PROJECT INFORMATION DOCUMENT (PID)

APPRAISAL STAGE

Report No.: AB1482

Project Name

/ ENERGY SECT REF
Region / EUROPE AND CENTRAL ASIA
Sector / Power (100%)
Project ID / P083702
Borrower(s) / UKRAINE
Implementing Agency
Environment Category / [ ] A [X] B [ ] C [ ] FI [ ] TBD (to be determined)
Date PID Prepared / March 23, 2005
Date of Appraisal Authorization / March 3, 2005
Date of Board Approval / June 16, 2005
  1. Country and Sector Background

After a decade of economic decline, which halved the country’s economic output and raised the poverty rate to almost a third of population, GDP has rebounded by over [30%] since 2000, and indications are that the poverty rates are beginning to decrease. The recent economic growth in Ukraine has been a mixture of revival of old and emergence of new activities, both supported by access to inexpensive energy supplied from aging, inefficient and often environmentally polluting sources through extensive electricity, gas and oil networks inherited from the former Soviet Union. Furthermore, the low priced domestic coal (and electricity) is one of key resources helping the revival of the steel industry which accounted for 37% of the total exports of Ukraine in 2003. Ukraine now faces the difficult task of ensuring the sustainability of the economic growth and the consolidation of market reforms which are critical if the country is to fulfill its stated aspirations with regard to increasing integration with the European Union (EU) and with the World Trade Organization (WTO).

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

Ukraine has made considerable progress in energy sector reform which started with the restructuring and corporatization in the oil, gas, and power sectors in 1994. As a result of its reform effort, Ukraine unbundled its power industry[1], introduced elements of competition on the wholesale electricity market (WEM) and the coal market, and liberalized the oil market. In dealing with the aftermaths of the 1999 financial crises, the Government (of then Prime Minister Yushchenko) has been reasonably successful in reducing non-payments and in moving tariffs towards cost recovery levels. It has established the National Energy Regulatory Commission (NERC) which is steadily building its capacity and has opened the energy sector to private investors. Annex 1 provides an overview of main issues that constrain further improvements in sector performance and key reform measures needed in the power, coal and gas sub-sectors. The common problems affecting all three sub-sectors are outlined below.

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

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

Electricity sector restructuring, privatization and market liberalization, which started in the mid-1990s, slowed down after 2001 when financial discipline in the “single buyer” electricity market was strengthened by increasing NERC’s control over its financial flows. While this measure helped reduce the non-payment problem, it could not compensate for the low tariffs and the lack of market competition in fuel (coal and gas) supply which stifle competition among thermal power producers and further undermine their poor financial viability. A failure of the state management to address increasing financial strains in the power sector prompted the Government’s decision to merge the remaining state-owned power generation and distribution assets (except the nuclear power company) into a single holding – Energy Company of Ukraine (ECU) in June 2004. ECU in many ways resembles the state owned, vertically integrated gas company, Naftogaz, but unlike Naftogaz which has a monopoly in the gas market, ECU does not control the whole power market and most importantly it does not control the high voltage transmission network and power dispatch. A similar increase in market concentration occurred in the coal sector after the Government merged all state-owned coal mines into a national holding company – Coal Company of Ukraine (CCU) in October 2004. The separation between political and economic functions through the creation of national holding companies in the energy sector is expected to help commercialize state-owned enterprises, reduce costs and improve financial discipline. The Government action plan recognizes that meeting these objectives requires the improvement in corporate governance of state-owned energy enterprises and the strengthening of NERC’s independence and capacity in order to mitigate risks of monopoly abuses which arise from the growing market concentration. Furthermore, the Government is committed to develop a strategic action plan for continuing ownership transformation and attracting private sector investments in the energy sector.

  1. Objectives

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

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

-  Increased production of hydroelectric energy by 360 GWh;

-  Increased (winter firm) hydropower capacity by 250 MW;

-  Reduced O&M costs in rehabilitated hydropower plants by 20%; and

-  Reduced emissions from thermal power plants due to the increased production of hydroelectric energy.

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

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

Advancing energy sector reform and ensuring sustainable provision of reliable, affordable and environmentally acceptable energy services is crucial for improving the investment climate in Ukraine, which has a high concentration of production and exports in energy intensive industries. From this point of view, key aspects of the proposed Energy Program are: (i) resolution of large debts accumulated in the energy sector; (ii) reduction and ultimate elimination of subsidies in the sector both explicit (for coal) and implicit (for gas and electricity); (iii) improvement of financial solvency and corporate governance of state-owned energy enterprises; (iv) strengthening the independence of NERC; (v) improvement of security, reliability and quality of the energy supply; and (vi) capacity building in the Ministry of Fuel and Energy (MFE) and NERC.

Ukraine’s location on the main corridor for energy trade between Russia and the EU[3] and the country’s large energy resources and infrastructure make energy sector reform and sustainable development essential for integrating Ukraine into the global economy, including its membership in WTO. The proposed Energy Program would support Ukraine’s aspirations with regard to legal and technical harmonization and increasing integration of its energy market with the EU Internal Energy Market. Strengthening energy interconnections and opening access to the EU electricity market will improve energy security and the reliability of energy supply in the whole region and result in significant economic benefits for all market participants. Furthermore, the proposed Energy Program would help Ukraine benefit from its large surplus of GHG emission reductions under the Kyoto Protocol. This would also help other countries (i.e. developed countries) meet their obligations under the Protocol and jointly mitigate the impacts of the growing energy demand on the global climate.

  1. Rationale for Bank Involvement

The Bank has supported Ukraine in its efforts to reform and restructure its energy sector through policy dialogue, technical assistance and financing of adjustment and investment projects since the early 1990s. The Bank prepared several energy sector policy notes[4] in the last two years, which reviewed the results of the first decade of transition and mapped a way forward for a more strategic sector-wide approach. This deep country and sector knowledge puts the Bank in a strong position to provide policy advice, lending and technical assistance to further support energy sector reform and sustainable development. Through the proposed Energy Sector Reform and Development Program (the Energy Program) – based on the Government action plan for financial stabilization of the energy sector – the Bank would provide sector-wide support for sustainable energy development which, in Ukraine, requires coordinating and adapting financial support, policy advice and technical assistance to a rapidly changing and growing economy.

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

Cooperation in the energy sector is high on the agenda of several donors, notably the European Commission (TACIS), and Governments of Japan (PHRD) and Sweden (Sida), although the overall donors support to the sector declined in the last few years after USAID and CIDA reduced its assistance and focused on the Chernobyl sarcophagus project and the nuclear safety. The Bank, through the multi-donor agency PPIAF, is also providing support for the further development of WEM. The enhanced cooperation in the energy sector is an important element of the EU-Ukraine Action Plan which was signed in February 2005. This Action Plan outlines a number of concrete steps required to harmonize the structure, regulatory framework and operation of the Ukraine energy market with the EU Internal Energy Market. Two recently approved TACIS projects will support Ukraine’s progressive participation in the trans-European gas and electricity networks. The proposed Energy Program would help implement priority reforms and investments identified in these technical assistance projects, and, thus, it would facilitate the implementation of the EU-Ukraine Action Plan. Furthermore, the proposed Energy Program would help establish a framework for sector-wide cooperation and partnership among the Bank, EBRD and bilateral donors in assisting Ukraine to reform and to further develop its large and strategically important energy sector.

Ukraine is the 11th largest emitter of Greenhouse Gases (GHGs) in the world[5] and has one of the largest “surpluses” of emission reductions (estimated at about 1.8 billion tons of CO2 equivalent) compared to the 1990 baseline emissions under the Kyoto Protocol (KP). GHG emissions in the energy sector of Ukraine account for about 75% of all GHG emissions in the country. The energy sector offers ample opportunities for cost-effective reduction of GHG emissions which could be used to attract significant financial support through the KP mechanisms to meet growing investment needs in the sector. Unfortunately, institutional capacity, which is necessary to implement KP mechanisms, is low in Ukraine and the country is poorly prepared to capitalize on this opportunity, which, at the same time, would help other countries (i.e. developed countries) meet their obligations under the KP. Through its unique Carbon Financing (CF) experience and the pivotal position in the Carbon Market, the World Bank can help Ukraine build its institutional capacity in this area and mobilize CF support for Joint Implementation (JI) projects in the energy sector, which would also provide a valuable learning experience for further use of KP mechanisms.