PROJECT INFORMATION DOCUMENT (PID) CONCEPT STAGE Report No.: AB3526 Project Name Railway Modernization Region EUROPE AND CENTRAL ASIA Public Disclosure Authorized Sector Railways (100%) Project ID P110200 Borrower(s) UKRAINE RAILWAY Implementing Agency Ministry of Finance Ukraine Ukrzaliznytsya 7 Tverska Street Ukraine Environment Category [ ] A [X] B [ ] C [ ] FI [ ] TBD (to be determined) Public Disclosure Authorized Date PID Prepared December 12, 2007 Estimated Date of June 2008 Appraisal Authorization Estimated Date of Board October 2008 Approval 1. Key development issues and rationale for Bank involvement Railway transport is critical to Ukraine’s economic development, for three reasons: (i) Ukraine’s natural resource endowments and strong metallurgical industries give rise to a demand for very high concentrated flows of bulk materials. Such traffic can be carried much more Public Disclosure Authorized cheaply by rail than by road transport; (ii) Ukraine is an important and growing transit country for bulk traffics such as oil and grain from Russia and Kazakhstan to the Black Sea Ports. These commodities demand the freight logistics of heavy haul rail transport to minimize logistics cost and maximize market opportunities; and (iii) Ukraine has many large cities located 200-600 km from Kiev. These are distances at which inter-city rail transport can be most competitive over bus services and against airline competition. Transport Market Share. These economic, geographic and demographic characteristics have created a very busy mixed-use railway. In 2006, Ukrzalistnitza1’s turnover was USD 4.5 billion. Rail transport carries over 80 percent of Ukraine’s freight traffic (measured in ton-km) and around 60 percent of public long-distance passenger traffic (measured by passenger-kms). The railway operates to the same infrastructure and train operating standards as its eastern neighbors. Public Disclosure Authorized It is therefore a key contributor to Ukraine’s regional economic integration. Not surprisingly then, while the rail network density (in terms of route-km/ square km) is around 20 percent less 1 Ukrzalistnitza is the Ukrainian National State Railways, referenced as UZ thereafter in this note. than that of the European Union (EU) its rail network utilization, in terms of traffic-kms/route kms, is nearly three times as high as that of the EU. Transport Market Trends. The modal shares of road and airline transport will likely grow as those modes develop to serve new industries and social needs, but the railway network will continue to play a major role in Ukraine for the long-term future. Indeed since 2000, rail freight transport has increased by 39 percent (an increase in tkm that is greater than the total freight carried by railways in France) and intercity passenger transport has increased by 39 percent (an increase in passenger business greater than the total passenger traffic carried by rail in Sweden or Portugal). The attraction and retention of traffic on railways contributes to a transport system that in overall terms is safer and less environmentally damaging than the alternatives. The efficiency of railways will have a significant impact on Ukraine’s economic competitiveness. Railway Infrastructure and Governance. During the years of transition, investment in Ukrainian Railways was not sufficient to maintain assets in a ‘steady state.’ The reduction of investment in transport infrastructure that occurred in the 1990’s was a response to serious railway budgetary constraints and declining traffic levels as the national economy plummeted and then restructured. However, the investment hiatus led to railway assets that are now comparatively old, often technologically outdated, and that have deteriorated in quality. With resurgent economic growth over a number of years, Ukraine now faces the prospect of serious bottlenecks in the quality and capacity of its rail infrastructure and rolling stock assets. In addition to asset modernization, there is a need to modernize Ukraine’s railway sector governance. Market forces are increasingly determining the generation, distribution and market shares of transport demand. In this environment the ability of Ukraine’s railway industry to adapt to market forces will determine whether its promising market performance since 2000 can be maintained. This need to adapt is driving efforts by railway management to reform. On-going Sector Reform. UZ, with support from EBRD,2 has undertaken a number of reforms in recent years while still essentially a department of government. It has transferred its social, housing and educational functions to more appropriate administrations; it has created specialist entities for non-core businesses and divested over 200 of them; it has transferred Metro Systems in Dnepropetrovsk, Kharkov and Donetsk to Ministry of Transport. UZ has established a medium-term rolling business planning cycle, and provided its 2006 Business Plan to the Bank. It is operating at a small after-tax profit (about US$ 250 million per year) over the last few years.3 Reform Process. However, UZ’s management recognizes the need for more fundamental corporate reform of Ukrainian Railways itself and has submitted a 10 year reform strategy to the Council of Ministers. The starting point for these reforms would be the corporatization of UZ to re-establish it as a joint-stock company at arm’s length from the Government. The Council of 2 EBRD has provided a series of loans to UZ, including one in 1999 for track maintenance machines, and one in 2004, a loan for track maintenance machines and reconstruction of a tunnel. Throughout this period, EBRD has provided support to UZ to develop its restructuring program. 3 Based on the ‘new’ Ukrainian Accounting Standards, transformed to IFRS. Ministers approved the Concept of the State Program on Reform of Ukrainian Railway Transport in December 2006. It envisions a three stage reform process: • Commercial Management. In the first stage of reform, commercial activities of railways would be separated from policy activities government. UZ would become a joint stock company, and the six regional railways would be merged into one railway entity. • Passenger Separation/Funding. In the second stage of reform, freight and passenger activities will be separated. At present UZ receives minimal compensation for public service obligations and cross-subsidizes these services from freight profits, effectively a crude tax on production and/or trade. The proposal is gradually to replace the cross-subsidy with direct budgetary support from Central and (where appropriate) regional/municipal governments (though it is acknowledged that in Ukraine’s budgetary situation this may take many years to achieve). • Gradual Introduction of Competition. In the third stage of reform passenger and freight services would be completely separate from infrastructure and open access to the infrastructure for competing companies would be established. Draft Railway Law. These reforms have been expressed in a draft railway law which UZ has been circulating to interested ministries. Passage of the law has been delayed by the current unsettled political situation, but UZ now expect passage in mid-2008. UZ’s restructuring plan is ambitious, but it is one in which the Bank has extensive prior experience and which through continuing engagement and dialogue it should be able to support. UZ Investment Program. Between 2007 and 2015, UZ plans to invest nearly US $ 19 billion to renew it capacity to provide rail service and meet the predicted increase in transportation demand. UZ’s investment priorities include: railroad infrastructure modernization especially for international transport corridors (East-West, North-South); launching high speed passenger train services; rolling stock renewal; adoption of energy efficient technologies and mitigation of environmental impact through electrification of tracks; use of information technologies and state- of-the-art train traffic control systems.4 Bank Program. The Bank would take a programmatic approach to the railway sector reform, supporting an agreed reform path through a series of specific investment loans (SILs). IBRD would focus on upgrade of infrastructure. Rollingstock would be financed through more commercial sources. EBRD is preparing a $750 million non-sovereign loan for rolling stock, of which $500 million would be syndicated to commercial banks. IFC has also expressed interest in financing UZ rollingstock. Project Linkage with the CAS and CPS. The CAS Progress Report (2005) identifies the quality of infrastructure as an emerging constraint to growth. This report indicates that the Bank will help the Government identify priority projects that address bottlenecks in physical infrastructure and provide fast, world-class solutions. The proposed project would support the first pillar the Country Partnership Strategy “to contribute to sustained economic growth and improved competitiveness of Ukraine.5” In particular, it will be a part of the core program for “making use 4 UZ has agreed to provide a detailed investment program. 5 IBRD and IFC, Country Partnership Strategy for Ukraine, p. 46. of Ukraine’s transit potential and improving transport infrastructure.6” The CPS recognizes that “... maximizing Ukraine’s unique potential as a transit country is a top government priority going forward. Consequently, the government has provided ample room for external borrowing by Ukravtodor (the State Road Agency) and Ukrzalistnitza (the State Railways)