to concernsover physical losses and reluctanceto incur further foreign debt. As a result, substantial areas of the country are not receiving gas at the present time. While the Governmentand Azerigazdo not anticipatethe resumptionof gas imports in the near future, they also regard the interruption in supply to outlying areas as a temporary conditionwhich will reverse as consumption is rationalized and as domestic supplies of gas increase.

5. The gas receivedfrom SOCAR contains significantwater and liquid hydrocarbonsand is not of pipeline quality. In fact only about one third of the gas produced offshore by SOCAR is processed in the Karadag plant, which is in a poor state of repair and does not have any dehydrationfacilities. It is envisaged that the necessaryoffshore compressionand dehydrationfacilities would be installed by SOCAR to restore the offshore gas fields production. Currently, a technical study is being conductedunder a World Bank funded technical assistance project to review and propose optimum gas processing plans for SOCAR.

6. Azerigaz operates two undergroundgas storages in depleted fields, Karadagand Kalmas,both of which need major rehabilitationdue to obsolete and unsafe surface facilities.Further, Azerigazhas been withdrawingfrom the cushiongas of these two structures to compensatefor the gas supply to domestic consumers. Rehabilitationof Karadag and Kalmas is being reviewedunder a study funded by TACIS.

7. The distribution system,with some 40,000 km of pipeline which supplies gas to over one million consumers,is practicallynot metered.Although a large percentageof industrial customersare metered,their meters are old and in a state of disrepair with very low accuracy. In the residentialsector, only a few hundred meters have been installed.This lack of gas measurementleads to large discrepanciesbetween actual gas consumptionsand billed quantities. - 83 - Annex 4.1 Page 2

8. The gas transmission system as well as the distribution system are practicallyunder no cathodic protection and are severelysuffering from corrosion.Leak detection is assured by continuousmonitoring of pipelines.Network maintenancehas been adverselyaffected by lack of financialresources to procure materi- als and spare parts.

9. Azerigaz's LPG Division receivesLPG from plants operated by SOCAR,Azerigas and Azerchimia. LPG is transported by rail to eight bottling plants operated by Azerigaz. Cylindersare filled in these plants and deliveredto end users by road trucks. The distributionsystem for LPG is also obsolete and is suffering from lack of spare parts.

PROJECTBACKGROUND

10. Against the above background,Azerigaz and the World Bank have initiated a gas system rehabilitationproject (GSRP). Sofregazwas retained as consultantto carry out a study of the investments needed for rehabilitationof the gas transmission and distribution systems and to prioritize these investments. Upon request, copies of the Sofregazreport would be provided to the consultantsinvited to bid for the PEMS assignment. Based on the Sofregazreport, and as a result of discussionsbetween the World Bank and Azerigaz,the followingcomponents have been identifiedas critical to the rehabilitationof the transmission and distribution systems in Azerbaijan,and for fundingunder the proposed GSRP:

Metering: The meteringcomponent would include:(a) rehabilitationof the city gate meter stations throughoutAzerbaijan by replacing the existing instrumentationor by replacing the entire meter at some stations; (b) installing new meters at industrial and large commercialconsumers who currentlyhave no meters; and (c) rehabilitating the meteringat the industrial consumerswho currently have meters by either replacing the meters or replacing the measuring instrumentation.In addition, financingwould be providedto acquirerelated meter proving equipment and equipmentpackages to facilitatemeter installation.

a. City Gate Stations: Approximately214 meter sets at the city gate stations wouldbe rehabilitatedor replacedunder the project. This includesall the city gate stations which are currently in operation in Azerbaijan and those industrieswhich are fed directly from the main high pressure pipeline. This programwould cover all of the locationswhere gas is currently deliveredfrom the main transmissionpipelines.

b. New and ReplacementMeters: Approximately465 industrial and large commercial consumersare currently operatingwithout meteringand these would have meters installed. Approximately690 industrialand large non-industrialconsumers are currentlyoperating with meters which are either not functioningor are obsolete and inaccurate. The larger consumerswould have instrumentationreplaced and some consumerswould also have the meters replaced,where this is justified.

c. Meter Proving Equipment: Meter proving equipmentwill also be purchased for each meter type and housed in appropriatelyconstructed facilities that would meet international standards.

d. Installation Equipment: This componentwould includethree vehiclesequipped with lifting and weldingequipment and necessarytools to modernizeand facilitateinstallation of meter sets.

Cathodic Protection System Rehabilitation: The cathodicprotection (CP) of the pipeline system throughoutAzerbaijan is in poor conditionand in need of rehabilitation,largely as a result of a lack of funds for investment. The CP rehabilitationcomponent would focus on the Apsheron peninsulaand cover about - 84 - Annex 4. 1 Page 3

2,700 km of pipelinesserving that area. The rehabilitationprogram would includeelectrically isolating the pipelines into discretesections, designingthe detailed CP requirementsfor each section and then installing the required CP for each section. A specializedconsultant would assist Azerigaz in the initial isolationof two sections,one on the transmission system and another one on the distribution network,carrying out the design and training Azenrgazto continue the work. In additionto the CP equipment,an allowancefor approximately 900 tons of large diameterpipe has been included in the cost estimate. This would be used to replace seriously corrodedpipe which is discoveredduring implementation.

Analytical Equipment: This componentconsists of three sub-components:(a) gas quality test equipment; (b) leak detectionequipment; and (c) computer software and hardware to undertakenetwork modeling.

Technical Assistance: This includes modernizationof office equipment includingexpansion of computer application,and training in modem commercialbusiness and managementpractices, as well as the assistance in procurement,engineering, management and supervisionwhich is the subject of these terms of reference.

OBJECTIVES OF THE CONSULTANCY SERVICES

11. The main objectiveof the consultancyassignment is to assist Azerigazto provide a complete engineeringand managementpackage for the proposed project components. In this regard, the Consultant will work with the ProjectImplementation Unit (PIU) within Azerigaz,the core of which has been established as a liaison unit during the Sofregazconsultancy. On assignmentof the project, the Consultantwill promptly plan and render all necessaryadvice to the client for causing the project to be executedexpeditiously and economicallyin conformitywith the highest industrypractices and standards. The main general objectivewill be the timelycompletion of the proposed project in an efficient manner, taking into accountthe local circum- stances and conditions. A related objectiveof the consultancyis to assist Azerigaz in developingits capacity to plan and implementfuture investmentprojects.

SCOPE OF THE CONSULTANCY ASSIGNMENT

12. The consultancyassignment would be undertakenin two phases, with the executionof the second phase dependentboth on the approval of the IDA credit for the proposed project and on the consultants' satisfactory completionof the first phase. The first phase of the assignmentwould be financed under a Project Preparation Facility(PPF) which would cover activitiesthrough to the point of credit effectiveness (currentlyestimated as December31, 1996).

Phase I

The objectivesof the first (PPF) phase of the assignmentwill be to advancethe procurementof equipment to upgrade gas measurementcapability at major City Gate Stations (CGS) in the Apsheron Peninsula,to continue preparationof specificationsand bidding documents for the remainingsubcomponents of the meteringprogram, and to undertakeminor items of procurementincluding the acquisitionof leak detection equipmentand basic office equipmentfor the operation of the Project ImplementUnit (PIU). It is envisionedthat this assignmentwill be undertakenby two or threespecialists, operatingon a short term basis in Azerbaijan. Activities undertakenin this Phase are not expectedto includeany activitiesrelated to mobilizationfor the second phase of the assignment. Specifically,the activities to be covered underPhase I includethe following: - 85 - Annex 4.1 Page 4

Meter Upgrading/Instrumentationat City Gate Stations

a) Assist Azerigaz in finalizingtheir ongoingsurvey of the specificrequirements in terms of meteringand instrumentationat the City Gate Stations (CGS) in the Apsheron Peninsula. The consultant is expectedto confirm the least cost solution for establishingreliable measurementat these and any other CGS's, i.e., retrofitting of the existing orifice meters vs installationof new meters.

b) Finalizethe design, technicalspecifications and quantities for the meter upgradingprogram at these stations, based on the results of the above mentionedsurvey as well as necessarysite visits.

c) Assist Azerigaz in preparingbidding documents for the procurementof the initial packageof meters and regulators based on InternationalCompetitive Bidding (ICB), and assist them in initiating the tendering for these items in accordancewith the guidelinesand requirementsof World Bank/IDA financed projects.

d) Monitorthe progress, and render such assistance as is necessaryto Azerigaz in extending their survey to includethe remainingCGS's as well as major industrial and commercialcustomers who are proposed for meter replacement/upgradingunder the project.

Leak Detection Equipment

a) Reviewthe specificationsand quantities for the proposed leak detectionequipment. Finalize technicalspecifications and bidding documents.

b) Reviewthe appropriatenessof acquiringthe equipmentin a single or multiple packages, based on an assessmentof Azerigaz's need for the equipmentand their ability to undertakea comprehensiveleak detectionprogram. Based on the findingsof this review,define the appropriate quantities and assist Azerigaz in initiating procurementof these items.

Other

a) Assist Azerigaz in identifyingand packaging a basic complementof office and communicationsequipment, for procurementunder the PPF (estimated value, approximately $75,000). Define the appropriateprocurement methodologies (Local Shopping, International Shopping)and, once IDA approval is obtained, assist Azerigaz in carryingout the procurement.

Phase II

Phase II of the assignmentwill extend from the time of crediteffectiveness through to the completion of the implementationof the project (1997 through 2000). Duringthis phase, the Consultant is expectedto assist the Azerigaz PIU in all aspects of procurement,engineering, project managementand supervisionof installation. The Consultantwill provide the services of highly qualifiedand experiencedpersonnel from his own organization and from other organizationsunder his responsibility.The Consultant will carry out the assignmentby using the modem up-to-date techniquesof gas industry,especially for natural gas transmission and distribution. In addition,the consultantis expectedto assist Azerigaz in developingits own capabilities to design, manage and execute investmentprograms. The scope of the assistance is broadly defined below in terms of specific engineering/procurementactivities to be undertaken with regard to each of the project components, and in terms of general activities related to project management,engineering, procurement, implementationsupervision and commissioningof the various project components. It is recognized,however, that these are inter-dependentactivities, and that the general activitieswill be carried out in the context of undertakingthe specificproject components. - 86 - Annex 4.1 Page 5

Procurement,Engineering and ImplementationActivities

Metering and Meter Proving Equipment:

a) Assist Azerigaz in completingtheir ongoingsurvey of the specific requirementsin terms of metering and instrumentationat the City Gate Stations (CGS) and at major industrialand commercialcustomers throughoutthe service area. The consultantis expectedto confirm the least cost solution for establishingreliable measurementat each of these installations.

b) The Sofregaz design and specificationsprovide for factoryassembled packagesof meters and regulators; the GSRP is based on the assembly of the meter and regulator sets in Azerbaijan in accordancewith the design to be provided by PEMS consultant. The PEMS consultant is required to prepare a program for installation of units by Azerigazunder the consultant's supervision. The consultantmay includein the bidding necessaryprovision for assembly, installation and commissioningof the first few units by the supplier in Azerbaijanfor trainingof the Azerigaz staff.

c) In conjunctionwith Azerigaz and the AzerbaijanState Standards Committee,specify the equipmentrequired to meet agreed proceduresfor regular testing and proving of the meters to be acquired under the project, and define the arrangementsnecessary for the proper housing of this equipment.

d) Assist Azerigaz in the procurementof the remainingmeters, meter proving equipmentand installationequipment.

e) Reviewthe existing contracts between Azerigaz and its customers/suppliersand propose necessarymodifications to bring them in line with industrynorms and practices;or, alternatively propose new model contracts. The consultant is required to provide Azerigaz with the modifications/modelcontract both in Azeri languageand English..The modificationsor model contracts should establish clear obligations and procedure for security of the new metering and regulating stations, their maintenanceand treatment of measurementdisputes between customers, Azerigaz and the Azeri State Standard Organization.

f) ReviewAzerigaz' program for installation of meters in the residentialsector and assist in introducingpossible improvements.

Pipeline System Upgrade:

a) Organizethe cathodic protectionprogram, possibly in phases as proposed by Sofregaz.

(i) conduct a pilot project including surveyand implementationof pipelineprotection sys- tem in limitedareas of the transmission and distribution systems;

(ii) organize on-the-job training as well as seminars/programsfor Azerigaz staff to introducemodern techniquesfor cathodic protectionassessment and installation of pipeline protectiondevices such as isolationjoints and rectifiers;and

(iii) set-up a complete program for the surveyof the entiretransmission and distribution systems followedup by implementationof a corrosion protection program.

b) Prepare bid documentsfor procurementof necessaryequipment and materials for implementationof this program which would include installationof insulatingjoints, rectifiers, anodes, etc. - 87 - Annex 4.1 Page 6

c) Reviewthe proposed quantityand specificationsfor emergencypipes, prepare bid documents and assist Azerigaz in procurement

Gas Quality Analysis Facilities and Network Modeling

a) Reviewthe list of analytical equipmentproposed for financingunder the project. Finalize technicalspecifications and bidding documents,and assist Azerigaz in initiating procurementof these items.

b) Prepare necessary design for establishmentof the gas quality control facilities.

c) Assist in the design and supervise the fitting-up of the premises that will host the analytical equipmentas well as the installation and commissioningof the gas quality equipment which would includepressure gauge calibration,gas choromatograph,hydrogen sulphide analyzer, sulphur /mercaptan analyzer,water dew point analyzer,hydrocarbon dew point analyzer,analyzer calibration device, and computerfor sorting and reportingdata.

d) Reviewthe list of computerhardware and software proposedto establish an appropriate networkmodeling capability withinAzerigaz. Finalize technical specificationsand bidding documents,and assist Azerigaz in initiatingprocurement of these items.

Office Equipment and Training

a) Assist Azerigaz in finalizingthe most efficient mix and functional allocationof office and communicationsequipment (excluding that which is to be used by the PIU), within the overall objectiveof strengtheningthe general commercialmanagement and planning capabilitiesof the organization.

b) Define an appropriatetraining program(s) for senior and middle managementof the company,with a view to enhancingtheir ability to operate the companyin a commerciallyviable manner. Assist in contractingwith suitable agenciesfor the provision of this training.

General

a) Adviseon the existing rights-of-way,easements and land purchases (if any) as requiredby the project schedule.

b) Assist in the preparation of an environmentalimpact statement and environmentalmitigation plan, as may be required by the local authoritiesand by the guidelinesof the World Bank for projects of this nature.

Project Management

13. The Consultant will review all existing studies,data, design and will acquirethe additionaldata necessary for the executionof his assignment.Of special importancewould be full familiarizationwith the World Bank Staff Appraisal Report particularly with the chapters dealing with project scope, cost and procurement.He will further define the project and establish the criteria for its design and construction.He will assist Azerigaz to prepare the Project Master Plan (criticalpath method, CPM) and a project cost estimate, which should be based on sufficientengineering to be conductedby the consultant. All of these should be continuouslyupdated during the project implementation. The Consultant will assist PIU to establish a modem project managementsystem in order to optimize costs, manpowerand scheduling. - 88 - Annex4.1 Page7

14. The Consultantwill assistAzerigaz to establishan efficientproject organization covering the activitiesenvisaged for projectcomponents. The Consultantmay rendersuch managementfunctions that maybe mutuallyagreed upon, namely act at all timesand in all situationsto the best interestof the client. Generallyhe will:

a) Providethe necessaryprogress reports, budgetary monitoring and establishingcontrol and informationsystems to keepthe Managerand the teammembers adequately informed on progress, problemsand development;

b) Assist Azerigazin establishingfinancial accounts, documentation and financialcontrol proceduresfor the proposedproject in accordancewith internationalaccounting standards and best practices;

c) AssistAzerigaz in meetingthe financialreporting requirements associated with the implementationof Bankprojects, including periodic reports of actualand estimatedexpenditures, and annualfinancial statements for the project. Assist in the engagementof qualifiedindependent auditorsto carry out an annualreview of the projectaccounts, statements of expenditureand Special Account;

d) Establishcommunication procedures and systemsas well as providinginformation systems eg. computersthat are necessaryfor the functioningof the PIU and maintenanceof liaisonbetween the clientand otherconcerned parties;

e) Adviseon insurancecoverage, advise on timelycompliance with government and local regulatorylaws and licensingrequirements;

f) Assist Azerigazin establishingan efficientworking procedure for its PIU,provide on the job trainingfor its staff andimprove its organizationalstructure.

EngineeringDesign

15. The Consultantwill prepare/enhance the basic engineering,lists of materialsand additional engineeringas may be requiredfor the preparationof tenderdocuments and investmentcost estimates. He will be responsiblefor the timelypreparation and all necessaryadvice for successfulimplementation of all engineeringdesign of the project.The engineeringdesign will includenecessary measures for the successful constructionand commissioningof the project. Thesewill include:

a) Preliminaryactivities such as data acquisitionand systemevaluation.

b) Preparationof the list of materialsand equipment,including their specificationsin ac- cordancewith pertinentintenational/domestic codes and standards.

c) Preparationof the technicalspecification to be incorporatedin the tenderdocunents for procurementof materialsand services.

d) Detailedcost estimatesand expenditureschedules.

e) Construction,commissioning and start-up. - 89 - Annex4.1 Page8

Procurement

16. The Consultantwill assistAzerigaz in all phasesof procurementin accordancewith the WorldBank ProcurementGuidelines and the localprocurement rules andregulations, depending on the sourcesof funding for each procurementpackage. This will include:

a) Assistancein finalizingthe quantities,technical specifications, the most suitable procurementmethods, includingpackaging and phasing,potential suppliers (both local and abroad), and estimatedcosts at currentmarket prices of materialsand equipmentrequirements of the GSRP; and preparea procurementschedule including bid documentpreparation, bid evaluation, contract award,and receipt and commissioning;

b) Reviewof Azerigaz'procurement practices, including the role of localend users and nationalsupervising authorities in variousphases of procurementand their effectson the speedof procurement;and estimate the averageduration of variousstages of procurement;

c) Trainingof Azerigaz'staff whowill be involvedin projectprocurement in international commercialpractices as appliedin the naturalgas industryand the World Bankprocurement guidelinesand assistthem in bid collectionand evaluation.

ConstructionSupervision

17. The Consultantin conjunctionwith the PIUwill be responsiblefor the supervisionof all construction activitiesand field services.His responsibilitieswill include:

a) Adviceon establishmentof the necessaryorganization and physicalfacilities to enablethe propersupervision of the projectimplementation.

b) Superviseand co-ordinateall work progressby the client,suppliers/contractors and other concernedagencies with referenceto the criticalpath, so as to notify/advise/warnthe respective bodiesin case of delays/impendingdelays.

c) Establishingand performingall requiredinspection, testing and other qualitycontrol pro- ceduresand measures.

d) Maintainingthe necessaryrecords, progress reports and other managementinformation system.

e) Maintaining"as built" records,contractual variations and changeorders and negotiating settlementsfor changes.

f) Assist in reviewingand certifying invoices.

g) Assistin the preparationof the tender documents,and evaluationof tendersfor specific activitiesassociated with construction/installation.

Commissioning

18. The Consultantwill assistin supervisingthe commissioningof the new facilitiesfor the first three months(or any suchother periodthat the clientmight wish to negotiateat a laterdate withthe contractors)of operations.This responsibilitywill include: - 90 - Annex 4.1 Page 9

a) Ensure the preparation and assembly of all necessary operating and maintenanceprocedures and instructions, including preparation of operating manuals for the modernized installations.

b) Organize a specialized team to start-up the facilities with the full participation of Azerigaz's operating staff

c) Designate and organize the operating and maintenanceteam to assist Azerigaz's staff in operating the new facilities, for the first three months.

d) Provide on-the-job training and familiarize Azerigaz's staff with the operating manuals.

TIMING

19. The Consultant's proposal must be received within 45 days from the bid issuance date. The time assigned for this plus bid evaluation, contract negotiation and consultant mobilization is estimated at about 3 months, followedby project implementationto take place over the period of 1997 - 2000.

ASSISTANCE TO BE PROVIDED BY AZERIGAZ

20. Azerigaz, through the PIU Manager, will provide the following services to the Consultant:

a) Suitable office space within the Azerigaz premises, sufficient to accommodateboth the consultant team, the PIU staff, support staff and project files and equipment.

b) The services of qualified staff to carrv out the envisioned work program under the general guidance of the Consultant.

c) Administrative assistance in obtaining visa, custom clearances and any other administrative permits required by the Consultant in the performance of his assignment.

d) Existing data, maps, surveys and studies.

e) Liaison with governmental and local bodies.

f) Any other assistance not readily available which the consultant may reasonably request.

REPORTING

21. The Consultant will report to Azerigaz, who has assigned the PIU and its manager to supervise the activities of the consultant. At the same time, the PIU and its manager will facilitate the performance of the Consultant's assignment. A coordinating committee will be established by Azerigaz. The representatives of other Azerbaijan agencies, such as Azeri State Standard, SOCAR or the World Bank would be invited to join this committee whenever required. The committee would meet on a regular basis and/or as to be invited by PIU.

22. The Consultant will closely cooperate with Azerigaz's representatives in charge of the PIU, who will render the necessary assistance to the Consultant in carrying out his assignment. The Consultant will provide the PIU with all the necessary advice, including but not necessarily limited to the items in this TOR, for a suc- cessful implementationof the project. It is understood that the PIU Manager will give/receive and the Consultant will promptly provide all such advice in time; and also, in order to enable the Consultant to be - 91 - Annex4. 1 Page 10 heldresponsible for the assignment,the Managerwill normallyact upon the adviceon time.Generally, the Consultantwill keep the Managercontinuously informed upon progressof the work,particularly with refer- enceto problemsthat couldcause delays or technicaland financialdifficulties.

23. The Consultantis requiredto submitto PIU Managerthe followingreports in 10 copiesboth in Russianand English:

a) Monthlyreport by the I 0th of each month,summarizing the activitiesof the previousmonth, cost vs budget,any issues andrecommendations; two copiesof this report willbe directlysent to the World Bankfor reviewand comments.

b) Design,specifications and costestimates for the meteringand regulatingstations.

c) Diagnosticreport following the cathodicprotection assessment, implementation of the pilot projectas wellas cost estimateand implementationprogram for pipelinesystem upgrade.

d) Design,specifications and cost estimatefor the qualitycontrol laboratory including the equipment.

e) Proposedtraining program and operationand maintenance manuals.

f) Commissioningreports.

g) The final report summarizingthe projectdesign, final cost,reference list of all drawingsand any lessonsto be learnedfrom the projectimplementation. Azerbaijan Republic Gas System Rehabiltaton Project Project Implemntaton Schedule

1996 1997 1998 1999 2000 CQtrlOQlr2 Otr3. OQb4Ctrl I0tr2 Qtr3 OQtr4Otrl OQlr2IQtr3 tr4 t1 1Otr2 IQtr3 rQtr41Qr IIQtr2 Qtr3

______i6i| 1 _t~tr& __ ~& ______

______Boen Presentation ___ CreditEfiectiveness

- bAsants(PES Consubet) _ _ Propof InvitationPackage (TOR, LOI. etc.) = - |-

______Bid lsmg ProposalsReceived and Evaluated __ __ = ______BankReview Contac Negotation __ - ______Consultant in Piae" Procd,Enging. Mangrnt & Supem. _ - Customwand CGS Su rvey

Cky|G_____or_ |Survey andGas Sales Contract Amnmends. __ _ _ =__- - _

r______|Design andSpecificatons and procurement = - - - = t -_= FirstCGS Padcage Received_L Instaitation - -- Seond CGSPackag Recemivd Instaflation------rInduarlall MewrSeft _=___ =______IDesign andS andProcurerent _ _ _ _ I _ -

______ge I Received LPadu ______P c ______Packag 2 Received__

______Package3 Received LPadwge4 Received lnsftNation Catodic Protection

Survey Impiemntation Training RohabWlteton ,Survey ______I Procuremnent Ilnstmabton

Annex 4.2 Pagc I - 93 - \\;ii4 | XI I 12~i

,~~~~~~~i111LI i iil111 i - : i( IH , 1ix Annex 4.3 Page 1

AZERBAIJAN GAS SYSTEM REHABILITITATIONPROJECT PROCUREMENT PLAN AND SCHEDULE

Description of Project Elements Total Foreign Financing Procure. No. of Bid Timetable Completion Costs* Costs* Source Method Packages Issue Contract Date l______A w ard CGS Meter Instrumentation 2.90 2.44 IDA ICBa/ 2 Oct. 96 Mar. 97 Jun. 99 Industrial/ConunercialMeters 10.24 9.01 IDA ICB 4 Jul. 97 Dec. 97 Jun. 00 Isolating Joints 3.38 2.62 IDA ICB 2 Feb. 97 Apr. 97 Dec. 99 CP Stations 0.50 0.39 IDA ICB I Dec. 97 May 98 Dec. 99 Steel Pipes 1.20 0.93 IDA ICB 1 Nov. 97 Apr. 98 Dec. 99 Leak Detection Equipment 0.66 0.50 IDA LIBa/ I Oct. 96 Feb. 97 Jun. 97 Gas Quality Equipment 0.36 0.27 IDA LIB I Jan. 98 Jun. 98 Jun. 99 Network Modeling 0.49 0.38 IDA LIB I Sept. 97 Jan. 98 Jun. 98 Meter Proving Equipment 0.60 0.42 IDA LIB I Jan. 98 May 98 Dec. 98 Meter Installation Equipment 0.20 0.20 IDA LIB I Oct. 96 Feb. 97 Jun. 97 PEMS 2.87 2.02 IDA SL'/ I June 96 Sept. 96 Jun. 00 Corporatization Support 0.57 0.49 IDA SL I Jun. 97 Nov. 99 Dec. 98 Office Equipment 0.31 0.31 IDA isa/ I Jan. 97 May 97 Jul. 97 Training 0.29 0.25. IDA SL I Feb. 97 Jun. 97 Dec. 99 Totals 24.57 20.21 19 * (US$ million),Costs includecontingencies a/ InternationalCompetitive Bidding (ICB), LimitedInternational Bidding (LIB), and InternationalShopping (IS) under IDA financingto take placein accordance with the WorldBank Guidelines (January 1995, and revisedJanuary 1996). b/ Procurementof consultantsunder short-listingprocedures in accordancewith the WorldBank Guidelines for the use of consultants(August 1981). - 95 -

Annex 4.4 Page 1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT DEVELOPMENT INDICATORS

MonitorableTargets 1997 1998 1999 2000 MeteringInstaled (cumulative) - City Gate Meters 20 100 200 214 - Industrial Meters 100 600 1200 1355 Cathodic Protection (percent) - Pilot program 100 - Main system(percent rehabilitated) 10 15 25 35 LeakDetection (percent) 80 100 Network Modelling(percent) 80 100 Gas Analysis(percent) 80 100 New Computers Installed (cumulative) 30 50 50 50 Technical and Non-TechnicalLosses 15 12.5 10 8.5 (percentof purchases) CollectionsRate (percentof invoicevalue of 75 90 90 90 shipments) Energy EfficiencyImprovements

- Industrial Gas Consumption/Industrial . -2% -3.5% -5% Output(MCM/$1,000)

- Total Gas Consumption/GDP -1% -2% -4% (MCM/$1,000) - 96 - Annex4.5 Page 1

AZERBAUIANGAS SYSTEM REHABILITATION PROJECT PROPOSED SUPERVISION PROGRAM

Approximate Activities ExpectedSkills Manweeks

Dates R qired ______August 1996 Project Launch - RecruitConsultants Task Manager 2 - Preparetender documents Gas Engineer 2 - Reviewcustomer survey FinancialAnalyst 2 - Review1996 Financial budgets Procurement 2 December1996 Bid DocumentReview - ReviewBid Documents Task Manager 2 - ReviewTest Equipment Gas Engineering 2 - ReviewMetering FinancialAnalysis 2 - ReviewFinancial Procedures Procurement 2 April 1997 Bid Evaluation - ReviewBid Documents Task Manager 2 - ReviewTest Equipment Gas Engineering 2 - ReviewMetering FinancialAnalysis 2 - ReviewFinancial Statements Procurement 2 July 1997 Year 1 Review - ReviewBid Evaluations Task Manager 2 - ReviewImplementation Logistics Gas Engineering 2 - ReviewMetering & CP FinancialAnalysis 2 - ReviewFinancial Statements & AuditReport Procurement 2 October1997 Bid DocumentReview - ReviewBid Documents Task Manager 2 - ReviewCathodic Protection Gas Engineering 2

- ReviewMetering FinancialAnalysis 2

- Reviw EinanialStatmentsq Prourement 2 - 97 - Annex 4.5 Page 2

CY98 - 00 l March - Review Bid Evaluations Task Manager 2 - Review Implementation Logistics Gas Engineering 2 - Review Financial Statements Financial Analysis 2 Procurement 2 October - Review Bid Evaluations Task Manager 2 - Review Implementation Logistics Gas Engineering 2 - Review Financial Statements Financial Analysis 2

l______.______2Procurement - 98 - Annex 5.1 Page I

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT FINANCIAL RATES OF RETURN

Assumptions

1. Financialinternal rates of return were calculatedfor the project as a whole and for each of the investmentcomponents. Capitalcosts and investmentcash flows were based on the total cost estimateand implementationschedule discussed in Annexes3.1 and 4.2, excludingphysical and price contingencies.For purposesof the analysis,investments in cathodicprotection and testing equipmentwere combinedunder the headingof "asset preservation".

2. Assumptionsregarding the impactsof each of the project components(including both incrementalcosts and benefits)are summarizedin Table 1. Savingsin gas losseswere valued at the price of gas importsfrom Turkmenistan,on the premisethat imports representthe marginal source of supply. In the absenceof a long-termtake-or-pay purchase contract with Turkmenistan,Azerbaijan should be able to limit importson a year-roundbasis. Even if domestic gas supplyexceeds demand during the summerperiod, surpluscan be injectedinto storageto reduce the need for winter imports. Costs associatedwith lost marginsas a result of customer responsesto more accuratemetering (and hencehigher gas bills)were valued at the margin betweenthe current sellingprice and the cost of importedgas. In the case of industrialmetering, the lost marginswere based on industrialtariffs. For city gate instrumentation,where the conservationimpact will be spread over a broader range of customerclasses, the difference betweenthe weightedaverage selling price and the cost of importswas used to value lost margins. In this instance,however, because residential and communalprices are both below the import cost, the weightedaverage marginsare negative.

3. All impactswere measuredover a 20 year life, from 2001 whenthe project is fully implementedthrough 2020. Both FIRR's and NPV's were calculated,the latter based on a financialopportunity cost of capital of 12 percent. The opportunitycost used is equivalentto the current short term, foreigncurrency lending rate. Becausethe capitalmarkets in Azerbaijanare shallowand poorly developed,longer term moneyis not available. Incometaxes of 35 percent were appliedto net incrementalincome.

Summary of Findings

4. Tables3 through 7 show the detailedcash flow statementsand results for the base case analysis. The results are summarizedin Table2. - 99 - Annex 5.1 Page 2

Table I Financial Impacts - Summary of Assumptions

Component Impact Extent of Impact Unit Value

Asset Preservation Reduced pipe replacement needs Annual replacement needs for $273,000/km on protected sections 2,600 km section decline from 5% to 2.5% over 15 years

Savings in electricity costs 20% saving on 300 MW of $0.04/kWh capacity

Reduced leakage Losses drop from 5% to 4% on $43.00/MCM throughput of 2 BCM/yr

Incremental O&M costs $1 00,000/yr

New Industrial Meters Reduced non-technical losses Losses decline from 10% to 0% $43.00/MCM on throughput of 424 million m3/yr

Reduced margins due to Conservation impact equivalent $10.33/MCM conservation effects to 15% of current consumption

Incremental O&M costs 3% of capital cost

Replacement Industrial Reduced non-technical losses Losses decline from 8% to 0% on $43.00/MCM Meters throughput of 1,302 million m3/yr

Reduced margins due to Conservation impact equivalent $10.33/MCM conservation impacts to 3% of current consumption

City-Gate Reduced non-technical losses Losses decline from 10% to 8% $43/MCM Instrumentation on throughput of 6 BCM/yr

Reduced margins due to Conservation impact equivalent ($19.84)/MCM l______conservation impacts to 1.5%of current consumption _ - 100 - Annex5.1 Page 3

Table 2 Summary of Financial Returns

Component FIRR NPV @ 12% l ______(Sm illions) Asset Preservation 46.3% $32.8 New IndustrialMeters 33.6% $3.2 ReplacementIndustrial Meters 70.9% $13.5 City-GateInstrumentation 108.9% $14.8 Total Project 51.6% $62.9 TO 3

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Lung d P AbddA 2,O60 be ULMVja dAinh S 273,000 p.r bn AmL4 Pk. Rapadamwi W I Wh - udprod 5.0%per yw 3.0% in5 y 2.5% in15 ya Erimby C _mayO- S 315.30D 0 S 0.04 per kW%i Elmhity Sa-i s S 63.072 20% a ma"ofOM i S 100,ODWper yw hku9wvbs 1966 LOA LO"" 5.0% VMtoLi 4.0% WiMh Tow T lU~ 2,000 mUn m3 S 43.00 per MCM hame Tax Rob 35% lPrent V_ @a12% 532.8 FRR 46.3%

harnatd Rapicn-r Repitni' R _pmorw Net Savig Ebdridiy Lgd Losa Incramn(W NetCah F- CUa tSS OUA No Poed WYhPret WWhPet in R _piwnertSavkgs Re&xUbn ha Flow Yew (S miow) (S mi-) (S mm-) (yr) (S mrias) (S mria) (Smniibn) (Smrians) Tax (S mUom) H

1966 - (35.5) 5.0% (35.5) - 1997 (2.2) (35.5) 50% (35.5) - - 0.1 (2.2) 1998 (1.9) - (35.5) 5.0% (35.5) - - 0.2 (1.7) 1999 (1.4) (355) 5q0% (35.5) - - 0.2 (1.2) 2000 (0.7) (35.5) 5.0% (35.5) - - 0.2 (0.5) 2001 (0.1) (35.5) 4.6% (32.7) 2.8 0.06 0.9 (1.0) 2.6 2002 (0.1) (35.5) 4.2% (29.8) 5.7 0.06 0.9 (2.0) 4.5 20D3 (0.1) (35.5) 3.8% (27.0) 8.5 0.08 0.9 (3.0) 6.3 2004 (0.1) (35.5) 34% (24.1) 11.4 0.06 0.9 (4.0) 8.2 2005 (0.1) (355) 3.0% (21.3) 14.2 0.06 0.9 (5.0) 10.0 2006 (0.1) (35.5) 3.0% (20.9) 14.6 0.06 0.9 (5.1) 10.2 2007 (0.1) (35.5) 2.9% (20.6) 14.9 0.06 0.9 (5.3) 10.5 2006 (0.1) (35.5) 29% (20.2) 15.3 0.06 0.9 (5.4) 10.7 2009 (0.1) (35.5) 2.8% (19.9) 15.6 0.06 0.9 (5.5) 10.9 2010 (0.1) (35.6) 2.8% (19.5) 16.0 0.06 0.9 (5.6) 11.2 2011 (0.1) (35.5) 2.7% (19.2) 16.3 0.06 0.9 (5.8) 11.4 2012 (0.1) (35.5) 2.7% (18.8) 16.7 0.06 0.9 (5.9) 11.6 2013 (0.1) (35.5) 2.6% (16.5) 17.0 0.06 0.9 (6.0) 11.8 2014 (0.1) (35.5) 2.6% (18.1) 17.4 0.05 0.9 (6.1) 12.1 2015 (0.1) (35.5) 2.5% (17.7) 17.7 0.08 0.9 (6.3) 12.3 2016 (0.1) (35.5) 2.5% (17.7) 17.7 0.06 0.9 (6.3) 12.3 2017 (0.1) (35.5) 2.5% (17.7) 17.7 0.06 0.9 (6.3) 12.3 2018 (0.1) (35.5) 2.5% (17.7) 17.7 0.06 0.9 (6.3) 12.3 2019 (0.1) (35.5) 2.5% (17.7) 17.7 0.06 0.9 (6.3) 12.3 CD tA 2t0 (0.1) (35.5) 2.5% (17.7) 17.7 0.06 0.9 (6.3) 12.3 -. _ - 102 - Annex 5.1 Page 5

-'rooecoooooo------.

C-

^- W- . . . -. -. . . . - . -. -. -. -. -. .-. .-

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jIi I - ,;NNNN e0 NN' N N~ NN N Na

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b bW - Nh m

C_ad Cad - 4. OUSS CAm Cad PmU Yw 0.0% Yw 2 1.1% Y_ S 362% Yw 4 31-.3 Yew 5 23% 1CO.O%

C0sTadAInd Sdm mUon m3 1,302 Non-TedmiadLu_ pI 80% 0.0% C_ wIm ki paS p 0.0% .0% Cs odPdma $ 4300 per MCM V&ddaS S 5333 pw MCM TaMu i S 10.33 peMCH kown Tm Rd. 35%

NoPr..uiVdm@12% S13S FMRR 70.9%

Cqpd ULktUdU.. Sd. MOW Uribad Us Sd.. Mwgk Net Change NdtChngs kwnentl Irncmwesntl Nd Cah Cost No Pric. No Psd No P.d wm Pi@d vW P Yth Pr.d j d Use hi Mmhi 01 him.m Fbw O Yew t(*dU-) (rlons) (8dl's) (SmEr.) (Smllion) (bulions) (Smi) (Smir.) (SmE-) (Smillns) Tax (mEns)

1906 - (4.5) 69.4 134 (4.5) 69.4 13.4 0.0 - 1997 (0.1) (4.3) 66.6 12.9 (4.3) 66.6 12.9 0.0 - - 0.0 (0.1) 19S8 (1.9) (4.1) 63.9 12.4 (4.1) 63.9 12.4 0.0 0.0 - 0.1 (1.8) 1990 (1.5) (4.0) 61.3 11.9 (2.4) 63.2 12.2 1.6 0.4 - (0.6) (0.1) 2000 (1.4) (4.0) 61.9 12.0 (1.1) 64.6 12.5 2.9 0.5 - (1.0) 1.0 2001 (4.0) 62.5 12.1 - 66.0 12.8 4.0 0.7 - (1.5) 3.3 2002 (4.1) 63.1 12.2 - 66.2 12.8 4.1 0.6 - (1.4) 3.2 2003 (4.1) 63.8 12.4 - 66.8 12.9 4.1 0.6 - (1.5) 3.2 2004 (4.2) 64.4 12.5 - 67.5 13.1 4.2 0.6 - (1.5) 3.3 2005 (4.2) 65.0 12.6 - 68.1 13.2 4.2 0.6 - (1.5) 3.3 2006 (4.2) 65.7 127 - 66.8 13.3 4.2 0.6 - (1.5) 3.3 2007 (4.3) 66.3 12.9 69.5 13.5 4.3 0.6 (1.5) 3.4 2008 (4.3) 67.0 13.0 - 70.2 13.6 4.3 0.6 - (1.5) 3.4 2009 (4.4) 67.7 13.1 - 70.9 13.7 4.4 0.6 - (1.6) 3.4 2010 (4.4) 88.4 13.2 - 71.6 13.9 4.4 0.6 - (1.6) 3.5 2011 (4.5) 69.0 13.4 - 72.3 14.0 4.5 0.6 - (1.6) 3.5 2012 (4.5) 69.7 13.5 - 73.1 14.2 4.5 0.6 - (1.6) 3.5 2013 (4.5) 70.4 13.6 73.8 14.3 4.5 0.6 - (1.6) 3.6 2014 (4.6) 71.2 13.8 - 74.5 14.4 4.6 0.7 - (1.7) 3.6 2015 (4.6) 71.9 13.9 (0.0) 75.3 14.6 4.6 0.7 - (1.7) 3.6 2016 (4.7) 72.6 14.1 (0.0) 76.1 14.7 4.7 0.7 - (1.7) 3.7 2017 (4.7) 73.3 14.2 - 76.8 14.9 4.7 0.7 - (1.7) 3.7 A 2018 (4.8) 74.1 14.3 0.0 77.6 15.0 4.8 0.7 - (1.7) 3.7 CD 2019 (4.8) 74.8 14.5 - 78.4 15.2 4.8 0.7 (1 7) 3.8 (D qjk 2020 (4.9) 75.6 14.6 - 79.2 15.3 4.9 0.7 - (1.8) 3.8 - Tames -D(jb -1 - .

CI Cad. - 23 _r USn C auo Cod Pmcg YewlI .0% Yw 2 35.2% Yw 3 318% Y_ 4 31.0S Y_S QOS% 10D0%

Cuffct Amun SimM mom MiS 6.071 Ion-TcIuc l_. p$ 10% I0% C _ harvilan I 0% 1.5% COi d Purtt_ S 4300 pWMCM VmndSn S 2.16 prMCM Teim _ S (19.84) pw MCMA av. Tm. 1m 35%

NiPnmwVim.12% 814.8

C Ubi*Ud W. Si lmjs9 r b Use SW" Mwgn' Not Chwp Not Chang howm tu ol,mm l4i Not C_h Cowi No P. No Pp*d No Po*d WM Praje V Pi WM Prajad UL*bd U_ in Mhrgi OWA 1nm Fb1w Yew ($mSm) (Oi) (Mar) (SmE ) (b.61mw) (S.61mm) (SmE (m ) (SmVi-) (SmWhocn) Tax (milc) O

199I (28.1) 140.6 (120.4) (26.1) 140.6 (120.4) 0.0 - 1997 (0.8) (25.8) 138.9 (1189) (25.8) 138.9 (118.9) 0.0 - - 0.0 (0.8) 1998 (0.8) (25.5) 137.2 (117.5) (23.7) 138.2 (11.3) 1.8 (0.8) - (0.3) (0.1) 1999 (0.7) (25.5) 137.6 (117.9) (22.0) 138.8 (1188) 3.5 (1.0) (0.8) 1.0 2000 - (25.6) 138.0 (118.2) (20.5) 139.3 (119.3) 5.1 (1.1) (1.3) 2.7 2001 (25.7) 138.4 (1185) (20.6) 139.0 (119.1) 5.1 (0.6) - (1.5) 3.1 2002 (25.8) 138.8 (11&9) (20.6) 1395 (119.4) 5.2 (0.6) (1.5) 3.1 2003 (25.8) 139.2 (119.2) (20.7) 139.9 (119.8) 5.2 (0.6) - (1.5) 3.1 2004 (25.9) 139.6 (119.6) (20.7) 140.3 (120.1) 5.2 (0.6) - (1.5) 3.1 2005 (230) 140.0 (119.9) (20.8) 140.7 (120.5) 5.2 (0.6) - (1.5) 3.1 2X6 (26.1) 140.4 (120.3) (20.9) 141.1 (120.9) 5.2 (0.6) - (1.5) 3.1 2C07 (262) 140.9 (120.7) (20.9) 141.5 (121.2) 5.2 (0.6) (1.5) 3.1 2008 (26.2) 141.3 (121.0) (21.0) 14ZO (121.6) 5.2 (0.6) (1.5) 3.1 20DO (26.3) 141.7 (121.4) (21.0) 142.4 (122.0) 5.3 (0.6) - (1.6) 3.1 2010 (28.4) 142.2 (121.8) (21.1) 142.8 (122.3) 5.3 (0.6) - (1.6) 3.1 2D11 (27) 143.6 (123.0) (21.3) 144.3 (123.6) 5.3 (0.6) - (1.6) 3.2 2012 (28.9) 146.0 (124.2) (21.5) 145.7 (124.8) 5.4 (0.6) - (1.6) 3.2 2013 (27.2) 146.5 (125.5) (21.8) 147.2 (128.1) 5.4 (0.6) (1.6) 3.2 2014 (27.5) 148.0 (126.7) (22.0) 148.7 (127.3) 5.5 (0.6) - (1.6) 3.3 2015 (27.8) 149.5 (128.0) (22.2) 150.2 (128.6) 5.6 (0.6) (1.6) 3.3 2016 (28.0) 151.0 (129.3) (22.4) 151.7 (129.9) 5.6 (0.6) - (1.7) 3.3 2017 (28.3) 152.5 (130.6) (22.7) 153.2 (131.2) 5.7 (0.6) - (1.7) 3.4 2018 (28.6) 154.0 (131.9) (22.7) 154.8 (132.6) 5.7 (0.6) - (1.7) 3.4 2019 (28.9) 155.6 (133.3) (23.1) 156.3 (133.9) 5.8 (06) - (1 7) 3.4 ( 2020 (29.2) 157.2 (134.6) (23.3) 157.9 (135.2) 58 (0.6) (1.7) 3.5 Table 7

AzerlgasInvestnent Program Summaryof FinancialRetuns

Net Prsent Vaka @12% $62.9 miHions FRR 51.6%

CapitalCost Net Benefits Asset New Replacernent City Gate Impementation Asset New Replacement City Gate Net Preservation Meters Meters Instrumentation Assistance Preservabon Meters Meters Instrumentabtion Cash Year ($millions) (Smillbns) ($millions) (Smillions) (Smillions) ($mnillions) (Smillions) (Smillions) (Smillions) Flow

1996 - - (02) - - - (0.2) 1997 (2.2) (0.1) (0.1) (0.8) (0.7) 0.1 0.0 0.0 0.0 (3.8) 1998 (1.9) (1.6) (1.9) (0.8) (0.6) 0.2 0.1 0.1 0.7 (5.7) 1999 (1.4) (1.5) (1.5) (0.7) (0.3) 0.2 0.7 1.4 1.7 (1.3) 2000 (0.7) (0.1) (1.4) - (0.3) 0.2 1.1 2.4 2.7 4.0 o 2001 - - - - 2.6 1.0 3.3 3.1 9.9 Ln 2002 - - - - - 4.5 0.9 3.2 3.1 11.7 2003 - - - - - 6.3 1.0 3.2 3.1 13.6 2004 - - - - - 8.2 1.0 3.3 3.1 15.5 2005 - - - - - 10.0 1.0 3.3 3.1 17.4 2006 - - - - - 10.2 1.0 3.3 3.1 17.7 2007 - - - - - 10.5 1.0 3.4 3.1 17.9 2008 - - - - - 10.7 1.0 3.4 3.1 18.2 2009 - - - - - 10.9 1.0 3.4 3.1 18.5 2010 - - - - - 11.2 1.0 3.5 3.1 18.8 2011 - - - - - 11.4 1.0 3.5 3.2 19.1 2012 - - - - - 11.6 1.0 3.5 3.2 19.4 2013 - - - - - 11.8 1.1 3.6 3.2 19.7 2014 - - - - - 12.1 1.1 3.6 3.3 20.0 2015 - - - - - 12.3 1.1 3.6 3.3 20.3 2016 - - - - - 12.3 1.1 3.7 3.3 20.4 2017 - - - - - 12.3 1.1 3.7 3.4 20.5 2018 - - - - - 12.3 1.1 3.7 3.4 20.5 '. 2019 - - 12.3 1.1 3.8 3.4 20.6 (t X 2020 - 1-2.3 1.1 3.8 3.5 20.7 a ____ cee-~~~~~~~~~~~~~~~~~~~~~~~~II - 106 - Annex 5.2 Page 1

AZERBAIJANGAS SYSTEMREHABILITATION PROJECT PRO FORMAFINANCIAL PROJECTIONS

1. The followingtables present pro forma financial statementsfor Azerigaz for the years 1995 through 2003. The projections assumethat the project is implementedin accordance with the cost estimategiven in Chapter 3 and the scheduleoutlined in Chapter 4. The projectionsalso assume that Azerigaz will undertakenon-project related capital investments including: (a) acquisitionof new compressors from the Ukraine ($3 million in each of 1996 and 1997); (b) purchase of additional residentialmeters from China (approximately$5 million per year from 1996 through 1999); and (c) continuedreplacement of older pipes throughout the system(approximately $35 million per year).

2. The projections also assumethat Azerigaz will earn a positive margin averaging $4.00/MCM on its gas sales, beginning in 1996, and will maintainthat margin in real terms thereafter. However, while this will provide sufficientfunds to finance the project-related investments,it is not sufficientto allow for the full capital investmentprogram described above. In order to meet these investmentplans, Azerigaz will have to charge higher margins in the future and/or improvethe efficiencyof its operations. Hence, Azerigaz will be required, under the credit agreement, to prepare an annual businessplan satisfactoryto the Bank which demonstrateshow they propose to meet their financial obligationsfor the coming year. In addition, Azerigaz would be required to obtain prior clearance from the Bank before undertakingcapital investmentswhich are not related to the project. Azergas 30)A4f96 10:32 Financial Projections - Bass Scenario - 4 Margin fhfmzn Average Mspn of 54-OMCM)

Caleder Year 1995 1996 1997 1998 1999 2000 2001 2002 2003

EconaoidFicmnancl Aasunptlons: ht11W(onSMU(nid1993=100) 110.2 113.8 116.5 1194 122.4 125.4 1286 131.6 134.4 etunmIaulktkIa-lthUS 69% 3.3% 2.3% 2.5% 2.5% 2.5% 2.5% 2.4% 21% AmiCPI(mid 1993=100) 11973.5 14716.3 16582.8 18685.9 21055.7 23726.1 26735.1 30125.8 33946.5 Azeraijan hileni 598.7% 22.9% 12.7% 12.7% 12.7% 12.7% 12.7% 12.7% 12.7% Nan Exchrg Rte- avge 4,271 3,770 3,770 3.770 3,770 3.770 3,770 3,770 3,770 Nam Erlne Rate- yen erdt 4,021 3,770 3,770 3,770 3,770 3,770 3.770 3.770 3,770 PPPExuew Rale - ap - - - - - PPPErlenge Rade- ye end ------

Gas Balance Sales- Mm m3 - Base - hflflhdsir 1,911 1,833 1,758 1,686 1,703 1,720 1,737 1,754 1,772 - Resla sec 2,686 2,686 2,686 2,686 2,686 2,686 2,686 2,686 2,686 -CaurmaliSecter 1,552 1,552 1,552 1,552 1,552 1,552 1,552 1,552 1,552 Losses- Base - Tedc a 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% - NornTedwici -hkLalsed|> 10% 10% 10% 10% 10% 10% 10% 10% 10% - Resrdh seOr 10% 9.5% 90% 8.5% 8.0% 8% 8% 8% 8% -Con-M SSastr 10% 10% 10% 10% 10% 10% 10% 10% 10% Szbs - dimnam3-fl Prect - h lm.sdc1r 1,911 1,833 1,758 1,690 1,785 1,740 1,634 1,640 1,657 1 -Reslsk erscar Z686 2,686 2,686 Z686 2,686 2,686 2,686 2,686 2.686 -Cana-Secr 1,552 1,552 1,552 1,552 1,552 1,552 1,552 1.552 1,552 1 h zat dCnserabori 0.0% 0.0% 0.0% 0.3% 8% 14% 15% 15% ° Losses - Wb Pr* - - Tednd 5.0% 5.0% 5.0% 50% 5.0% 5.0% 5.0% 5.0% 5 0% - Non-Teahcal - hMdl sear 10% 10.0% 10.0% 9.8% 4.8% 0% 0% 0% 0% - ResarA sei 10% 9.5% 9.0% 8.5% 8.0% 8% 8% 8% 8% -Conma Sectr 10% 10% 10% 10% 10% 10% 10% 10% 10% Cos Pwhs - n- ar rn3 -us disecr 2,248 2,156 2.068 1,983 1,980 1,838 1,720 1,727 1,744 -ResideSSseocr 3,160 3,142 3,123 3,105 3,087 3,087 3,087 3,087 3,087 -Crna lSer 1.826 1.826 1,826 1,826 1,826 1,826 1,826 1,826 1.826 Doi.e Pzusa - iCon m3 5,600 4,40D 3,700 3,500 3,200 3.200 3,520 3,872 4,259 hI flletdoGs- nranm3 594 Z724 3,317 3,414 3,693 3,552 3,113 2.768 2,398 Price 1,634 Purdme Price per MCM Danesic Gas 3.5 10.8 11.0 11.3 11.6 11.9 12.2 12.5 12.8 hqbdGas 430 44.4 45.4 46.6 47.7 48.9 50.2 51.4 52.4 Opating Coat. Aveag Wages($S-ye) 257 265 271 278 285 292 299 306 313 Stefig 13.000 13,000 13,000 13,000 13,DD0 13,000 13,000 13,000 13,000 SocialWelae Cosb (% o wages) 37% 37% 37% 37% 37% 37% 37% 37% 37% FicedO&M-Trwrissin (on$") 1,550 1,601 1,638 1.679 1,721 1,764 1,808 1,851 1,890 Langofnetworkirse 1,750 1,750 1,750 1,750 1,750 1,750 1,750 1,750 1,750 Dist ioOSM (SHMCM) 0.53 0.55 0.56 0.58 0 59 0 61 0.62 0 64 0.65

Prperty Taxes 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1 5% krcwre Tax(%) 35% 35% 35% 35% 35% 35% 35% 35% 35% flerest Rate - Foreig Debt 8.0% 8.0% 8.0% 8.0% 8.0% 80% 80% 80% 8.0% CD hlres Ret. - LocalDebt na-uwi 636% re Rae - Loael ot -nrom $ 13.5% 9.7% 8.7% 8.9% 89% 8.9% 8.9% 8.8% 8.4% CD IJ DepreiaDnRab 4% 4% 4% 4% 4% 4% 4% 4% 4% FinancialProjections - Bas Scenario- S4Margin

Scenario Wfit Proect Tariffon RequiredRevenue? No SocarProduction Low

Summaryof Results 1995 1996 1997 1998 1999 2000 2001 2002 2003

Retun on NRFA 152% 10% 5% 2% 1% 0% -1% -1% -2% DebtService Coverage 49.2 13.6 7.8 6.0 3.0 3.2 3.4 1 - 3 yearaverage 23.5 9.1 5.6 4.1 3.2 3.4 CashFlow Surplus/(Defcit) -Smillbns 41.8 (66.0) (10.9) (29.5) (34.9) (22.7) (22.2) (23.4) (18.8) o Total1995-2003 (186.6) Surplusl(Delcit)exci change in W.C. 41.7 (35.3) (36.6) (34.3) (33.5) (27.5) (25.8) (22.7) (19.6) Total1995-2003 (193.4) Unmet Demand 884 ------

AverageTariff - S/MCM $ 23.16 $ 31.76 $ 36.05 S 37.71 $ 39.74 $ 39.85 $ 38.42 $ 37.04 $ 35.27 Averae Margin- $/MCM $ 12.49 $ 4.00 $ 4.09 $ 4.19 $ 4.30 $ 4.41 S 4.52 $ 4.63 $ 4.72 WeightedAverage Price of Gas -$/MCM S 7.29 $ 23.65 $ 27.31 $ 28.73 $ 30.97 $ 31.38 $ 30.01 $ 28.69 $ 27.05 WeigntedAverae Cost,inchuding blses $ 8.57 $ 27.76 S 31.96 $ 33.51 S 35.44 $ 35.44 $ 33.90 $ 32.41 S 30.55

An Financial Projections -BoS Sculmmo- $4 Margin

Scurio Wkh Projed Twiff on RequiredRevenue? No Sow Produn Low

IncomeStatement Yew EndrdDecember 31- nilion USS 1995 1996 1997 1998 1999 2000 2001 2002 2003

Revenuesfrm Sales 192.8 216.1 223.5 239.3 238.2 225.6 217.7 207.9 - Induutrit 87.3 - Reetdenr 3.2 -CommnnalSector 31.5 Gm Pwchases - Donwmeu 19.6 47.5 40.9 39.6 37.1 38.1 42.9 48.4 54.3 - imports 25.5 121.0 150.7 159.0 176.3 173.8 156.1 142.2 125.8 Opaeing Mwgin 76.8 24.3 24.5 24.9 25.9 26.3 26.5 27.2 27.8 Opo EN O&M-Trniemision 2.7 2.8 2.9 2.9 3.0 3.1 3.2 3.2 3.3 CAM - DidbxAon 3.3 3.4 3.4 3.4 3.5 3.6 3.7 3.8 3.9 Vages nidStwies 3.3 3.4 3.5 3.6 3.7 3.8 3.9 4.0 4.1 Socil Cods 1.2 1.3 1.3 1.3 1.4 1.4 1.4 1.5 1.5 PrpeptyTaxes 0.4 1.1 1.7 2.3 2.8 3.7 4.1 4.5 4.7 Depeion0a 1.4 1.5 3.3 5.2 6.9 8.7 11.4 13.0 14.5 Intere on DOfic LoanInteor Eenses - 0.0 0.2 0.6 1.2 1.5 1.5 1.4 1.3 TotalOpending Coas 12.4 13.5 16.3 19.4 22.5 25.9 29.2 31.4 33.3

Prof beforeTae 64.4 10.8 8.3 5.5 3.3 0.5 (2.7) (4.2) (5.5) IncomeTaes 22.5 3.8 2.9 1.9 1.2 0.2 Prft Ar Taxes 41.9 7.0 54A 3.6 2.2 0.3 (2.7) (4.2) (5i5)

LI Financial Projections - BaseScnrbo - $4 Margin

Scenario With Prject Taiff on RequiredRevenue? No SocarProduction LOW

Balance Sheet as of December31 - miliion USS 1995 1996 1997 1998 1999 2000 2001 2002 2003 Cu"w Assets Cash in Bank 1.9 2.0 2.4 2.9 3.4 3.9 4.4 4.7 5.0 Invednmets (Surplus Cash) 41.8 (24.2) (35.1) (64.6) (99.5) (122.2) (144.4) (167.8) (186.6) Accounts Receivable 30.5 48.2 54.0 55.9 59.8 59.6 56.4 54.4 52.0 lnvearies ------TotalCurnrtAssets 74.1 26.0 21.4 (5.9) (36.3) (58.8) (83.6) (108.6) (129.6) FomdAssets CapitalWork In Progress - 0.2 5.4 14.6 21.9 (0.0) (0.0) (0.0) (0.0) Cross RevauedAssets 38.4 83.4 129.1 173.2 218.6 285.1 324.9 362.5 397.1 H Less: Accunulated Depreciion (10.9) (12.8) (16.5) (22.0) (29.5) (39.0) (51.4) (65.6) (81.5) 0 Not Revalied Assets 27.5 70.5 112.6 151.2 189.0 246.1 273.5 296.9 315.6 LongTerm Inredments Total FDed Assets 27.5 70.7 118.0 165.8 210.9 246.1 273.5 296.9 315.6

Tot Assets 101.8 96.7 139.4 159.9 174.6 187-4 189.9 188.3 186.0 ShortTerm LiabUties: Accounts Payable 27.6 14.7 46.2 52.8 55.3 59.8 60.3 57.6 56.0 ShortTeen Debt 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3

Long Teem Debt - 0.1 4.3 11.8 17.6 20.2 18.9 17.5 16.2

CharterCapita 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7 RevaluationSurplus 26.7 27.6 29.2 32.1 36.3 41.6 47.7 54.3 60.5 AccumLation& CXherFunds 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 RetainedEariings 39.9 46.9 52.3 55.8 58.0 58.3 55.6 51.4 45.9

To Liabiiind EqIty 101.6 96.7 139.4 159.9 174.6 187.4 189.9 188.3 186.0

An vo co It' Financial Projections - Base Scnario - $4Margin

Scenario With Project Tarf on RequiedRevenue? No SocarProducin Low

Source and Application of Funds YearEndit December31 - monb US$ 1995 1996 1997 1998 1999 2000 2001 2002 2003

Sources: Incomefrom Opeoabons 41.9 7.0 5.4 3.6 2.2 0.3 (2.7) (4.2) (5.5) Deprecidion 1.4 1.5 3.3 5.2 6.9 8.7 11.4 13.0 14.5 InrterestCrged t Opwatons - 0.0 0.2 0.6 1.2 1.5 1.5 1.4 1.3

Borowings- Foreig - 0.1 4.2 7.4 5.8 2.6 - - -

Total Sources 43.3 8.7 13.1 16.8 16.1 13.2 10.2 10.2 10.3

Applications: I DebtService PrindpalRepayment ------1.3 1.3 1.3 Loan Interest - 0.0 0.2 0.6 1.2 1.5 1.5 1.4 1.3 Interest onDeficit ------

Capital Expenditureskid IDC- Project - 0.2 5.3 9.1 6.9 3.2 - - - CapitalExpenditures - Oter - 43.7 43.8 40.9 41.0 35.5 32.7 29.8 27.0

Nd Inclrease(Decrease)in Non-csh WordngCapital (0.0) 30.7 (25.7) (4.7) 1.4 (4.8) (3.6) 0.7 (0.8)

TotalAppkatons (0.0) 74.5 23.5 45.9 50.5 35.4 31.9 33.3 28.8

NetChange in CashPosition 43.3 (65.8) (10.4) (29.1) (34.4) (22.2) (21.7) (23.0) (18.5) of which Cashin Bank 1.5 0.2 0.4 0.5 0.5 0.5 0.5 0.3 0.3 Surplus for OtherInvesrments 41.8 ------Shortfall- to befinanced - (66.0) (10.9) (29.5) (34.9) (22.7) (22.2) (23.4) (18.8)

OS tA

4~ ~~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ % - 112 - Annex 5.3 Page 1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT SENSITIVITY ANALYSIS - CASH FLOW PROJECTIONS

1. The followingtables address the sensitivityof the cash flow and other financial projections to the possibilitythat the Governmentwill decide to maintain indefinitelytheir current policy of disallowinggas imports. As with the pro forma financial statements presented in the Base Case (Annex 5.2), the projections are based on the assumptionthat the project is implementedin accordancewith the cost estimate given in Chapter 3 and the scheduleoutlined in Chapter 4. The projectionsalso assumethat Azerigaz will undertake non- project related capital investmentsincluding: (a) acquisitionof new compressorsfrom the Ukraine ($3 million in each of 1996 and 1997); (b) purchaseof additionalresidential meters from China (approximately$5 million per year from 1996 through 1999); and (c) continued replacementof older pipes throughoutthe system(approximately $35 million per year).

2. The sensitivityanalysis further assumes that: (i) gas importsare not resumed; (ii) gas supplyfrom domesticfields declines in line with the projectionsshown in Table2.1; (iii) supply shortfallsare spread over all customer classesin proportionto their demand;(iv) pricesto consumerswould be held constantin real terms, apart from the doublingof residentialprices requiredprior to credit negotiations;and (v) a minimum$4.00/MCM (1996 price levels)average marginwould be maintained.

3. The sensitivityanalysis demonstrates that, at least in the short term, Azerigazis in a moderatelybetter financialposition as a result of continuedcurtailment of imports,provided that current purchaseand sellingprices are maintainedin real terms,and that the curtailmentin supply is spread proportionatelyacross all customerclasses. If, however,as a result of politicalor social considerations,curtailments are focussedon industrialcustomers in order to maintainsupply to residentialand communalcustomers, there would be a rapid deteriorationin Azerigaz'saverage marginat current prices. Furthermore,unless domesticproduction could be maintainedat or near current levels,the curtailmentof importswould entail as much as a 50 percentdrop in Azerigaz's sales, and the companywould be unableto cover its full operatingcosts even with a $4.00/MCM average margin. Azerigas 1i.43 Financil Proectio" - No -omUcmb (No ROI Chins kdhflVuUluIS Pd 05, PIC;laI LoadShd

1sse 1959 2000 200 2002 2003 C earY 19Y5 1isi 1i7

131.6 134.4 1102 113.8 116.5 119.4 122.4 125.4 128.6 wtu,SUSIUJV*4d1 883i00) 2.4% 2.1% 8.9% 3.3% 2.3% 2.5% z5% 2.5% 25% hturSorS hu'- ais 30125.8 33946.5 11973.5 14716.3 16S82.6 18685.9 21055.7 23726.1 26735.1 And CPIOMd IM100) 121% 12.7% 12.7% 127% Azb i IrIlIuI 598.7% 22.9% 12.7% 12.7% 1Z7% 3,770 3,770 3,770 3,770 3,770 3,770 Non PS R.IS - aWe 4271 3,770 3,770 3,770 3,770 3,770 3,770 3,770 3,770 NOunP amb-YevuiRml 4,021 3,770 3,770 PFW PA_ - a - --- PPP ESw gRda-YW - --

- BasmI./ Sobs- al .3 s1,911 i.e33 1,758 1,686 1,703 1,720 1,737 1,754 1, - lmuhlS se t ~ 2,686 286 2686 2,686 2.686 2,606 2,666 - Red ses 2Z686 2.66 1,5525 52 52 1,552 1,552 1,552 1,552 - conwam_t _ets 1,552 1,552 1,552 Loses - one 5.0% 5.0% 5.0A% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% - Ted t 10 -Nowchni4ed 10% A10% 10% 10% 10% 10% 10% 10% 10% 8% 6% 8% Rataiml set 10% 905% 9,0% 8.5% 8.0% 8% 1O% 10% 10% 10% 10% 10% -C dS _eto 10% 10% 1O% - a nS3-VMPrCOd 8ea 1,740 1,634 1,640 1,657 * 1,911 1.e33 1,758 1,690 1,785 - knew sets 2,686 2,686 2,686 2,666 2,666 2,656 2,686 2,686 2,886 - RaIII sector 1,552 1,552 1,552 1,552 1,552 1,552 Coinue dsetor 1,552 1,552 1,552 0.0% 0.3% 8% 14% 15% 15% hated _mlabWCmuau 0.0% 0.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5% - Tededh 5.0% 5.0% 5.0% 4.8% 0% 0% 0% 0% N-rTchne mdv10% 10.0% 10.0% 9.0% 8% 8% 8% ReskeS sesr 10% 9.5% 9.0% 8.5% 8.0% 8% 10% 10% 10% 10% 10% 10% -c ns s_ed 10% 10% 10% GasPurudaes - ant m 1,744 2,158 2.068 1,963 1,960 1,838 1,720 1,727 - Smw sector 2,248 3,087 3,087 3,087 3,160 3,142 3,123 3,105 3,087 3,087 -hResid d sects 1,826 1,826 1,82 1,828 1.52 1,626 1,826 1,826 1,826 -Corimised es 3,260 3S,8 3,I72 4,30 n in3 50 4.40 3f,700 3,50s 3,e26 Q2adte5fla 3,693 3,552 3,113 2,768 2,3s8 GmdG- m3 sm594 2,724 3,317 3,414 1,634 Pit" 50 Sagv Pie" per"CM637 59.2 60.7 8Z2 63.7 85.0 - hktNsets 53.33 55.1 58.4 57.6 3.0 3.0 3.1 3.2 3.3 3.3 - Redde_t sesr 1.41 2.2 z9 25.6 25.3 26.9 27.6 28.3 28.9 - CassvuS Sec_ 23.67 24.4 25.0 11.3 11.6 11.9 12.2 12.5 12.8 Donedo 3.p 10MC 11.0 48.9 50.2 51.4 524 h awosd 43.0 44.4 45.4 46.6 47.7 -Coms 299 306 313 257 265 271 278 285 292 AIW^ _ (SAiusW) 13,000 13,000 13,5 13,000 13.ODD 13,000 13,000 13,000 13,00 s5.k 37% 37% 37% 37% 37% 37% 37% 37% 37% Scold mu.f costs % of Wages) 1,764 1,608 1,851 1,890 TrueSselmnCAM- (Shn~v) 1,550 1,601 1,638 1,679 1,721 ~~ 1355 1,750 1,750 1,750 1,750 1,750 Lutd oM-ThkluES 1,750 1,750 1,750 0.s61 0.a2 0.e4 0.65 ofsh no.ss _ inso u 0.58o.se 0.59 0.1.8064.5 WatbonD OLM (SACM) 0.53 0.55 0.58 15% 11 Prpep TMa 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 35% 35% 35% 35% 35% 35% _oms Tax(%) 35% 35% 35% 8.0#A e.0% e.0# e.o% e.o% e.o#% htt" Rd* - F a Debt 5.o%A e.o% e.0# 88 8 _eissR t- Locl Ded - n 636% 8.s# 8.8% 6.4% f Ul ktedRd,-Lcal Ded - ruinS 13.5% 9.7% 8.7% 8.9% 8.9% 8.S% 4% 4% 4% 4% 4% 4% DepredSsiRde 4% 4% 4% FinancdalProjections - No hwqpodScario (No Rl ChwtgeIn hkdustrialCommnal Prices, ProportionalLoad Shed)

Soenorio Wit Prjdct Twriffan Requhed Revenue? No SocarProduction Low

Sunwmry of Results 1995 1996 1997 1998 1999 2000 2001 2002 2003

Returnan NRFA 152% 26% 11% 6% 4% 3% 2% 2% 3% DebtService Coverage 90.9 22.8 13.2 10.2 5.8 7.2 9.1 - 3yeravrage 56.9 42.3 15.4 9.7 7.7 7.4 8.7 Cah FlowSurpl/(Defct)-Smilions 41.8 (28.7) (24.7) (28.4) (26.4) (21.3) (18.4) (12.4) (5.8) Total1995-2003 (124.4) Surplus/(Deficit)exIchangeinW.C. 41.7 (23.9) (29.2) (28.3) (27.1) (21.2) (18.0) (11.6) (4.7) Total1995-2003 (122.1) UnmetDemand 884 2,321 2,834 2,925 3,183 3,134 2,804 2,498 2,165

AveageTariff - S/MCM $ 23.16 $ 23.85 $ 24.29 $ 24.52 $ 25.67 $ 26.05 $ 26.06 $ 26.73 $ 27.40 Average Margin- S/MCM $ 14.59 $ 11.18 $ 11.36 $ 11.32 $ 12.59 S 12.67 $ 12.07 $ 12.43 S 12.84 WeightedAeragePriceofGas-$/MCM $ 8.06 S 10.80 S 11.05 $ 11.32 $ 11.61 $ 11.90 S 12.20 S 12.49 S 12.75 WeegnddAverageCost,includinglosses $ 8.57 S 12.67 S 12.93 $ 13.20 S 13.08 $ 13.39 $ 13.99 $ 14.30 $ 14.56

w A Financial Projections - No imports Sceorio (No Ral Change In ndustrialCoommunal Prices, Proportional Load Shed)

Scenario Wit Project Tariff on Required Revenue? No Socar Producbi LOW

Income Statement Year Ended December 31 - million USS 1995 1996 1997 1998 1999 2000 2001 2002 2003

Revenuesfrom Saes - Irdkustnl 87.3 62.4 52.2 49.4 49.8 50.2 53.1 60.1 68.2 - Residential 3.2 3.6 4.1 4.0 3.8 4.0 4.5 5.0 5.7 - Communa Sector 31.5 23.4 20.5 20.2 19.2 19.9 22.4 25.2 28.3 Gas Purhases - Domestic 19.6 47.5 40.9 39.6 37.1 38.1 42.9 48.4 54.3 - Imports 25.5 ------e Opering Margin 76.8 41.9 35.9 34.0 35.8 36.0 37.0 42.0 47.99'

Open Expenses O&M - Transmisson 2.7 2.8 2.9 2.9 3.0 3.1 3.2 3.2 3.3 O&M - Diibution 3.3 3.4 3.4 3.4 3.5 3.6 3.7 3.8 3.9 Wages and Saaries 3.3 3.4 3.5 3.6 3.7 3.8 3.9 4.0 4.1 Social Costs 1.2 1.3 1.3 1.3 1.4 1.4 1.4 1.5 1.5 Pmperty Taxes 0.4 1.1 1.7 2.3 2.8 3.7 4.1 4.5 4.7 DepreciaIon 1.4 1.5 3.3 5.2 6.9 8.7 11.4 13.0 14.5 Interest on Defict Loan Interest Expenses - 0.0 0.2 0.6 1.2 1.5 1.5 1.4 1.3 Totl OperatingCosts 12.4 13.5 16.3 19.4 22.5 25.9 29.2 31.4 33.3

ProfitbeforeTaxes 64.4 28.4 19.6 14.6 13.2 10.2 7.8 10.6 14.6 Income Taxes 22.5 10.0 6.9 5.1 4.6 3.6 2.7 3.7 5.1 ProfitAfterTaxes 41.9 18.5 12.8 9.5 8.6 6.6 5.1 6.9 9.5

Cp, Lo Financal Projecions - No -w Scerbio (N RPAl Chg n hInInstrlallComnurmal Prices. Propotonal Lod Shed

Scwic Wkh Pmpd T rf on RequmodRevenue? No Sow on LW Ba9ac Shwt ao D ewenbr 31 -..MSon USS 1995 1996 1997 1998 1999 2000 2001 2002 2003

Cuwer Assds Cash hi Bnk 1.9 2.0 2.4 2.9 3.4 3.9 4.4 4.7 5.0 kIrndm sr (Surpks Cah) 41.8 13.1 (11.6) (40.1) (66.5) (87.8) (108.2) (118.6) (124.4) AoaLsfteot v ie 30.5 22.4 19.2 18.4 18.2 18.5 20.0 22.6 25.5

Tobt Cunnt AsMds 74.1 37.5 10.0 (18.8) (44.9) (65.4) (81.8) (91.3) (93.8)

Fbhd As_ CupNd Work hi Prtop - 0.2 5.4 14.8 21.9 (0.0) (0.0) (0.0) (0.0) Grons RevisedMAeds 38.4 83.4 129.1 173.2 218.6 285.1 324.9 362.5 397.1 Less: Accumundd DeprecldOn (10.9) (12.8) (16.5) (22.0) (29.5) (39.0) (51.4) (65.6) (81.5) o Not ReyAsd Amds 27.5 70.5 112.6 151.2 189.0 246.1 273.5 296.9 315.6 Long Term hkwsslnnB Tob Fbmd Muds 27.5 70.7 118.0 165.8 210.9 248.1 273.5 296.9 315.6

To4uIMuds 101.I 10B.4t 1& 1470 1972.0. 2218:

Short Tomn LAUbHs: Acoasmi PuySbl 27.6 14.7 16.0 15.1 15.5 15.8 16.8 18.6 20.4 Short Term DW 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3

LonrgTun DaM - 0.1 4.3 11.8 17.6 20.2 18.9 17.5 16.2

Cwt.r CapNd 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7 R.AILxhd n Srpku 26.7 27.6 29.2 32.1 36.3 41.6 47.7 54.3 60.5 ActrnumLdon &Oiw Funds 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 Ret FAdE.Sncg 39.9 58.4 71.1 80.6 89.2 95.8 100.9 107.8 117.2

T... h ...... 1.... 48 147.0 8 00.8 1205.t . 221.8 umom" J.A:.~~~~~~~~~~~~~~~~~~~~~~~~~~~~~3v Financid Projecons .No be'ou& ScNWlO X Rua Chw. I M&mtriaICommunal PrineP,Propotonml LoadShed Swb WE P Taf on RequhadReme? No Sow Pmod n LOW Source anidAppicatkon of Funds Yw Endh9Doeenber 31 - milln USS 1995 1996 1997 1998 1999 2000 2001 2002 2003

Souroas: knammfrom OpuabonS 41.9 18.5 12.8 9.5 8.6 6.6 5.1 6.9 9.5 Dereckdoln 1.4 1.5 3.3 5.2 8.9 8.7 11.4 13.0 14.5 IrieauCchgedtoCOprorn - 0.0 0.2 0.6 1.2 1.5 1.5 1.4 1.3 BcoroWbe- Fonoqi - 0.1 4.2 7.4 5.8 2.6 - - -

ToW Sources 43.3 20.1 20.5 22.7 22.5 19.5 18.0 21.3 25.3

ApplHons: - Det Sovce Pthn R.popnwei ------1.3 1.3 1.3 LoanIIn m - 0.0 0.2 0.6 1.2 1.5 1.5 1.4 1.3 1 oesanDec - - -

Capta Ewiperwud ivdk [DC- Protect - 0.2 5.3 9.1 6.9 3.2 - - - Capit Emxpenikua- Other - 43.7 43.8 40.9 41.0 35.5 32.7 29.8 27.0

NetIncrem(Decreeme) in Non-cahWoCddngCapial (0.0) 4.9 (4.5) 0.1 (0.7) 0.1 0.4 0.9 1.1

Tota Applicatsn (0.0) 48.7 44.8 50.7 48.4 40.3 35.9 33.4 30.7

NetCwge hiCah Posin 43.3 (28.6) (24.3) (28.0) (25.9) (20.8) (17.9) (12.1) (5.5) of whic CashhI Bnk 1.5 0.2 0.4 0.5 0.5 0.5 0.5 0.3 0.3 Surpusfar Oter Invesnefnts 41.8 ------Sh - to efInanced - (28.7) (24.7) (28.4) (26.4) (21.3) (18.4) (12.4) (5.8)

o X. - 118 - Annex 6.1 Page 1

AZERBAIJAN GAS SYSTEM REHABILITATION PROJECT ECONOMIC ANALYSIS

A. Costs

1. The costs of the project are taken as being the financial costs. In the case of the foreign cost component, this reflects the cost of equipment and implementation services procured competitively on the international market, and is thus representative of opportunity cost. In the case of local cost, much of the cost is for services provided by Azerigaz and local contractors. Since these services are labor intensive and since there may be little alternative employment for these resources elsewhere in the economy, it could be argued that the services should be priced at below their financial cost. However, no adjustment has been made, both because of the relatively modest proportion of local costs in the total project cost, and in the interests of maintaining a straightforward and conservative economic evaluation.

B. Benefits

2. The project yields a number of benefit streams, including:

(a) Savings on future expenditure on pipeline replacement due to the extension of the useful life of pipelines through rehabilitation of the cathodic protection system;

(b) Reduced gas use as customers who have new, or more effective, meters installed are given an incentive to use gas more efficiently; and

(c) Reduced gas leakage due to improvement in average pipeline quality, replacement of damaged and corroded pipe and improved leak detection and gas quantity accounting.

3. All of these benefits are evaluated against a "counter-factual" (or "without project") case in which no investments are made. The nature of the project is such that alternative cases of other investments, or intermediate variants, are not easily applicable. It should also be noted that the project implementation process will involve many micro-decisions on specific investments, for cathodic protection of particular stretches of pipeline, and for replacement of individual meters. Screening procedures will ensure that only investments which meet certain basic criteria of viability will be made (eg. only pipelines which will continue in use will be cathodically protected, and meters will be installed only at premises likely to continue to use gas). In this sense, it is likely that the final investment pattern will be somewhat different than currently assumed but will have an element of self-correction away from sub-optimal outcomes.

4. Economic Value of Natural Gas: The economic value of natural gas is taken to be fuel oil parity. The economic value of fuel oil, fob Baku, is taken as $50/ton, based upon a Mediterranean price for low sulphur fuel oil of $1 10/ton and transport costs from Baku to the Mediterranean (by rail and ship via a Black Sea port) of $60 /ton. The equivalent value of gas is taken as $45/MCM. - 119 - Annex6.1 Page 2

5. In the short run, it could be argued that the economicvalue of gas shouldbe based upon the cost of gas importsfrom Turkmenistan.At the margin,under presentcircumstances, additionalgas madeavailable through more efficientusage would probablyreduce the need for gas imports.However, it is difficultto estimatea realisticeconomic value for such imports, since these are paid for largelyin barter goods. In addition,in the mediumterm and long term (during which projectbenefits accrue), Azerbaijan'sgas productionis expectedto stabilizeand then recover. In this case, gas importsmay be eliminatedand gas willcompete with fuel oil in the substitutablepower market(which is currentlyusing mostly fuel oil). Hence fuel oil parity representsthe most useful benchmarkfor economicvaluation of gas in Azerbaijan.

6. EconomicInternal Rate of Return (EIRR):The EIRR of the projectunder base case assumptions(outlined below) is relativelyhigh, at 46.9%. It shouldbe noted that the calculation of the projectEIRR includesallowance for the cost of ImplementationAssistance ($1.3 million), whichis not includedunder the individualcomponents below.

C. Evaluation of Benefits by Major Component

7. Asset Preservation:The EIRR of this componentis estimatedat 53.4% under base case assumptions.It is assumedthat 2,600 kilometersof pipe willbe protected through rehabilitatedcathodic protection systems, with unit replacementcost of $273,000/km.With improvedcathodic protection, remainingaverage lifetimes of pipelinesare estimatedto be extendedfrom 20 years to 40 years. The averageproportion of pipelinereplaced each year thus decreasesprogressively from 5% at the start of the project, to 2.5% after 15 years.

8. Additionalbenefits from this componentcome from savingsin electricitycosts, as stray currents and lossesare eliminatedand a reductionin gas leakagedue to improvedpipe quality. However,these savingsare smallin relationto those yieldedby the reduced spendingon pipe replacement.

9. New Gas Meters:The EIRR of this componentis estimatedat 43.0%. Introductionof meters for consumerswho are currentlynot metered is assumedto provide a strong inducement to use gas more efficiently.It is expectedalso that the generalenvironment in Azerbaijanwill move towardsincreased effectiveness of marketmechanisms (through privatization,creation of hard budget constraintsand increasedmanagement autonomy). It is assumedthat the efficiencyof gas use is improvedby 15% three years after meters are installed.This is a fairlyconservative assumption,since it is often observedthat introductionof meters can lead to improvementsin gas efficiencyof 25% or more.

10. However,it shouldbe noted that the improvementin gas use efficiencywill entail some burdenfor consumers,who previouslydid not have to concernthemselves with the quantityof gas used. Improvedefficiency of use among these consumerswill mostlytake the form of simple behavioraland operationalchanges (turningoff gas usingequipment when not in use, adjusting temperatureof heaters,calibrating equipment). However, there is in principlea cost perceivedby consumersin the form of lost "consumersurplus", since the previous availabilityof gas at zero marginalcost presumablygenerated a certain levelof conveniencewhich was of some valueto the users. In the case of a normalprice increase,it can be argued that a part (up to half) of the value - 120 - Annex 6.1 Page 3 of the reduction in gas usage (at the new higher price), should be counted as a loss of consumer surplus (this corresponds to the area under the demand curve). However, in this case this would probably overstate the loss, since consumers were probably not operating on any meaningful demand curve due to the effects of the previous non-market planning system. Moreover, a substantial part of gas use represents pure "waste", the reduction of which does not correspond to any significant loss of welfare to the consumer (such as turning off appliances when these are not needed). Hence in the evaluation, a 25% reduction in the value of gas saved has been taken to represent the loss of consumer surplus associated with introduction of gas meters, or with more effective metering (which raises metered gas costs).

11. Replacement Gas Meters: This component yields an EIRR of 2 .1%. The evaluation of the benefits from this component consists of two separate items:

(a) Many of the meters currently installed are not working properly, or are completely non-functional. The proportion of such meters is believed to be at least 10%, based upon selected site inspections. In these cases gas usage is based upon norms or negotiations between Azerigaz and the customer, rather than on metered usage. In this case, installation of a replacement meter has much the same effect as installation of a new meter, and the benefits are measured as described for "New Meters". The total reduction in gas use will be about 1.5% within three years (i.e. 15% of 10%).

(b) Meters are estimated to be under-reading consumption by about 10% on average due to a lack of temperature and pressure compensation systems. Hence replacement of these meters with new meters will lead to a rise of approximately 10% in the customers' gas bill. As in the case of new meters, customers are assumed to reduce consumption by 0. 15% for each 1.0% rise in gas prices, and total gas consumption is expected to fall by about 1.5% within three years of introduction of replacement meters.

12. As in the case of new meters, the economic benefit from the reduction in gas use is offset by a loss of consumer surplus (of 25% of the total), as consumers are burdened with the inconvenience of higher gas costs. However, the above estimate also underestimates the benefits to some extent, since it does not quantify the savings of gas that would result from elimination of gas theft through meter tampering, as tamper-proof meters replace current obsolete models. Such a reduction in theft will show up not only as a reduction in "non-technical" losses to the gas company, but will also induce a cut-back in gas consumption. Much of the gas used "free" when stolen will probably not be used at all when consumers are forced to pay for it. However, it is difficult to quantify this effect.

13. City Gate Instrumentation: This component has an EIRR of 74.3%. This relatively high rate of return is based upon the fact that while the cost of the component is relatively low ($2.4 million), it affects all of the gas used in Azerbaijan (since all gas flows through city gate stations). The economic benefits result from the reduction of gas use following upon introduction of effective city gate metering. At present, it is estimated by Azerigaz that a significant proportion of non-technical losses take the form of theft of gas through tampering with city-gate station meters. - 121 - Annex6.1 Page 4

The elimination of this theft will have a large effect on gas use, since the gas which was stolen is presumably used very inefficiently.Once consumers have to pay for this gas its use will be curtailed sharply. Overall reduction in gas use is estimated at 1.5%.

D. Risk Analysis

14. The mainfactors which could lead to lower economicreturns to the projectare:

(a) Possiblelower benefitsfrom cathodicprotection, due to the conditionof current pipelinesbeing poorer than expected,or due to unexpectedtechnical factors (eg. soil characteristics);

(b) Possiblelower demandresponse (improvement in efficiency)following introductionof new and replacementmeters;

(c) Lower benefitsfrom savingsof gas due to lower internationalfuel oil prices(or a future surplusof gas in Azerbaijanas large gas depositsare developedmore rapidlythan anticipated),

(d) Highercapital costs than assumed.

15. The results of varioussensitivities on these parametersis shown in Table2. It can be seen that the project EIRR is extremelyrobust to a varietyof adverse assumptions. A case has also been run in which all the "downside"assumptions have been combined. Even in this case the overallProject EIRR remainssatisfactory, at 23.0 %.

16. Switchingvalues for the key variablesare fairlyextreme. The overallEIRR of the Project fallsbelow 12% onlywhen capitalcosts exceedthe base case figureby a factor of 6.6 (ie. costs are 660% of the base case figure).For gas prices,key componentsfall below 12% only at gas prices under $10/mcm. Demand response can be 4 times less than estimated(ie. 25% of the base case), with the project stillyielding over 12%.

17. The componentwith the lowest rate of return, and which is hence most vulnerableto unfavorabledevelopments in projectvariables, is the ReplacementMetering component. In a technicalsense, it is possibleto separatethis componentand to carry out only the other componentswhich have a higherreturn. However,it should be noted that it is not practicalor desirableto eliminateor greatly curtailthis component,because: (a) it wouldbe undesirableto create two classesof consumers,those with accuratenew meters, and those with unreliable "Soviet-era"meters, since the latter would continueto disputetheir bills,while the formerwill feel that they are payingfor the non-technicallosses of the latter; and (b) the maintenanceof many inaccuratemeters willimpede the overallgoal of creatinga fullgas accountingsystem for Azerbaijanwith consequentbenefits in terms of networkmanagement and efficiency. - 122 -

Annex 6.1 Page5

ECONOMICANALYSIS BaseCase AzwbaljanGas System Rehabilltation Project GasValue = $45mcmbased on FuelOil $5aton Asset Preservation

CapitalCos - 6.2 millionUSS ConstructionCost Profile Year1 0.0% Year2 36.1% Yer3 30.1% Year4 22.5% Year5 11.3% 100.0% Assumptions: Lengthof ProtectedAssets 2,600 km UnitValue of Assets $ 273,000per km AnnualPipe Repiacement lMhoutProct With PFrojoct 5.0%per year 3.0%In 5 yers 2.5%In 15years

ElectricityConsumption $ 473,040 (0.OM/kwh) ElectricitySavings $ 94,68 20% IncrementalO&M $ 100,000per year InService 1998 LeakLosse 5.0%vUthout Proj. 4.0%VYth Proj. TotalThroughput 2,000 millionm3@ $ 45.00 perMCM EIRR 53.4%

Capital Incremntal ReplacementReplacermnt Replmment NetSaving Eecbtity L"k Loss Net Cost O&M NoProject VWthProject vWthProject In Replacemnt Savings Reduction Bnefts Y"r (Smillions) (Smililons) (Smillons) (%/yr) (Smililons) (Smillions) (Smillons) (Smillns) (Smliilons) @5.0%tyr

1996 - (35.5) 5.0% (35.5) 1997 (2.2) - (35.5) 5.0% (35.5) - ' (2.2) 1998 (19) (35.5) 5.0% (35.5) , 9) 1999 (1.4) - (35.5) 5.0% (35.5) - - - (1.4) 2000 (0.7) (35.5) 5.0% (35.5) - (0.7) 2001 (0.1) (35.5) 4.6% (32.7) 2.8 0.1 0.9 3.7 2002 (0.1) (35.5) 4.2% (29.8) 5.7 0.1 0.9 6.6 2003 (0.1) (35.5) 3.8% (27.0) 8.5 0.1 0.9 9.4 2004 (0.1) (35.5) 3.4% (24.1) 11.4 0.1 0.9 12.3 2005 (0.1) (35.5) 3.0% (21.3) 14.2 0.1 0.9 15.1 2006 (0.1) (35.5) 3.0% (20.9) 14.8 0.1 0.9 15.4 2007 (0.1) (35.5) 2.9% (20.6) 14.9 0.1 0.9 15.8 2008 (0.1) (35.5) 2.9% (20.2) 15.3 0.1 0.9 16.2 2009 (0.1) (35.5) 2.8% (19.9) 15.6 0.1 0.9 16.5 2010 (0.1) (35.5) 2.8% (19.5) 18.0 0.1 0.9 16.9 2011 (0.1) (35.5) 2.7% (19.2) 18.3 0.1 0.9 17.2 2012 (0.1) (35.5) 2.7% (18.8) 16.7 0.1 0.9 17.6 2013 (0.1) (35.5) 2.6% (18.5) 17.0 0.1 0.9 17.9 2014 (0.1) (35.5) 2.6% (18.1) 17.4 0.1 0.9 18.3 2015 (0.1) (35.5) 2.5% (17.7) 17.7 0.1 0.9 18.6 2016 (0.1) (35.5) 2.5% (17.7) 17.7 0.1 0.9 18.6 2017 (0.1) (35.5) 2.5% (17.7) 17.7 0.1 0.9 18.6 2018 (0.1) (35.5) 2.5% (17.7) 17.7 0.1 0.9 18.6 2019 (0.1) (35.5) 2.5% (17.7) 17.7 0.1 0.9 18.6 2020 (0.1) (35.5) 2.5% (17.7) 17.7 0.1 0.9 18.6 - 123 -

Annex 6.1 Page6

ECONOMICANALYSIS BaseCass Azarb qan GasSystem Rehabiliation Project

Industrial Meters - New

CapitalCoat - 3.3 milion USS ConstructionCost Profile Year 1 0.0% Year 2 2.2% Year 3 49.4% Year 4 45.1% Year 5 3.4% 100.0% Assumptions: M44thoutProject WIthProject AnnualSals millon m3 466 Non-TechnicalLorse percent 10.0% 0.0% ConservationImpact percent 0.0% 15.0% EconomicVable of Gas S 45.00 per MCM ConsumerSurpkis Loss percent 25.00% Benefitsreduced by 25%due to lss of consumersurplus Incr.MeterO&M 0$mlllion/yr 0.10 3% orcaptai cost

EIRR 43.0%

CapIal Cons. Cons. Conserv. Cons. Cons. Net Change NetChange Incremental Consumer Net Cost No Projet NoProject Impact VWthProjed VWihProject Cons. Cons. O&M Surplus Benefits Year (Smkons) mmcm (Smillions) % mmcm (Smillions) mmcm (Smillions) (SmIllIons) (Smillions) (Smions)

1996 - 466 21.0 0.0% 466 21.0 0 - - 0.0 1997 (0.1) 452 20.3 0.0% 452 20.3 0 - - 0.0 (0.1) 198 (1.6) 438 19.7 0.0% 438 19.7 0 - - 0.0 (1.6) 1990 (1.5) 425 19.1 0.3% 424 19.1 (1) (0.1) (0.1) 0.0 (1.5) 2000 (0.1) 412 18.5 7.7% 380 17.1 (32) (1.4) (0.1) (0.4) 0.9 2001 416 18.7 14.5% 356 16.0 (80) (2.7) (0.1) (0.7) 1.9 2002 421 18.9 15.0% 357 16.1 (63) (2.8) (0.1) (0.7) 2.0 2003 425 19.1 15.0% 361 16.2 (64) (2.9) (0.1) (0.7) 2.1 2004 429 19.3 15.0% 364 16.4 (64) (2.9) (0-1) (0.7) 2.1 2005 433 19.5 15.0% 368 16.6 (65) (2.9) (0-1) (0-7) 2.1 2006 437 19.7 15.0% 372 16.7 (66) (3.0) (0.1) (0.7) 2.1 2007 442 19.9 15.0% 376 1e.9 (66) (3.0) t0.1) (0.7) 2.1 2008 446 20.1 15.0% 379 17.1 (67) (3.0) (0.1) (0.8) 2.2 2009 451 20.3 15.0% 383 17.2 (68) (3.0) (0.1) (0.8) 2.2 2010 455 20.5 15.0% 387 17.4 (68) (3.1) (0.1) (0.8) 2.2 2011 460 20.7 15.0% 391 17.6 (69) (3.1) (0.1) (0.8) 2.2 2012 464 20.9 15.0% 395 17.8 (70) (3.1) (0.1) (0.8) 2.3 2013 469 21.1 15.0% 399 17.9 (70) (3.2) (0-1) (0.8) 2.3 2014 474 21.3 15.0% 403 18.1 (71) (3.2) (0.1) (0.8) 2.3 2015 479 21.5 15.0% 407 18.3 (72) (3.2) (0-1) (0.8) 2.3 2016 483 21.8 15.0% 411 18.5 (73) (3.3) (0.1) (0.6) 2.3 2017 488 22.0 15.0% 415 18.7 (73) (3.3) (0.1) (0.8) 2.4 2018 493 22.2 15.0% 419 18.9 (74) (3.3) (0.1) (0.8) 2.4 2019 498 22.4 15.0% 424 19.1 (75) (3.4) (0.1) (0.8) 2.4 2020 503 22.6 15.0% 428 19.3 (t75) (3.4) (0.1) (0.8) 2.5 - 124 -

Annex6.1 Page7

ECONOMICANALVWS EseCase Az.rbalijn GasSystem Rehabilitaton Projct

Industral Meters- Replament

Capitl Coat - 4.6 milion US$ ConstructionCosd Proll Y"r I 0.0% Yer 2 1.1% Yer 3 39.2% Yewr4 3123% Yer 5 26.3% 100.0% Assumptin: m,outProject Km Poject AnnualSales nion m3 1,302 Non-TechnialLos percent 2.5% 0.0% ConservationImpa perent 0.0% 3.0% 1.5%conatsvatbn hM 10%undsrr-oadg, 1.S%s*c 10%mters are b*en. Economi Vaklof Gs S 48.00 per MCM ConsumeSurpku Loss percent 2S.00% Beneftsxduce by 25%due to l of consurnerurpu s' Incr.Metr O&M $mnontyr - Repacs .xlstg OlAf cosb.

MRR 21.1%

Captl Cons. Cons. Conev. Cons. Cons. Net Change Net Change Incrmntal Consumer Net Cost No Projec No Project Impact VYUhProject Wth Projed Cons. Cons. O&M Surplus Beneb Year ($nmllons) mmcm (Smulons) % mmcm (Smilonc) mmcm (Smumns) (Smilbons) (SNons) (Smuons)

1996 - 1.302 68.6 0.0% 1302 68.6 0 - 0.0 1997 (01) 1.294 S8.2 0.0% 1294 56.2 0 - 0.0 (0.1) 1998 (1.9) 1,254 56.4 0.0% 1254 56.4 0 - - 0.0 (1.9) 1999 (1.5) 1,216 64.7 0.0% 1216 54.7 0 - - 0.0 (1.5) 2000 (1.4) 1,179 53.1 1.2% 1165 52.4 (14) (0.5) - (0.2) (0.9) 2001 1,191 53.6 2.2% 1165 52.4 (25) (1.2) - (0.3) 0.9 2002 1,203 54.2 3.0% 1167 52.5 (M (1.6) - (0.4) 1.2 2003 1.215 54.7 3.0% 1179 63.0 (35) (1.6) - (0.4) 1.2 2004 1,227 56.2 3.0% 1190 53.6 (37) (1.7) - (0.4) 1.2 2006 1.239 S6.8 3.0% 1202 54.1 (37) (1.7) - (0.4) 1.3 2006 1,262 56.3 3.0% 1214 54.6 (38) (1.7) - (0.4) 1.3 2007 1,264 56.9 3.0% 1226 56.2 (38) (1.7) - (0.4) 1.3 2008 1,277 67.5 3.0% 1239 56.8 (38) (1.7) - (0.4) 1.3 2009 1,290 68.0 3.0% 1251 56.3 (39) (1.7) - (0.4) 1.3 2010 1,303 S6.6 3.0% 1264 56.9 (39) (1.8) - (0.4) 1.3 2011 1,316 59.2 3.0% 1276 67.4 (39) (1.8) - (0.4) 1.3 2012 1,329 59.8 3.0% 1289 56.0 (40) (1.8) - (0.4) 1.3 2013 1,342 W0A 3.0% 1302 58.6 (40) (1.8) - (0.5) 1.4 2014 1,356 61.0 3.0% 1316 592 (41) (1.8) - (0.5) 1.4 2015 1,370 61.6 3.0% 1329 59.8 (41) (1.8) - (0.6) 1.4 2016 1,383 82.3 3.0% 1342 80.4 (42) (1.9) - (0.6) 1.4 2017 1,397 62.9 3.0% 1356 61.0 (42) (1-9) - (0.6) 1.4 2016 1.411 63.5 3.0% 1389 61.6 (42) (1-9) - (0-5) 1.4 2019 1,426 64.2 3.0% 1383 02.2 (43) (1-9) - (0t.) 1.4 2020 1,440 64.8 3.0% 1397 62.9 (43) (1i) - (0.-) 1.6 - 125 -

Annex 6.1 Page8

ECONOMICANALYSIS Base Case AzerbaijanGas System Rehabilitation Project

City Gate Instrumentation

CapitalCost - 2.3 millionUSS ConstructionCost Profile Year 1 0.0% Year 2 35.2% Year 3 33.8% Year4 31.0% Year 5 0.0% 100.0% Assumptions: VWlthoutProJect f7thProJect CurrentAnnual Sales millionm3 6,071 Non-TechnicalLosses percent 10% 8.0% ConservationImpact percent 0% 1.5% EconomicValue of Gas $ 45.00 per MCM ConsumerSurplus Loss percent 25.00% Benefitsreduced by 25%due to '7ossof consumersurplus" Incr.Meter O&M $millionlyr - Replacesexisting O&M costs.

EIRR 74.3%

Capilal Cons. Cons. Conserv. Cons. Cons. Net Change Net Change Incremental Consumer Net Cost No Project NoProject Impact WVthProject With Project Cons. Cons. O&M Surplus Benetis Year (Smillions) (mmcm) ($millions) % mmcm ($millions) mmcm (Smillions) (Smillions) (Smillions) (Smillions)

1996 - 6071 273.2 0.0% 6071 273.2 0 - - 0.0 1997 (0.8) 5996 269.8 0.0% 5996 269.8 0 - - 0.0 (0.8) 1998 (0.8) 5924 266.6 0.0% 5924 266.6 0 - - 0.0 (0.8) 1999 (0.7) 5941 267.3 0.5% 5910 265.9 (31) (1.4) - (0.4) 0.3 2000 - 5958 268.1 1.0% 5896 265.3 (62) (2.8) - (0.7) 2.1 2001 5975 268.9 1.5% 5885 264.8 (90) (4.0) - (1.0) 3.0 2002 5992 269.6 1.5% 5902 265.6 (90) (4.0) - (1.0) 3.0 2003 6010 270.5 1.5% 5920 266.4 (90) (4.1) - (1.0) 3.0 2004 6028 271.3 1.5% 5938 267.2 (90) (4.1) - (1.0) 3.1 2005 6046 272.1 1.5% 5955 268.0 (91) (4.1) - (1.0) 3.1 2006 6064 272.9 1.5% 5973 268.8 (91) (4.1) - (1.0) 3.1 2007 6082 273.7 1.5% 5991 269.6 (91) (4.1) - (1.0) 3.1 2008 6100 274.5 1.5% 6009 270.4 (92) (4.1) - (1.0) 3.1 2009 6119 275.4 1.5% 6027 271.2 (92) (4.1) - (1.0) 3.1 2010 6138 276.2 1.5% 6046 272.1 (92) (4.1) - (1.0) 3.1 2011 6200 279.0 1.5% 6107 274.8 (93) (4.2) - (1.0) 3.1 2012 6262 281.8 1.5% 6168 277.6 (94) (4.2) - (1.1) 3.2 2013 6325 284.6 1.5% 6230 280.4 (95) (4.3) - (1.1) 3.2 2014 6389 287.5 1.5% 6293 283.2 (96) (4.3) - (1.1) 3.2 2015 6454 290.4 1.5% 6357 286.1 (97) (4.4) - (1.1) 3.3 2016 6519 293.4 1.5% 6421 289.0 (98) (4.4) - (1.1) 3.3 2017 6584 296.3 1.5% 6485 291.8 (99) (4.4) - (1.1) 3.3 2018 6651 299.3 1.5% 6551 294.8 (100) (4.5) - (1.1) 3.4 2019 6718 302.3 1.5% 6617 297.8 (101) (4.5) - (1.1) 3.4 2020 6786 305.4 1.5% 6684 300.8 (102) (4.6) - (1.1) 3.4 - 126 -

Annex 6.1 Page 9

Table 1

AzerbaijanGas SystemRehabilitation Project

Summaryof EconomicReturns BaseCase($4&/MCM)

EIRR 46.9% NPV $73.06 million

CapitalCost NetBenefds Total Asset New Replacement CityGate Implementation Asset New Replacement Ciy Gate Net Preservation Meters Meters Instrumentation Assistance Preservation Meters Meters Instrumentation Benefts Year (Smillions) (Smillions) (Smillions) ($millions) (Smillions) ($millions) ($millions) (Smillions) (Smillions) (Smillions)

1996 - (0.2) (0.2) 1997 (2.2) (0.1) (0.1) (0.8) (0.5) (2.2) (0.1) (0.1) (0.8) (3.7) 1998 (1.9) (1.6) (1.9) (0.8) (0.4) (1.9) (1.6) (1.9) (0.8) (6.6) 1999 (1.4) (1.5) (1.5) (0.7) (0.2) (1.4) (1.5) (1.5) 0.3 (4.2) 2000 (0.7) (0.1) (1.4) (0.7) 0.9 (0.9) 2.1 1.3 2001 3.7 1.9 0.9 3.0 9.6 2002 6.6 2.0 1.2 3.0 12.9 2003 9.4 2.1 1.2 3.0 15.7 2004 12.3 2.1 1.2 3.1 18.6 2005 15.1 2.1 1.3 3.1 21.5 2006 15.4 2.1 1.3 3.1 21.9 2007 15.8 2.1 1.3 3.1 22.3 2008 16.2 2.2 1.3 3.1 22.7 2009 16.5 2.2 1.3 3.1 23.1 2010 16.9 2.2 1.3 3.1 23.5 2011 - - - - 17.2 2.2 1.3 3.1 23.9 2012 17.6 2.3 1.3 3.2 24.3 2013 17.9 2.3 1.4 3.2 24.8 2014 18.3 2.3 1.4 3.2 25.2 2015 18.6 2.3 1.4 3.3 25.6 2016 18.6 2.3 1.4 3.3 25.7 2017 18.6 2.4 1.4 3.3 25.8 2018 18.6 2.4 1.4 3.4 25.8 2019 18.6 2.4 1.4 3.4 25.9 2020t 18.6 2.5 1.5 3.4 26.0 - 127 -

Annex 6.1 Page 10

Table 2

Economic Rate of Retum Sensitivities

Asset New Replacement CityGate Total Assumption Preservation Meters Meters Instrumentation Project

Base Case 53.4% 43.0% 21.1% 74.3% 46.9%

Demandresponse 50 % 53.4% 23.7% 10.4% 44.9% 39.8% lowerthan BaseCase

Effectof CathodicProtection 30.5% 43.0% 21.1% 74.3% 34.9% delayed5 years

Lowinternational oil prices- 52.5% 30.7% 14.4% 55.6% 41.7% gas valueS30/mcm

Capitalcosts 20 percentabove 49.1% 37.1% 17.9% 65.4% 42.1% BaseCase

All of the above 29.9% 12.6% 3.9% 28.2% 23.0% - 128 - Annex 7. 1 Page I

Azarbaycan Respubllkasini:n Repuiblic of Azerbaijan

13A. NAZIRI PRIME MINIS1TER

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, - 130 - Annex 7.1 Page 3 34/20-I3I I2 07

Mr. J.ohannes Linn Vice Prcsident, Europe and Central Asia Region INT' ERNATrONAL DEVELOPMENT ASSOCTATION l8lS Street Washington D.C., U.S.A Dear Sirs: Re: Gus Svsteln Rchabilitation Project

The Government of Azerbaijun understands that thle IntcrnationaI Dcvelop-ent Association proposes to extcnd a credit of USS 20,2 million eqLiivalent to Azerbaijan to finance a Gas System Rchabilication Projcct. Within this contcxt the Govern ment.confirms its intention to undertake its certain policy initiatives necessary for the sustainable devcEloment of the gLq .q-rtNr wichin a markct cco-nomy. rni view uC tLlhvitall lMportancz of' the gas industry to A2erbaijan, the Go-vernmentt agrees that policy reform in this subsecror is a priority. T'he Govern-ment confirms its intention to undertake, in the most timely possiblc manner, the following actionis.

(,a) tO SUppott the development of domestic gas pLoduction by undertaking a review of the producer pricing system for gas, which addresses the in-vestment ne_ds of gais developmcnt and also the nccd tc actract foreign investnmen. to gas developnient projects;

(b) to ensure the adoption and cnforccnient of a sound legal and iegulatoVy framework for the cfficient operation and developmenit of the gas sub-sector within Azerbaijan. The preparation of thlis framework will be bklsed in part on work to be undertaken with Eu-TrACIS financing;

(C) tO sUpport the cfficient supply ot liquefied petroleum gas (LPG) to do-mestic and cxport markets by establishing the LIG distribution branch ot'Azerigaz as a separ;ite company, and privatizing it in asmanncr which attracts significant investment from a qutalified foreign conmpany, while maiintainiing competitive corLdicions for LPG distribution in Azerbaijan.

Th,e Government will consult from tisne to time with AssociaLtion regard-ing the implementation of thcse policies, and will take into account the Associotion's views on these issues.

Sincerely Z

F. Guliev

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GAS PRESSUREREDUCING AND METERING STATIONS ( / / GREENSPACES I E A I2 BINAGADY 23 ZARRATI AIRPORT I KHRADAG 9 S E 2 KETYROALAN 13 KIDEELY-KNOT 24 -ZARRAT 3 DYGHAKH I4 SECTION 30 25 - NARDARAN RVERS 26 ESASHTAGI l4UZOYNA I5 XOTLY STATION 16KARACHUKHUR 27- BINA B~~~~~~~~~~~~~-AKU DISTRICT BOUNDARIES 5 POWER 1, 288OX KAIA SHOR 6 SU-GAYIT ID KILOMETERS SOUNDARIES 0 7 4 4 8 SEATEORI 19aPORK PRODRJCTIONPEANr 29 - ZYPYA - - BAKUB ADMINISTRATIVE AREA B D NGDU GUM ADA5Y 9 B99SNE ITE I6YKEE o 3 IDGANLY G6t 20 0139 ADASY _ INTERNATIONALBOUNDARIES INSETJ I GANLYGOL 2 SURAKHANI

5015 50'00 4P45 JUNE i99q I i i i i i i

IMAGING

Report No: 15378 AZ Type: SAR