Dociusm of

The World Bank

FOR O0CIAL USE ONLY

-Rlps No. P-6390-AM

EIMORAUNDU AND RECOMMENDATION

OF THE

PRESIDEINT OF THE

INTERNATIONAL LEVELOPHE ASSOCIATION

TO THE

EXCUTIVE DIRECTORS

0X A

PROPOSED CREDIT

OF SDR 9.4 MILLION

TO THE

REPUBLIC OF ARMENIA

FOR A POWER MAINTENANCE PROJECT

NOVEMBER 11, 1994

1bis document has a restictd distibution and may be used by reipints ody in dte peformace ofthdr official duties. lts _tens may not othew be dislosed withwot World BDan authorizaton.

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Currency ut Russian Ruble (RR)IArmeian Drams

EXCHANGE RATES: RUDLES/DRAMS PER US$(End of Period)

Ruble.* 1990 (Avg.) 19 Dram Jan 1994 71 (official)1991 (Avg.) 62 Apr 1994 262 (official)Jan 1992 169 Apr 1994 400 (makt)Jul 1992 144 Aug 1994 320 (official)Jan 1993 415 Oct 1994 362 (official)-Jul 1993 106i Oct 1994 370 (maiket)Jan 1994 1247Apr 194 1736

Mosoow Inter-Ba*k Foreign Cuncy Exchange/Foregn Exchange Aucton Market (VEB) rate

US51 = 143 Dram (At introduction in November 1993)

WEIGHT AND MEMetric system

ACRONYMS AND BBRELTIONS

ARMENERGO menia State Electicity CompanyCI Combied Heat and Power Plt)DH Distict HeaigEBRD Europe Bank for Reo and DeveopmentBC European misson (formerly Commis of the Europe Communities)EU European Union (formerly European Community)FSU Former Soviet UnionGDP Gross Domestic ProductGoA Government of ArmeniaGWh gigawatt hourIAEA teatwional Atomic EegV AgencyICB Intarnatonl Competitive BiddingkWh kilowatt hourMEP Minirtty of Enegy and FuelNPP Nular Power PlantSCADA System Conrl and Data AcqusitonUSAID US. Agency for nteraonal Development

JF DSCAL Dec r

Januaw I - December 31

FOR OFFICIAL USE ONLY

ARMA

POWER MAINEANCE PROJECT

CREDIT AND PROJECT SUMMRY

Bo-ower: Republic of Armenia

Nenefidary Armenia .tMe Electicity Company (ARMENERGO)

Povy Category: Not applicable

Credit Amount: SDR 9.4 million (US$13.7 million eqaivalent)

Terms: Stadad IDA tms with a maturity of 3S years, including a graceperiod of 10 years

Fee Variable within a 0 to 0.50 percent range on undisbrmsed credit balances,begining 60 days after signing

nlending Teram: Prwailng IBRD interest rate with a maturity of 20 years, including agrace period of 5 years

FJiac Plan: IDA US$13.7 millionARMENRGO US$ 0.8 millionTOTAL US$14.5 ndmlon

Economic Rate of Return: The project is the least-cost means of preserving installed capacity,providing reliable power, and restoring system efficiency. Calculadonof ERR was not possible becase erratic fuel supply over the last fewyes has made it difficult to determine baseline operating characteistcsand quantify expected improvements under the proposed project.

Ravironmal Levels: C

Staff Apprasal Report: 13347-AM

Map: IBRD 24491R

Ths docume has a resticted disibution and my be used ty cipias oy in t pfrmanc of their Ioffcial dutie s cntnts nm no o*ewlse be diclosed witout World Da autation.

1*

MEMORANDUM AND RECOMMENDATION OF THE PDENTOF THE IDA

TO TH EXECUIE DDIECTORSON A PROPOSED CREDIT TO THE REUDIC OF ARMENA

POR A POWER MAINTICE PROJECT

1. I submit for your approval the following memoradum and reom aon on aproposed devdopmet credit to the Republic of Armenia for SDR 9.4 mllion, the equivalent of US$13.7milion, on standard IDA tem with a matudty of 35 years to help finwee a ptoject to arest and reversetho dterioration in selected electric power generation, distribution and dispatch fcities. Credit proceedswinl be on-lent to the Beaeficary at the prevailing IBRD variable it rat with a maurity of 20 yeas,including a grace period of S years.

Pat Ik Country Backund

2. Icn=mIc Ovenlew. Armenia Is a small, landlocked country with a land area of 29,800square kilometers. Turkey lies to the west, Georgia to the north, ra and Nakhichevan (part ofAzebian) to the south, and Azerbaijan to the easL The population numbered 3.65 million in JauWary1992 and GNP per capita was esimated at US$867 for 1992, and US$662 for 19931, maing Armeniaelible for IDA terms. Armenia formally declared independence on September 23, 1991.

3. Like other countries in the region, Armenia is experiencing the economic difficultiesarising from the bredown in monetary and trade relationships within the fotmer Soviet Union (PSU),particldarly the rapid escaation in fossil fuel prices towards world maket levels. These difficulties haebeen compounded by the regiona conflict over Nagono-Karabakh, and the resulting trade and transportblockade by AzerbWjan, and by civil strife in Georgia, blocking Armenia's second major trade route.The efects of the blockade, imposed in 1991, have overshadowed all other economic problems. Themain economic effet include:

- a drop of S2 percent in GDP in 1992, to almost a third of the 1989 level, and a furiher declineof about IS percent in 1993;

* a growing fiscal deficit which reached 48.9 percent of GDP in 1993, fianced largely throughamars and credit emission (frm the banking sector);

* inflation reaching 3750 percent for 1993 contributed to by loose monetary policy and an influxof old rubles from other FSU counties; and

* a growing trade deficit financed mainly through trade credits, loans (from Russia) and atrears.

4. The authorities introduce their new currenc, the drm, in November 1993; however,conditions were not propitious, and the currency, inly set at 14.3 dram to the US dolar, depreciatedto around 400 drams/USS by May 1994. 'here are, however, signs of stabilizaion, and the excagerate in August 1994 was arwnd 320-340 drams/US$ and inflation declined from an average of more than50 petcet per month in January-May to 4 percent in August.

AMm metdmdolg.

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5. Rietm Prgam. he primay objecdves of the ovafnmens refom program are to: (a)achieve macroeconomic stability; O) create a strong private sector within the framework of a market-otiened economy. (c) develop an efficient public sector that povides public goods and services andimplements policies that promote susaable growth; ad (d) protect vulnerable groups in society. TheGovernment's immedia priority is to arresthe fail in output and assure social assistance to those mostin need while at the same tm narrowing the fiscal deficit and reaert conrl over money and credit

6. ror wittheReomProgra Armeniaundetookstrongstructwal reforms in 991.Nmety percent of agricultural land was privatized, followed by the privization of over 300 smallentprhies in 1992. Since that time, however, implemeon of thie reform prom has been slowbecase decision makers bave focussed larely on cisis -inall siege economy. Neverheless,.producer prices have been fiuy liberalized and consumer prices, liberaized in successive stages, are nowderegulated in all spheres except bread, public utilities, and transport. Administered prices have beenraised substanmialy. In recent months the pace of reforms has picked up, in conjunction with thecommencement of a stabization prgram which has led to a decline in monthy inflation to 9% in June,and a stabilization of the dram/US dollar exchae rate. Parliament has approved the privatizationprogram, implementation of which is set to begin with medium and large enterpis. In addition, moreprudent credit policies in the financial sector are being intoduced.

7. Medium Term Outlook. ITe restoration of economic performance depends crucially onimproviDg the eteral political suion and establish lastng peace in the region. Armenia continuesto have a level of export orders from both inside and outside the FSU which is high relative to currentoutput. Oc the blockade is lifted, exports, particularly to the FSU, but also to new markets, areprojected to recover rapidly. Once conditions stabilize, the Armenian diaspora could help to finance thelarge direct foreig investment flows needed to stimuate export-led grL Nth. Armenia currently has IDAstatus.

Part II: Energ Sector Outlook

.A,r Sector Isues

8. Key Co(stinht. Key secw constraints which limit Armenia s ability to adjust to a marketbasis and adequately respond to the energy price *shock' include: (a) high energy t ty of theeconomy, arising from artficially depsd energy prices in the past, energy infficient tecWologies andconsumption prctices, and limitd antion to commercial principles in enterprise operaion; (b)exsive Import dependence compounded by Armenia's landloced geographical position and the

reasuting vulnerability to spply disruptions; (c) a lmited fel mix with about 95 percent dependence onoil and gas (all of which is imported); and (d) market disrpton resulting from the conftrcn In theeconomies of Ameia's tadion tradig partnes. Mm sector s finan y constaied beas theincreased fuel and other opeaing costs have been eacebated by a depressed "siege economy withinwhich ) the Govemment has not been able or willing to raise energy tarift to 2teir full cost recoverylevels; (ii) severe energy shortoges and rationing have resulted in increasing theft and Illegal connections;(iii) the GoA and sector enteprise have been unwing or unable to enfor coflection of overdue aresand reduce system losses; and (iv) consumers would be unable to affird fll cost based ener prices.

9. Sectoral hnportance. The high energy intensity of the economy, high pernp of

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industrial productieon in the GDP, and its climatic conditions, make it essenial for Armenia to have anefficieat and rdiable y sector, and scure -energy supply aangemients. In 1990, the last yearpreceding the disrupfio in ener supply and regional trading relationships, the energy intensity of the-country's eonomy wa 1.04 kgoe/US$ of GDP and industial producdon made up about 45% of thenational mate pro;duct. hbis energy sity is 4-5 times higher ta Swedeo and Austria, but wascomparable with that of other East European countries such as Hungary and Belarus.

10. The move to word prices for energy and the decline in the counys GDP are having aprofound effect on balance of payments and energy in ity. Eneg mports were already two-thirdsof total imports in the -fint half of 1993 and, at present contract prices, 1993 levels of heavy fuel or(mazu) and gas impors (Para 11) would have cost about US$100 million, or about one xth of t secountr's 1994 GDP as projected by the IMP (Atlas methodology).

11. Roeoet Eergy Supply. Compared with about 3.0 milion tons (Mt) of mazut and 3.5 bilioncubic meters (bcm) of natural gas imported annually prior to 1991, only 0.225 Mt of mazut and 0.9 bcmof gas were received in 1993. Elecicity geneation was 6,295 gigawatt-hours (GWh) compared withabout 10,362 GWh in 1990, of which 4,292 GWh was from hydro (about 1,555 GWh in 1990) and 2,003GWh from temal (about 8,807 GWh in 1990). A daily average of 800 MW of generation capacity wasoperated (compared with about 2700 MW of installed and 1970 MW of available capacity) andhouseholds received electricity for 24 bouts/day.

12. Setor Orgrilzation. Ihe insttional relationships within the energy sector are still beingdefined. Ihe Ministry of Energy and Fuel (MEF) is responsible for formuat the sector's developmentstrategy, detrining the investment program, and advising the Ministry of Economy and the Councilof Ministers on price and tariff adjustments and on futue institutional framework and sector policies.Sector entities involved in commercial activities are a part of the MEF although their charters allow themmanagerial control over dayto-day activities and over the use of operating revenues and profits (withinguidelines established by the Government). These entities are ARMENERGO (for electricity and heatgeneration and asmission, and electricity distribution in all areas except Yerevar), the YerevanElectricity Distribution Authority, ARMPEMROL and ARMGAZPROM (for the transportation, storageand distribution of oil and gas respectvely), and ARMENERGOATOM (for the nuclear power plant).The Mistry of Economy establishes priciag and taxation policy and must approve all tariff adjustments.

The Electric Power Subsector

13. Demand and Supply. Electricity demand projectons are closely linked to the rate ofeconomic recovery following the lifting of the blockade and the estblishment of new monetary, trade andpayment systems. Although total energy demand projected by Bank studies is not expected to reach 1990levels until after the year 2000 under any likely economic scenario, electricity demand by itself wouldbe strongly influenced by the energy supply strategy followed by the GoA. Armenia's electricitygeneraton capacity is sufficient to meet the country's immediate needs,; however, reserve and replacementcapacity, and a cost-effective reduction in import dependence, ae needed to ensure reliable supply.Immediate investments are required in system maintenance, and in upgrading the electricity dispatch,transmission and distribution systems in order to reduce technical and commercial losses, and strengthenoverall commercial performance. The facilities targeted for maintenance under the proposed project areprime candidates for life-extension and efficiency-enhancement rehabilitadon under fature operations,even if the nuclear plant is recommissioned (para. 22).

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14. bultud l a s. lhe main credit beneicary, te Armnia State ElocticityCompany (ARMENERGO), witin the EF'o structur, Wa' established as a state'Conce iv February 1994 and Is an mtmaon of electic power entepi In Armenia.APJIENRGO Is responsble for al non-nuclear electricity and heat generaon and ftramissio adelectricity ditrb on in all areas exept Yernva. The Yrvan Electrici Distribution A-uthorty, lsounder the MW, is respomible for electricity dibuon in Yean. ARMENERGO also supplies smand- hot water genad f*om Its combined be and pow (CHP) plants to uzan ditict heatigcoanies (under ci and towin and to lar industries, and is responsible for beatdisbutin i rra area. Te recent estblishment of ARMEM GO as a state 'Concn' is a steptowards its saaion irom the Govmet with the view of It becoming n asset holding company frthe elec power subsector.

is. Elecrity Tari Polcy. Aithough the (3oA Ls commited to establishing full-cost basedtarf, its Itnis to do so have been compllcafd by: (I) the lack of clear evidence as to whetherinaprpit tariff policy. or inadeque management mechnsms and will to reduce system tosses, isthe primary cause of the financal difficulties of the sector, (i) the inability of a 9siege' economy to bearthe burden of full ecomic costs of supply, either by the final consumers or by the Government budget;(i) high inflation making it difficult to raise eectricity prices in re terms; and (iv) insufficient enesupply to serve both minimum human needs and adequately supply the indus sector. Whereaindustry, particularly export industry, could affrd higer tarifs for reliable supply, fuil cost recoveryfom households is unlikely in the short term without some form of subsidy.

16. Average tariffs are based on narrowly defmed fuel and non-fuel operating costs. A significantachievement in taiff setn wa the recent (April 1, 1994) indexton of electricity tariffs to the USdolr as a proton from inflato The avere tarff established in July 1994 was US cent 1.S/kWhand is expected to be raised every tree months. Tariffe or households and for iLrriadon puposes areonly 1.3 drans/kWh (US cens 0.40/kWh) and are crss subsidized by non-households (US centsM.43/kWh). Supply costs are strongly influenced by the proportion of electicity gertged from low fuelcost hydropower, while ARMENRG s revewes ae complicated by problems of thef, non-paymentfor services, and an insufficient povision for maitnace and depciation in tariff d in .Recogonizing this, and the limitations of raising ariffs for household conomes, the authorities areinvesgatng the possibility and mechanim for supplying commercial entities through monthly electicityauctions. Ihe frst stage of this process (to be tested in early 1995) is for ARMENERGO to auction 10pert of elecicity generated, with this proportion to be increased over time (until full cost recoverytariffs are established).

17. As Goverment has been unable to meet the tariff increases agreed to with EBRD under theHrazdan 5 Power Plant loan. Loan owvens have been re-negodated with the goal of reaching anavergetariffof US cents 4.0/kWh by end 1996, and an hterim tariff of US cens 2.0/kWh by end 1994.Ini targets were US cent 3.0/kWh by end 1993, US cents 3.5/kWh by end 1994, ad US cen4.0/kWh by end 1995. Te completion of recenty stard studies (para 18) by June 1995 would pmita better assessment of full-cost recovery tariffs in Armenia. During Credit negoiaons, the GoA agreedto adopt, by December 31, 1995, an interim electricity tariff which at least covers the ful opeating andmaintenance (O&M) costs of electricity supply. On-going and planmed studies (para. 18) would derminethe fll O&M costs by June 30, 1995, and, upon aprement by the GoA and IDA, these costs would befully reflected in the average electricity tariff by De&ember 31, 199S. Longer-term tariff revisions wouldbe deterined based on the overall restucuring of the asbsectr and the establishment of an independent

5

regulty amework

18. Teinc Astn CrA. Donor-funded studies are assisting the GoA to better asss its-titutionl ad policy rer ptios.- TA Inludes a financial streu enig study, a medium-em

Power Pacities Planning Stuy ng medium powr supply opons, advice to (overnintu:for energy cor restructuring and fud ot dag, detrion of ful O&M csts of the electricityWuply netwk, and a rtutuing and pri aion study for the power wbsector. The World Bank

was involved in prag the terms of rfrence for these studies which would pv an assessmetof ARENERGO's floancia conditio an idenficati of the level and structure of electrcity tarlfs7and the mediumtrm magind cost of delriy sply In Armenia. hese studies are expected to becompleted by mid-1995 and wod provide eptions for policy and institutional reom.

19. eIc Nwer Instr e The susecor consists of three mazut and gas based themalpower plaus (1.746 MW), two main hydro power cascades (29 MW), the Medzamor nuclear powerplan (815-MW) shut-down sinc eary 1989, several mini-hydro statons which had been shut-down butare being rehabilitated, a transmission network, with links to Georgia, Azerbaijan and Turkey, and urbanand rural diutio networks. Of the approximaty 3,515 MW of installed capacity, about 1,970 isavailable after derating on account of age, the low water level of Lake Sevan, and the shutdown of theaudear plant

20. The country's electric power infastructure has deterirated considerably, particularly overthe last three winters, due to fiel shortges. The system has been operated to meet the survival needsof the population and economy with only limited attention to commercia principles. Hydro powergeneraon in 1993 was three tmes hhr than in 1990, mainly from the draw-down of Lake San (para.46). Electr is now the domiat source of energy for hum;an needs and the use of electric space andwate heaters, and cooking stoves has increased substantially resulting in high (peak) load demand at all

aes in the winter. Electricity has been ratoned thoug rotating blaclouts and an elaborate system ofsWpiy regimes linked to fuel availabilit and the requements of the popuation and stategic industries.

21. Desigd in an era of abundat eectricity with scan regard for commercial vibility, theexisting elecity transmission and distuon infrtuctr i not designed to adequatey protct thesystem from ovioad durg periods of sarcity. Consequently there has been etensive damage to thedistruon system (destruction of over 300 trnsform and several hundred kilometers of cable),pauad y during the winter months. The siuaton is ace ted by rampant illegal comections andby-passig of cicut breaes at the resident buldis and sub-station levels.

22. Me _ Nudear Poww Plant (NPP). Given the energy scarcity arising from theblockade and the high cost of conventional fuels, the GoA has decided to re-sta the NPP. Although thesecurity of power supply ected from the NPP is considered an issue of economic survival, the GoAis committed to the plant's safe operation. This is a Soviet-built model VVER 440-270 plant (anupgraded version of the Model 230), and is the type tgeted by the 0-7 counies for early remntan account of afety limations intrinsic to its dedsg. Ihe plant consists of two reactors rated at 408MW each. The first unit Was commisoned in 1976 and the second in 1979. The plant was shut downin eady 1989 after the earthqe in 1988, as a pr measure since the plant is located within16 km of a seismc fult. No damage was sustn by the plant during the earthquake.

23. Notwitanding G-7 concerns on safety, the GoA strategy is to re-st unit 2 in eady 1995

6

(while leaving Unit I dosed) and opae k for 5-7 years, by which time altern resources ar expectedtD be developed (pa 27). Work needed to restat the unit was begun in late 1993. Costs for restotingthe uit to orginal design levels (about 20 year old desig) and resaWting It are estmated at US$70million of which about US$40 million is for fresh nuclear fuel. The GoA has seue this financing fromits own resources (US$15 million), the Armenian diaspora rpesented by the Medzamor Foundaton, andRussia (fres fuel, disposal of spent fuel and technical assistance). Russia is to provide the finmacingagainst a lien on about 15 perent of nuclear plant ass and a stake in other enterprises which exportproducts to Russia. The GoA is ilso seeking an additional US$25 milion for safety enhancementsbeyond the original design, including the insallation of advanced-instentation, leak detection reactorcontrols, and modern software from western suppliers. In this effort, the GoA is tying to get the 0-7countries to allow EBRD and western surpliers to provide credit and the equipment.

24. As agree under the EBRD Power Project loan, a Power Facilities Planning Study, to becompleted by December 1994, is investigating power supply options (mvestment plan) with and withoutthe retartng the NPP, and with its retrement after 5-7 years of operation. In addition, an BRD-appoited panel of independent experts is scheduled tO visit the NPP in early 1995 to assess whether thetargeted safety stdards are acceptable to the panel. As a loan condition, EBRD bas the right to cancelthe loan and accelerae repayment If the plant is resur without the panel's approval. 'he World Bankwould support this condiuion under the folow-on Power Rehabiitation Project (pan 31).

25. Govemment Subsector Strategy. Recognizing that an Imbalance between the relativelyinelastic, survival-level demand, and price and transportation-constrained supply is likely to continue forame time, the GoA nas embarked upon a short-term (1993- allocation stratgy aimed at: (a) providing

on a continuous basis at least a minimum level of electricity to critical facilities (such as hospitals,bakeries, public trasport, schools, and certain export industries); and (b) increasing the reliability, andif possible the quantity, of at least a minimum level of supply to other users mdusries, housebolds, etc.)through rotatig blackouts. The strategy identifies types of consumers by priority and allocates electricitysupply depending upon fuel availability. In addition, the GoA intends to recommission one nuclear powerunit (taking into account the findings of the EBRD-appointed panel), commission the 300 MW Hrazdan5 thermal power unit by end 1995, and rehabilitate and upgrade existing power facilities.

26. In order to implement the electricity allocation strategy, dedicated electricity feeders t criticalfacilities are being instlled (financed by the facilities), and system proection and control is beingstrengthened. Even though the strategy is driven primaily by considerations of energ security, and isbeing implementd by central alocation, the increased system coGtrol introduced would allow electricityto be distributed according to commercial principles in the futiue as the crisis siution eases.

27. The GoA's longer-erm strategy responds to the key energy sector comstain of severe fuelshorte, limited fuel mix (excessive dependence on fossil fuels), and insufficient useful and reliablepower generation capacity to meet medium term requiremen. The strategy includes the developmentof Armenia's oil, gas, and coal resources, the building of an Iran-Armenia gas pipeline to alleviatepresent dependencies, the devlopment of about 300 MW of new hydropower capacity, the canersionof a petrochemical phol into a I Mttyear oil refne, and an intensive investment and public Informationcampaign to promote energy conservation and efficiency.

28. Eney law and Private Sector Development. A -draft Energy Law is expected to befinalized by the end of 1994. In the power sub-sector, the GoA announced that plan of less ta 25-

7

MW city wd be privatized and six mini-hyd un, raig in capacity from 0.4 MW to 5 MW,wefe mtrasfrred to plant employees in the latter part of 1993; however, ownership and pricing detailsare stll beig worled out lhe ME expects tat private ownership, or joint venre with theGoverment, would also be allowed for largecapacity plas, and is actively encouraging foreignparutrs ivest in Armenia on the basis of attrtive electricity sales contracts. However, country riskremain hgh and it may be some time before these projects wre alized.

29. an Subsetor Stagy. 'Me proposd project, aimed at arresting the derioration inenegy fatructu, would be a integ pt of the Dan's leadig statgy which includes emergencyrehablitation of in ture. In the power subsector, the key element of the sty for the next 3-5years involves ssistng Armenia wih is transition to a market economy through a combination ofimvetmn and teical asitn amed at enhancing operating efficiency and mpetitiveness andimproving demand management. Investment assistance would be diced towards: (a) supportn thereommendations of ihe Power Facilities Plaming Stdy (par. 18), and is expected to include therehabilitadon of selected therma and hydro power generation units, and the electricit trms ion anddistribution syte and (b) strengthening the commercial performance of operatiwg enies throughinvestment support, sqearation of the ownership, policy making, and regulatory functions of theGovernment, and the corporatization and resucturing of the electric power subsector so that It is moreresponsive to the demands of a market economy.

30. Te proposed project was identified durng the preparaton of a Power RehUitaion Project(pro-apprased in October 1993 and tentatively scheduled for Board presentation in FY96), the processingof which has been hamed by the crisis conditions which have delayed policy and institutional reforms,accelerated system deteroration, and made it difficult to fully define the project's scope. Given thissituation, and the lack of financing available for urgently needed spare parts, the GoA requested that theBank proceed in two steps: the proposed Power Maintenanee Project, aimed mainy at arresdng andrevers system damage, followed by the Power Reabiltation Project, aimed at deeper efficienyimprovements and life extension. The first project could be implemented soon aRer the blockade is liftedand the second project would follow about one year later.

31. The credit would contai standard IDA conditions for procrement, disburseme andauditig. Project specific conditions include agreement on an interim electricity pricing methodology,system loss reduction targets, a reduction in the average tevenue collections period, and submission toIDA, by June 30, 1995, of a power subsector investment plan which takes into account the retrementof the NPP. Policy and institonal reforms needed to sustain poject beefits are being addressedthrugh on-going and planned TA, and through conditions agreed upon between the GoA and EBRD,presey the largest single lender to the power subsector. Up-front pricing policy reforms, a time-boundschedule for resucturing the electric power subsector according to recommendations of on-going studies,the safe opeaion of the NPP (if it is re-peed), and agreement on a power subsector investment planwhich takes into account the retirement of the NPP, are expected to be conditions of the followon PowerRehablitation project.

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PAr ml: The Project

32. Project Objecv. Ithe objectives of the proposed project are: (a) to arrest and revem thedetrio n of three theml geration uni and three bydro power generation plants, and mpwovo theravailability (reduce unscheduled down-time); and (b) to strfte the electricity load managemen a nddispatch capability of the natio dispatch cntr and arrast the firther deterioration of the electricitydistribution system.

-33. Ihe achievement of thes objectives would Trmit tP - coninued pation of the powerfacilities and defer expensive replacem cost arising from equipment faiures, some of which coud becaastrophic. An mprovement of 34 percent in generatiou efficiency (closer tothe design level of 33-35percent) is also exected from the general overhaul of boiles, turtbines and geerators.

34. Project Dwtlption. The pro, ised project consits of.

(a) PowerGeneration (US$7.7millon). Manencofselectedgenerationunits and ancillaryfacilities at: (i) two existing 200-MW thermal units at the Hrazdan power plant; (Hi) one 150-MW thermal unit and the water treatment facilities at the Yerevan power plant; (iii) one 100-MW and one 44-MW plant on the Sevan-Hrazdan hydro-power cascade; and (iv) one 170-MW plant on the Vorotan hydro-power cascade;

(b) Electridty Dispatch and Distribution (US$4.1 milleon). Strengthening and mainenance ofthe electricity dispatch comunications and distribution systems; and

(c) Tehical assistan (US$1.5 million) for project implementation and upgrading theelectricity dispatch systm.

Project preparation activities have been financed by a Project Preparation Faciity (PPF) advance of US$1.2 miMion equivalent. This PPF .dvance would be reinced under the proposed project.

35. Selection of facilties to be maintained. Selecdon was based on the critical need formaintace and system protecton, "rojected fuel availability, the potential for life extension of theselected generation facilties under fu&.e investment operations, and the level of financing avalable.Compared with annual electricity demand projected at 7252 GWh for 1995 (Energy Sector Review - basecase), the generation capacity maintained under the proposed project could supply 4340 GWh (3375 GWhfrom thermal and 965 GWh from hydro). Anither 1840 GWh would be supplied from Hrazdan 5 (300MW) upon its completion in 1995. If recommissioned (paras 23 & 24), 2500 GWh could be suppliedfrom the Medzamor NPP. Peak load demand would be supplied from the hydro units.

36. Project Costs and Fnancing. The total project cost, incuding contingencies and PPFrefinancing, is estmated at US$14.5 million equivalent, with a foreign exchange component of US$13.4million. The IDA Credit of US$13.7 million would finnce 100 percent of foreign costs and 94 percenof the total cost. A breakdown of costs and the financing plan are shown in Schedule A. The high levelof IDA financing is justified because of the poor financial condition of the Government and the CreditBeneficiary, ARMENERGO. Local costs not finaced by the Credit (US$0.8 million equivalent) wouldbe covered by ARMENERGO and are mainly associated with insilation to be carried out by its staff.

37. PIeen . ARMENERGO wi11 beresponiblefor project mplemetaon anda Project Implemetation iit (PIl), pardally fided by the PPP, has been established for this purposeand to stengtheln local capacity. 'he PIU wUIl hire intentonally qualifled expertise which is nt"vailable within ARMENERO, particularly In the aas of project managemen.

procrementcontacting, mainece mangement, and project accounting and reportig. A summaryof procement arrangerrentsand disbrsements is presented in Sdules B and C. Given GoA's andARMENERGO's limited eperience with WIlemenation of IDA fined projects, supervision isexpected to reure an above averge effort by IMA in the fist yeat (abouir 30 staff-weeks), and about17 stalf-weekslye thereafter.-

38.- Prjct Staabiity. Electricity tariff increases agreed upon between the GoA and theEBRD, establishm of an interim tariff methodology which will at least filly cover O&M costs byDecember 31, 199S, ad agreed targets for the reduction of system losses and averagt collections period,would stenghen the financial condition of ARMENERGO, the credit beneficiary. O-going technicalassistce would provide the basis for fiue tariff reforms and the restructuring of the electric powersubsector. Lifting of the tade blockade, and an overall resurgence in economic activity, is expected toensure the longer-term sustainability of project benefits.

39. Lessons Learned from Past Bank Repeience. Lessons learned from the Bank's considerableexperience in financing power projects in other parts of the world, including Eastern Europe and theFSU, have been incorporated into the Bank's sector strategy and into this project. Experience in Armeniahas been developed through preparation of the Energy Sector Review, a Power Demand and SupplyOptions study (prepared for the G-7), and in-going project pr-3paration activities, including theestablishment in November 1993 of a PPF of US$1.2 million for preparation of the Power RehabilitaionProject. Although the PPF advance was initially slow to disburse, it Is giving ARMENERGO valuableexpenence in Bank procurement and accounting procedures and guidelines2. The US$12 million [BRDInstitution Building Loan, effective in June 1993, has been slow to implement due to the difficult countrycircumstac. Tne Earthquake Reconstruction Project (US$28 million IDA credit approved in January1994) is moving reasonably well and the implementation experience is being shared with the PITUesablished fr the proposed project.

40. Rationale for IDA Involvement. An efficient and reliable energy sector is crucial forrestoring macroeconomic stability and growth in Armenia. World Bank financing and twnical assistanceover the short to medium term would permit implementation of policy and instieutional reforms neededto reduce the f cial and managerial dependence of sector entities on the Government. The GoA hasexpressed its commitment to iroduce market-based reforms; however, Armenia's transition to a marketeconomy has been complicated by regional conflicts and civil disorder. A limited country assiancestrategy (CAS) is to be presented in conjunction with the presentation of a Rehabilitation Credit to theBoard, tentatively scheduled for February 28, 1995. The proposed strategy is expmted to includefinancing of emergency inastructure rebabilitation to strengthen the economy and protect the population.The proposed project, aimed at arresting the deterioration in electric power ifrastructure, is an integralpart of this strategy.

41.- 'e strategy to proceed in two steps (para. 30) would permit a quick response by the Bank

2 Ih EBRD loan for Hrazdan 5 (approved in April 1993) was also slow to start but bas receny gatheredmomentum. Plant start-up is now expected by end 1995, about a si-month delay.

10

to awrest the continued deterioration in ARMENERGO's physica assets and in its financial position underthe first project, and give the Govrnment time, following the lifting of the blockade, to implement policyand institutional reforms needed to create an economically efficient and commercially sustainable powersubsector. The expenditures proposed under this, the first, project are neary in any case, are focussedon seMectd, urgently needed facilities, and will be complemented on a broader scale, including deeperefficiency and life extension investments, under the follow-up Power Rehabilitation Project. Earlyimplementation of this first prject is justified as benefits of quick implementation (prevention ofpremature failures and improved system reliability) far outweigh the benefits of delaying one year andintegrating the two project. Fuel savings alone (about US$3 milliontyea) would be more than twice thecompany's fir year's interest on the loan amount.

42. Progam ObJective Category. Ihe project meets the environmentally sustainabledevelopment objective by providing urgent maintenance for critical power facHities. The project wouldarrest the deterioration and costly damage to selected facilities, improve the reliability of electricity supplyto crital facilities such as hospitals, schools and universities, public transportation, bread factories,telecommunications stations and export industries and reduce worker safety risks in the power plants.

43. Actions Agreed. During Credit Negotiations, the following agreements were reached withthe Government of Armenia and ARMENERGO, the Credit beneficiary:

With the Goveun,ent of Armada:

(i) Agreement to submit to IDA, by June 30, 1995, a power subsector investment planwhich takes into account the retirement of the Medzamor nuclear power plant;

(i) Agreement to on-lend Credit proceeds to ARMENERGO, pursuant to a subsidiaryloan agreement between the GoA and ARMENERGO, for a period of 20 yers,including a grace period of 5 years, and at the prevailing IBRD annual variableinterest rate (presently 7.1 percent), with ARMENERGO assuming the foreignexchange risk;

(iii) Agreement on arrangements for establishing and operating the project's SpecialAccount;

(iv) Agreement to take all necessary measures to reduce the total electricity system losses(commercial and technical) by December 31, 1995, and again by December 31,1996, by at least 30 percent of the losses assessed for the preceding year;

(v) Agreement to submit to IDA, not later than July 15, 1995, an action plan to meet theabove mentioned electricity system loss reduction targets; and

(vi) Agreement to adopt, by Deembe 31, 1995, an interim methodology, satisfactoryto IDA, for setting and adjusting average electricity tariffs which at least coverARMENERGO's full operating and maintenance costs;

With ARNENERGO:

(vii) Agreementof ARMENERGO to maintain an adequately staffed PJU for thedurationof the proje;t

(viii) Agrment to contrat, by March 31, 1995, projec implementation assistanceaccording to terms of reference agreed upon during negotiations;

( -x) Agreement to prepae an Implementation Completion Report (ICR) and plan forfture operatioas in accordance with IDA guidelines and submit it to IDA not laterthan six months after the Credit Closing Date;

(x) Agreement to submit to IDA, not later than six months after the close of each fiscayear, the auditors report and audited fimncial statements for the Special Account,project accounts and statements of expenditure for the fiscal year;

(xi) Agreement that a mid-term review of project implementation take place no later thanSeptember 30, 1996;

(xii) Agreement to take all necessary measures to reduce total electricity system losses(commercia nd technical) by December 31, 1995, and again by December 31,1996, by at least 30 percent of the losses assessed for the preceding year;

(xiii) Agreement to submit to IDA, not later than July 15, 1995, an action plan to meet theabove-mentioned electricity loss reduction targets; and

(xiv) Agreement that the average revenue collection period for electricity sold not exceed60 days by December 31, 1995, 45 days by December 31, 1996 and 30 daysthereafter.

44. be only project-specific condition of credit effectiveness is the execudon of a suibsidiary loanagreement between the Government and ARMENERGO.

45. mternaI onal Waterways. Notification to riparians is not required because the mainanceof the hydropower facilities will not adversely change the quality or quantity of water flows to otherriparians. Also, project activities will not be affected by the use other riparians might make of the water.

46. Ewrnmatal Aspecls. The maintenance of the power facilities will reduce the danger ofequipment failure and improve worker safety. Although neglected due to lack of financial resources, theelectricity disution and dispatch system is basically sound in design from environmental, public health;and safety viewpoints, and the equipment financed will be installed at existing sites without additionaltr g. With the exception of transformer oil, the materials financed are not expected to contihazads chemicals such as PCBs. Bidding documents for transformer oil will specify that the materialnot contain PCBs. A more thorough review of the environmental and safety practices of the electricpower subsector, partIularly the enion l impact o the draw-down of Lake Sevan for powergeeadon, will be conducted prior to arai of the follow-on Power Rehabilitation Project and aftera greater level of normalcy, particularly with regard to fuel supply, has been restored in the country.

12

I any case, the improvement in plant availability and efficiency as a result of the proposed project arenot expeced to add measurably to noxious emissions or to water usage. 'Me proposed project has beenassigned an environm category C.

47. bojec Beeites. Ihe project would arrest the continuing deterioration and costly damageto the selected facilities and alleviate high human and economic costs by improving the reliability ofelectricity supply to critical facilities. In particular, the project would: (i) reduce forced- outages (down-time) of about 550 MW of thermal power capacity and about 315 MW of hydro capacity and preventpremture and costy replacement; (i) restore the-fuel efficiency of the them plants closer to designlevels; (i!l) reucsafaty risl by mtigaftg the chance of cat hic equipment failures; and (v) reducedamage due to the overloading of power facilities. At an average cost of about USS8.0kW of capacityto be mn , the project offers the least cost soludon to preserving installed capacity.

48. Risks. The main sorce of project risk relates to the sustainability of project benets.Deloys in mobilizing international financing to support Armenia's economic recovery (following thelifting of the blockade) woud prolong the poor financial condition of ARMENERGO and its customers.-Tis woud make it difficult to pass the full costs of electicity supply through to consumers and woutdhamper AMNER Os ability to function according to commercial principles. It would also make itdifficult for the government to mobilize fiscal resources to offset the shortfall in revenues, and hence thelikely continued deterioration of infrastructure. With the lifting of the blockade, physical constrain tofad and goods transport (inuding goods financed by the prposed credit) are expected to be alleviated.The remaining risk, mainly fincial in nature, are being addressed by on-going technical assistance andmeasures agreed to under the project (pas. 18 and 38).

49. ed ation. I am satisfied that the proposed credit would comply with the articles ofagement of the Association and recommend that the Executive Directors approve it.

Lewis T. PrestonPresident

Auachments

Washington D.C.November 11, 1994

-. Ef .| ji~1i ii IW

a.~~~.

a~~~~~~~~~: U. i

14

Sdhedule BPage I of 2

ARNMENPOWER MAINEANCE PROJECr

SUMARY OF IPROCUREMEN ARRANGEMENTS'(in USS millions)

procurent MethodNqject Ela t ICB LCB Other N.LFw Total Cost1. Good: Eg t & mA. Generation 3.7 3.5' 7.2

(3.7) (3.S) (7.2)B. Distribution and Dispatch System 2.4 1.4d' 3.8

(2.4) (1.4) (3.8)2., Works: hInalaflatonA. Geneation 0. 5 0.5B. Distntn & Dispatch System 0.3' 0.33. Co_X5j6jdM: Projec 1.2" 1.2

Implmenttionand SCAIDA Study (1.2) (1.2)

4. A. Incrmenta Operating Costs of PlU 0.3"' 0.3

(0.3) (0.3)B. Refinancing of PPF 1.2 1.2

(1.2) (1.2)TOTAL 6.1 7.6 0.8 143

( ̂6.1) (7.6) (-) (13.7)

a/ Figur in paenthoses are the amounts to be financed by the IDA credit.bl N.l.P = Not IDA financed.c/ Of which US$0.8 milion by interational shoppig (IS) and US$2.7 miion for replamtpat bydret co cting.dt Of which US$0.9 million by IS and US$0.5 million for replament pat va direct contating.el Force acount.if Two contats to be procured acoording to Bank guidelines for the use of consultants.St Off6ce supples and lgbical support over project period.

Schedule BPag2 d 2

- . DO I~~~WV CAwIDORY :..-

IDA mleC.t.gsu ~~(ai us satsn wto bie lumed

1. Equipment and Mdataimk 8. IO0% of foreap .xwaltr100% of lbd epeditre (ex-faco cost)85% of klca p. for otier item proured locally

2X T lcne A _ko LO 1D%3. OpratiogCos- 0.3 100%4. PPP R@&ing 1.2S. uniocatmd 2.4

TOTAL 13.7

DISBURSEMENT SCHEULWU'(millon USS)

IDA Find TeOW- 1995 199 1997 199

Aul 22 40 33 5

(LISS) 3.0 5S 4.5 0.7

Cmlt M(% 22 62 95 100

(US$) 3.0 85 13.0 13.7

ei Disbmurnt pro8e reects the proes ugt ma ateAsuming redit effeciv by Mard 15,1995 and including US$12 million for PPF reflundug.

16

Schedule C

-- ARMEA

POWER MANENANCE PROJBCr

Thntable of Key Prject Pr4v ig Events

(a) Tnme taken to Prepare: 11 moths (July 93-May 94)(b) Prepared by: Govere and ARMEN tRGO with assistance from IDA,

USAID and EU-fumded cotsulant(c) First Bank Mission: July 1993(d) Appraisa Mission Departu: Desk Appraisal (Aprfl 1994) authorized by RVP(e) Negotato: October 13, 1994(t) Planned Dato of Effectiveness: March 15, 1995

Bank Staff Responsble for Project Preparatlon

Salman Zaheer, Task Manager (Consultant) Dept. Director: Basil KavalskyIan Jicha, Power Eqgineer (Consultant) Division Chieft Dominique LallementJan Mastson, Operions Analyst Peer Reviewers: Joseph Giling (Energy Eoonomist)Miua Kichigna, Counel Winson Hay (power Enginer)

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MAP SECTION

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a TOWNS VILLAGEST. Nkhic ~~~~~~~~~~~~~MAIN CITIES

rO _akhXchewn') __& t * ^ H>Z7>hinwn * NATIONAL CAPITAL

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- INTERNATIONAL BOUNDARIES

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44' 4' 4r 48'

JANUARY 1994