Document of

The World Bank

Report No: 25592-HR

GEF PROJECT DOCUMENT

ON A PROPOSED LOAN

IN THE AMOUNT OF EUR4.4 MILLION

TO

HRVATSKA ELEKTROPRIVREDA D.D.

(THE NATIONAL POWER UTILITY)

WITH THE GUARANTEE OF THE REPUBLIC OF CROATIA

AND

A PROPOSED GRANT FROM THE GLOBAL ENVIRONMENTAL FACILITY

IN THE AMOUNT OF US$7.0 MILLION

TO

THE REPUBLIC OF CROATIA

FOR

AN ENERGY EFFICIENCY PROJECT

August 5, 2003

Infrastructure and Energy Services Unit

Croatia Country Unit

Europe and Central Asia Region

CURRENCY EQUIVALENTS

(Exchange Rate Effective July 15, 2003)

Currency Unit / = / Kuna (Kn)
Kn 1.0 / = / US$0.152
US$1.0 / = / 6.658 Kn

FISCAL YEAR

January 1 to December 31

ABBREVIATIONS AND ACRONYMS

EBRD / - / European Bank for Reconstruction and Development
EFSAL / - / Enterprise and Financial Sector Adjustment Loan
EMF / - / Environmental Management Framework
ERR / - / Economic Rate of Return
ESCO / - / Energy Service Company
ESMAP / - / Energy Sector Management Assistance Program
FI / - / Financial Intermediaries
FMR / - / Financial Management Report
FRR / - / Financial Rate of Return
GEF / - / Global Environment Facility
GFA / - / Guarantee Facility Agreement
HBOR / - / Croatian Development Bank
HEP / - / Hrvatska Elektroprivreda d.d. (National Power Utility)
HEP ESCO / - / Hrvatska Energy Service Company ( New Energy Service Company)
ICB / - / International Competitive Bidding
NEAP / - / National Environmental Strategy with Action Plan
NGO / - / Non-Government Organizations
PIA / - / Project Implementation Agreement
PIP / - / Project Implementation Plan
SE4 / - / South-East European Energy Efficiency
SME / - / Small and Medium Enterprise
SOE / - / Statement of Expenditure
TAL / - / Technical Assistance Loan
TG / - / Transaction Guarantee
TOE / - / Tons of Oil Equivalent
UNDP / - / United Nations Development Program
UNFCC / - / United Nations Framework Convention on Climate Change
USAID / - / U.S. Agency for International Development
USAID / - / United States Agency for International Development
Vice President: / Johannes F. Linn
Country Director: / Andrew N. Vorkink
Sector Manager: / Henk Busz
Task Team Leader: / Rachid Benmessaoud

CROATIA – ENERGY EFFICIENCY PROJECT

Table of Contents

Page

A. Project Development Objective / 7
1. Project development objective and key performance indicators / 7
2. Global objective and key performance indicators / 7
B. Strategic Context / 7
1. Sector-related Country Assistance Strategy (CAS) goal supported by the project / 7
2. Main sector issues and Government strategy / 8
3. Sector issues to be addressed by the project and strategic choices / 9
C. Project Description Summary / 12
1. Project components / 12
2. Key policy and institutional reforms supported by the project / 14
3. Benefits and target population / 14
4. Institutional and implementation arrangements / 14
D. Project Rationale / 25
1. Project alternatives considered and reasons for rejection / 25
2. Major related projects financed by the Bank and other development agencies / 26
3. Lessons learned and reflected in the project design / 27
4. Indications of borrower commitment and ownership / 27
5. Value added of Bank support in this project / 28
E. Summary Project Analysis / 28
1. Economic / 28
2. Financial / 29
3. Technical / 30
4. Institutional / 31
5. Social / 33
6. Environmental / 34
7. Participatory Approach / 35
7. Safeguard Policies / 36
F. Sustainability and Risks / 36
1. Sustainability / 36
2. Critical risks / 39
3. Possible controversial aspects / 40
G. Main Loan Conditions / 40
1. Board Conditions / 40
1. Effectiveness Conditions / 40
2. Other / 41
H. Readiness for Implementation / 41
I. Compliance with Bank Policies / 41

Annexes

Annex 1: Project Design Summary / 42
Annex 2: Detailed Project Description / 46
Annex 3: Estimated Project Costs / 51
Annex 4: Cost Benefit Analysis Summary and Incremental Analysis / 55
Annex 5: Financial Summary / 61
Annex 6A: Procurement and Disbursement Arrangements / 67
Annex 6B: Financial Management Assessment / 77
Annex 7: Project Processing Schedule [to be completed] / 80
Annex 8: Documents in the Project File [to be completed] / 81
Annex 9: Statement of Loans and Credits / 82
Annex 10: Country at a Glance / 83
Annex 11: Energy Efficiency Market Analysis Summary / 85
Annex 12: STAP Review and Team’s Response / 91
Annex 13: Focal Point Endorsement Letter / 96
MAP
A: Project Development Objective

1. Project development objective and key performance indicators: (see Annex 1)

The objective of the proposed project is to increase the demand for and supply of energy efficiency projects and services. This will be achieved by:

(i)creating a core developer of energy efficiency projects within Hrvatska Elektroprivreda d.d. (HEP—the national power utility). This new energy service company (HEP ESCO) will develop, finance and implement energy efficiency projects on a commercial, for-profit basis, using local businesses as key delivery agents; and

(ii)providing a framework for other emerging service providers to tap into new energy efficiency business opportunities.

Development objective indicators to be used during supervision include:

  • Market response and consumer acceptance of the HEP ESCO offerings
  • Number of service providers
  • Number of local banks engaged in energy efficiency financing, and lending activity
  • Track record of performance of commercially viable energy efficiency projects

Implementation progress indicators to be used during supervision include:

  • HEP ESCO sales and profitability
  • Energy savings achieved
  • Payback period per project
  • Share of projects reaching financial closure
  • Local banks’ lending volume and co-financing mix

2. Global objective and key performance indicators: (see Annex 1)

The project’s global objective is to overcome three barriers to energy efficiency market development and financing: (i) lack of capacity and know-how; (ii) lack of development and project financing; and (iii) lack of consumer demand. Removal of these barriers will create a sustainable market for economically viable energy efficiency projects and services, and achieve national and global environmental benefits.

Performance indicators for this global objective include:

  • Market Transformation Indicators:
  • Value of energy efficiency projects implemented by HEP ESCO and others
  • Energy efficiency financing provided by commercial banks
  • Number of firms actively engaged in provision of energy efficiency services
  • Availability and price of energy efficiency products in Croatia
  • Market penetration and growth by market segment and types of users
  • Global Benefit Indicators:
  • Reduction in greenhouse gas emissions, at national and project levels

B: Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project

Document number: 19280 HRDate of latest CAS discussion: June 3, 1999

and CAS progress report: August 22, 2001

The project supports two of the objectives laid out in the Bank’s Country Assistance Strategy for Croatia (and updated in the White Paper). The first is making the institutional changes and investments needed to ensure an efficient energy supply in an environmentally sustainable manner at realistic but socially acceptable prices. The second is achieving financial sustainability and efficient operations for public enterprises. The project will support both objectives by addressing market and institutional failures to promote the development and financing of energy efficiency projects and protect the environment. This will be achieved by

  • Establishing a utility-based energy service company (HEP ESCO) to develop the market for energy efficiency projects, finance their implementation, and create business opportunities for private providers of energy efficiency goods and services as partners to HEP ESCO;
  • Maximizing local co-financing of energy efficiency projects by using innovative financing mechanisms that reduce some of the perceived high risks of those projects and mitigate the rigid collateral requirements imposed on these projects by local financiers; and
  • Creating a framework for other emerging service providers to capture some of the energy efficiency market potential.

Increasing energy efficiency among private and public end users will lead to energy savings and lower supply costs, reduce the impact of tariff reforms, and contribute to a transition to energy services that are provided in a competitive and environmentally sustainable manner with adequate regulatory oversight.

1a. Global Operational strategy/Program objective addressed by the project:

The project is consistent with the objectives of GEF Operational Program 5: Removal of Barriers to Energy Efficiency and Energy Conservation. Section 5.7 of OP5 includes support for activities that remove barriers to achieve local, national, and global benefits.

The project will help Croatia’s Government meet its international environmental obligations and has been endorsed by the GEF focal point.

Croatia signed the UN Framework Convention on Climate Change (UNFCC) on June 11, 1992 and ratified it on April 8, 1996. It completed the first national communication on climate change activities in December 2001, which was submitted to the UNFCCC on February 7, 2002. Croatia’s National Environmental Strategy with Action Plan (NEAP), completed in 2001, calls for incorporating environmental protection costs in energy prices, encouraging the use of environmentally friendly fuels in thermal and electrical energy generation, and investing in energy efficiency.

2. Main sector issues and Government strategy:

Croatia faces a growing imbalance of energy demand and domestic supply. While two-thirds of its energy requirements are currently met from domestic production, mainly oil and gas, domestic production of primary fuels is declining. Energy imports will need to increase considerably if economic recovery is to be sustained. Electricity imports that are mostly thermal-based have almost doubled since 1995, and account for 22% of domestic consumption in 2001, despite increased electricity production at all domestic power plants. Since the war ended, investments have focused on repairing war damages. Years of under-investment and decapitalization and delayed restructuring in the gas and power sector have undermined productivity and raised costs for users. Large investments would be needed to rebuild and expand the energy supply infrastructure.

Aggravating the energy supply problems is a very inefficient use of energy. Some 25% of current energy consumption could be saved by improving district heating, 20-30% by incorporating energy efficiency measures in the design, construction, and use of houses and buildings, and another 50% in upgrading street lighting systems. More energy-efficient products and services in these areas alone could save Croatia at least US$50 million per year in energy costs, based on investments in energy efficiency of US$40 million per year over the next ten years. Other energy savings in the industrial and small individual building sectors could easily bring the total energy cost saving potential for Croatia to at least US$100 million annually.

As a result of the difficulties in the energy sector and the inefficient supply structure, energy costs are relatively high in Croatia. Energy prices have moved towards cost recovery levels, and retail tariffs are now about 77 USD/MWh for electricity and 7.4 USD/GJ for district heat. However, further tariff reforms are needed to cover supply costs, eliminate distortions within and between fuels, and promote optimal fuel use while meeting social goals.

To complete post-war recovery and achieve energy security, the energy sector needs transparent regulation, more competition and private sector participation, increased use of market mechanisms, and tariffs based on supply costs, as well as concrete programs for increasing energy efficiency and developing renewable energy resources. Those major energy sector restructuring and reform activities were developed with support from the World Bank and, more recently, the U.S. Agency for International Development (USAID). They are part of the Government of Croatia’s (GoC) Energy Strategy and codified in the Energy Law, approved in July 2001. The law also calls for local authorities to participate in national energy efficiency programs, to integrate energy efficiency activities into their development plans, to establish local energy efficiency action plans, and to report annually to the government on the savings achieved. But implementation of energy sector reforms has been slow, particularly the restructuring of the national power company, HEP. The implementation of energy efficiency projects has so far been precluded by the lack of knowledgeable providers of energy efficiency services, of funding, and of an enabling framework. The project will address the need to move ahead with energy efficiency investments by substantially removing those barriers.

3. Sector issues to be addressed by the project and strategic choices:

3.1.Barriers to energy efficiency

The provision of more energy-efficient products and services could reduce the pressure for increased energy imports and for investments in energy supply infrastructure, and ease the burden of high-energy costs. Despite the huge potential for savings, no significant private or public entity is actually developing and implementing energy efficiency projects in Croatia. The most daunting barriers are:

  • Lack of development and project financing. In a survey of over 150 companies, 78% of the respondents cited the lack of development and initial project financing as the main barrier. Typically, energy efficiency projects are small, and the associated risk of development costs can be quite high, particularly during the initial period during which new energy service companies develop capacity and expertise. The lack of an institutional framework to streamline project design, financing, implementation or verification, adds considerably to development costs of each project. In addition, the credit-worthiness of end users, who pledge assets as well as revenues streams for energy efficiency investments, is either weak or unknown. The Croatian commercial banks are generally lukewarm about providing longer-term financing needed for new business, especially for energy efficiency. As a result, no financial institution has so far financed energy efficiency projects.
  • Lack of capacity and know-how among key stakeholders. Information on the effectiveness of energy efficiency measures is lacking. Moreover, service and equipment suppliers (including HEP), lenders, investors, users, and other potential actors are unwilling or unable to learn more about the ways to structure, finance, and operate energy-saving projects. Such knowledge together with proper dissemination mechanisms is crucial for the sector to become commercially sustainable.
  • Lack of consumer demand. Despite the significant potential, energy end users—municipalities, private industries, commercial building owners, and residential building occupants—do not have enough information to make decisions about investing in energy efficiency projects.

3.2.Strategic choices

The four strategic choices followed under the project to overcome the above three barriers include:

Choice of ESCO mechanism. Energy service companies (ESCOs) use a performance-contracting principle to deliver turn-key energy efficiency services and financing. Through a partnership between the end-user, the lending bank, and the ESCO, investments are financed and implemented that reduce the consumer's energy consumption. The ESCO provides project financing for own equity and debt resources. End users benefit, at no risk or no upfront cost, from the facility improvement created by the energy saving investments. The cost of the investments is repaid from the consumer’s energy savings. Such “paid-out-of savings” projects do not result in incremental debt for the consumer. These projects also create a risk sharing arrangement whereby the ESCO retains the technical performance risk and the bank underwrites the end-user credit risk (which is the bank’s core business).

Choice of utility-based HEP ESCO. The rationale for starting the program with HEP ESCO is to capitalize on HEP’s substantial operating experience, strong knowledge of its customer base, the benefits of energy saving opportunities from the utility’s point of view, and the financial strength of the parent utility that provides a comfort level to commercial banks in a new business venture. HEP ESCO will demonstrate the commercial viability of energy efficiency investments and how stakeholders and beneficiaries can overcome technical and financial barriers to implementation. Initial projects would be able to show successes early in the project and build capacity and transfer skills and know-how to project partners, who can pursue independent initiatives thereafter. This contributes to a greater likelihood of replicability of energy efficiency investments, expanding the impact of the program far beyond the direct investments targeted by HEP ESCO.

Choice of markets, eligible energy efficiency projects and clients. HEP ESCO’s primary activities will be in markets with substantial replication potential and where it has natural opportunities to demonstrate the ESCO mechanism. These opportunities follow from the relationship with HEP and its relatively easy access to HEP’s electricity and heat customers in the municipal, street lighting, educational and multiple residential sectors. These target markets coincide with those in which ESCOs were successful in North America and some West-European countries. Eligible energy efficiency projects for this program shall be investments for plants and equipment aimed at improving efficiency of energy use in buildings and facilities, including investments in heating systems (small thermal and cogeneration plants and district heating systems upgrades), but excluding industrial processing. Investments must be for new projects, not refinancing existing projects, and for projects using proven technology that are developed with competent energy audit/feasibility studies and include energy savings monitoring plans. Greenfield projects using high efficiency technologies/systems may be supported, provided an appropriate energy baseline can be established. Having a broad range of eligible types of energy efficiency projects and eligible end users will make the program more useful commercially, and will increase its utilization. See Annex 11 for the Market Analysis.

Choice of funding mechanisms. Funding mechanisms were designed to address the barriers specific to each activity supported by the project.

  • An IBRD loan will co-finance energy efficiency projects carried out by HEP ESCO. The loan will be used by HEP ESCO to procure goods, and works and services to realize energy saving investments for its clients. IBRD financing will be disbursed in co-financing arrangements with local banks. IBRD financing will be a declining proportion of total HEP ESCO investments over time, to ensure sustainable local commercial financing.
  • A GEF contingent grant will support development of a ‘pipeline’ of potential projects, project development costs and early HEP ESCO saving investments. First, it addresses the current lack of funding in the market for development costs (such as feasibility studies), and will promote increased development of projects. Development costs will be recovered from those projects that reach financial closure and move to implementation. Second, it will provide bridge-financing, enabling HEP ESCO to move ahead with investments and demonstrate first year savings that might convince banks to provide commercial refinancing. Recovered funds will be re-applied to other development activities, thereby extending the reach of the program beyond the projects initially developed. Moreover, such development activities will increase learning and know-how.
  • A GEF credit enhancement facility will help overcome commercial banks’ concerns for energy end user credit risks. Credit enhancement is needed to ensure early involvement of local banks in co-financing initial projects, and mitigate the risks of client default in payment obligations to HEP ESCO, other energy service providers or commercial lenders. This facility is intended to be a credit risk management tool for participating banks and to partially substitute for collateral typically required by banks, thus allowing banks to offer more finance on more attractive terms. The facility will also encourage banks to incorporate the value of energy cost savings into the assessment of an end user's available free cash flow and ability to repay the loan.
  • A GEF technical assistance grant will support capacity building among stakeholders, including HEP ESCO staff, energy users, energy efficiency equipment and service suppliers, commercial banks, non-government organizations (NGOs), and government agencies. It will also support GEF environmental monitoring, reporting and dissemination of project results and best practices.

3.3.Cooperation with other donors