Document ofThe World Bank

Report No: 22303-YU

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED GRANT

IN THE AMOUNT OF US$6.0 MILLION EQUIVALENT

TO THE

FEDERAL REPUBLIC OF YUGOSLAVIA

FOR A

ELECTRIC POWER EMERGENCY RECONSTRUCTION PROJECT

June 25, 2001

Energy Sector UnitSouth East Europe Country UnitEurope and Central Asia Region

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CURRENCY EQUIVALENTS(Exchange Rate Effective May 30, 2001)

Currency Unit - Yugoslav Dinar1 Din. US$0.0144

US$1 =69.6 Din.

FISCAL YEARJanuary I - December 31

WEIGHTS AND MEASURESkV = kilovolt (1,000 Volts)kWh = kilowatt hourMWh = Megawatt hour (= 1,000 kWh)GWh = Gigawatt hour (= 1,000,000 kWh)TWh = Terawatt hour (= 1,000,000,000 kWh)MW = Megawatt (1,000,000 watts)

ABBREVIATIONS AND ACRONYMSEAR - European Agency for ReconstructionEBRD - European Bank for Reconstruction and DevelopmentEIRR - Economic Internal Rate of ReturnEMP - Environmental Management PlanEPS - Electric Power Company of SerbiaFMS Financial Management SystemFRY Federal Republic of YugoslaviaGOY - Government of the Federal Republic of YugoslaviaGOS - Government of Republic of SerbiaHV - High VoltageIAS - International Accounting StandardsIBRD - Intemational Bank for Reconstruction and DevelopmentICB - Intemational Competitive BiddingIS - International ShoppingLACI Loan Administration Change InitiativeMTR - Mid-term ReviewMV - Medium VoltageN/A - Not applicableNIS - Oil Industry of SerbiaPCB - Polychlorinated BiphenylPIU - Project Implementation UnitPMR - Project Management ReportSA - Special AccountSIDA - Swedish International Development AgencySOE - Statement of ExpendituresTFFRY - Trust Fund for FR YugoslaviaTA - Technical AssistanceUSAID - United States Agency for Intemational DevelopmentVAT - Value Added Tax

Vice President: Johannes LinnCountry Director: Christiaan PoortmanSector Manager: Henk Busz

Team Leader: Dejan Ostojic

FEDERAL REPUBLIC OF YUGOSLAVIAELECTRIC POWER EMERGENCY RECONSTRUCTION PROJECT

CONTENTS

A. Project Development Objectives ............................................................... 2

1. Project development objectives ............................................................. 7 22. Key performance indicators ............................................................... 2

B. Strategic Context .............................................................. 2

1. Sector-related Country Assistance Strategy goal supported by the project ............ 22. Main sector issues and Government strategy .............................................. 33. Sector issues to be addressed by the project and strategic choices ...................... 5

C. Project Description Summary .............................................................. 7

1. Project components ............................................................... 72. Project costs .............................................................. 73. Financing plan .............................................................. 74. Key policy and institutional reforms supported by the project .......................... 75. Benefits and target population .............................................................. 86. Institutional and implementation arrangements ........................................... 8

D. Project Rationale .............................................................. 10

1. Project alternatives considered and reasons for rejection ................................ 102. Lessons learned and reflected in the proposed project design ........................... 103. Indications of grantee commitment and ownership ....................................... 114. Value added of Bank support in this project ............................................... 11

E. Summary Project Analyses .............................................................. 11

1. Economic .............................................................. 112. Financial ............................................................... 123. Technical .............................................................. 124. Institutional .............................................................. 135. Environmental assessment ............................................................... 146. Social .............................................................. 157. Participatory approach .............................................................. 15

F. Sustainability and Risks .............................................................. 15

1. Sustainability ...................................................... 152. Critical risks ...................................................... 16

G. Main Grant Conditions .............................................................. 16

1. Effectiveness conditions .............................................................. 162. Agreements reached during negotiations ................................................... 17

H. Readiness for Implementation ......................... 17

I. Compliance with Bank Policies ......................... 17

Annexes

Annex 1 Project Design Summary .18Annex 2 Detailed Project Description .19

Table A Electricity Production in Serbia in 2000 .19Table B Operating Statistics of Thermal Power Unit Kostolac A2 .21

Annex 3 Estimated Project Costs .24Annex 4 Procurement Arrangements .25

Table A Project Costs by Procurement Arrangements .25Table B Consultant Selection Arrangements .27Table C Thresholds for Procurement Methods and Prior Review .27Table D Procurement Plan .28

Annex 5 Disbursement and Financial Management Arrangements .30Table A Allocation of Grant Proceeds .30Table B Estimated Disbursement Schedule .30

Annex 6 Project Processing Budget and Schedule .33Annex 7 Boiler Damage in Thermal Power Plant Kostolac A .34Annex 8 Documents in Project File .35Annex 9 Statement of Loans and Credits .36Annex 10 Country at a Glance .37

Map IBRD 31501

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FEDERAL REPUBLIC OF YUGOSLAVIAElectric Power Emergency Reconstruction Project

Project Appraisal Document

Europe and Central Asia RegionECC04 Country Unit

Date: June 25, 2001 Team Leader: Dejan OstojicCountry Director: Christiaan Poortman Sector Manager: Henk BuszProjectID: SF-P074136-LEN-BB Sector: EnergyLending Instrument: WB Trust Fund

Poverty Targeted Intervention: [ ] Yes [x] NoProject Financing Data

[ ] Loan [ ] Credit [x] Grant [] Guarantee [] Other [Specify]

For Loans/Credits/Others:Amount (US$m): US$6.0 millionProposed terms: [] To be defined [] Multicurrency [x] Single currency, US$

[] Standard Variable [] Fixed [ LIBOR-basedGrace period (years): N/AYears to maturity: N/ACommitment fee: N/AFront-end fee on Bank loan: N/A

-Z _Sburce~~,< aEPS 1.2 1.0 2.2IBRD 4.1 1.9 6.0SIDA 1.5 1.5Russian Suppliers' credits 8.7 8.7Chinese Suppliers' credits 1.6 1.6Total: 5.3 14.7 20.0Grant recipient: Federal Republic of YugoslaviaGuarantor: N/AResponsible agency: EPSEstimated disbursements (Bank FY/US$M):

200.Annual 0.0 5.0 1.0 0.0 0.0 0.0

Cumulative 0.0 5.0 6.0 0.0 0.0 0.0

Project implementation period: June 2001 - December 2002Expected effectiveness date: July 1, 2001 Expected closing date: June 30, 2003Implementing agency: EPS

Contact person: Danica Vukovic, Assistant General ManagerAddress: Balkanska 13, 11000 Beograd, Yugoslavia

Tel: (+381-11) 361-1304 Fax: (+381-11) 688-835 E-mail: dana.vukovic2t)eVs.co.yu

A: Project Development Objectives

1. Project development objectives

The proposed project is of an emergency nature and aims to help restore reliable electricity supplyin Serbia through urgent repairs of power facilities affected by lack of maintenance and damageduring the Kosovo conflict. Additional objectives are to improve the financial management systemof the Electric Power Company of Serbia (EPS) and to support the Serbian Ministry of Mining andEnergy in preparing an Energy Policy Statement and drafting a new Energy Law.

The project would provide support for increasing available generating capacity through repair of a210 MW unit in thermal power plant Kostolac A (representing 60% of capacity currently out ofoperation) and for improving reliability of the transmission network through reinforcement of thetransmission substation Sremska Mitrovica, which is key for the import of electricity and a reliableoperation of high voltage power grid. The 210-MW unit in Kostolac A has been out of operationsince March 2000 when its boiler's super-heater collapsed due to accumulated fatigue of thesupporting structure. The 300 MVA substation in Sremska Mitrovica became a bottleneck in thetransmission system after the break of the 400 kV tie line between Serbia and Croatia in 1991. Theload growth during the 1990s and the weakening of the transmission network due to damagecaused by the Kosovo conflict caused an overloading (up to 130%) of transmission lines connectedto Sremska Mitrovica substation.

2. Key performance indicators (the full set of performance and monitoring indicators is inAnnex 1):

Progress towards the development objectives would be monitored according to a set of indicatorsdeveloped during project preparation with the assistance of the Beneficiary. These include:

* Returning to operation unit A2 (210-MW) in thermal power plant Kostolac A;* Reinforcement of the Sremska Mitrovica transmission substation and its connection to the

400 kV network;- Introduction of a modem financial management system in EPS;

Issuance of an Energy Policy Statement by the Government of Serbia; and* Preparation of a draft Energy Law.

B: Strategic Context

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

The Bank's assistance program for FY02 is outlined in the Transitional Support Strategy (TSS) forthe Federal Republic of Yugoslavia (FRY). The first phase of the program (pre-membershipassistance) is supported under a special Trust Fund for FRY (TFFRY) established by the Board ofDirectors on March 13, 2001.

The proposed project supports the TSS goal of coordinating with other donors and raising urgentlyneeded funding that will complement a larger program to help restore electricity generation andtransmission capacity before the next winter. The project also supports the pre-membershipobjective of laying the foundation for sectoral reforms, through the introduction of a soundfinancial management system in EPS and the provision of technical assistance to the SerbianMinistry of Mining and Energy for the development of a new Energy Policy Statement.

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2. Main sector issues and Government strategy:

(a) Strategic Setting

The electric power sector suffered considerable damage during the 1999 Kosovo conflict with itsgeneration stations, transmission lines and substations being specific targets of bombing. Sincethat time, the stability of the power system has been maintained only by imposing rolling blackoutsin parts of the system and importing substantial quantities of electricity from neighboring countries(a total of 3.5 TWh was imported in 2000). It is estimated that in 2001, even assuming a doublingof electricity prices and a commensurate demand response, an additional 2.5 TWh of electricityimports will be required to meet demand due to the need to take domestic generating units out ofoperation for critical repairs. As a result, the priority needs for the near-term include continueddonor support for electricity imports, emergency repair of generation plants, and reinforcement ofkey substations and transmission lines to ensure a stable supply of electricity and, in particular, ofimports.

(b) Power sector structure

The electric power industry of Serbia (excluding Kosovo) is the responsibiJity of EPS, a verticallyintegrated, state-owned utility. EPS comprises three public enterprises for coal production, six forpower generation, one for power transmission and ten for power distribution. The power sector isregulated by the Ministry of Mining and Energy of the Republic of Serbia and electricity tariffs areapproved by the Govemment of Serbia.

Coal production. The coal sector in Serbia proper comprises two large lignite mining operationsand eight small underground mines. The lignite produced in the Kolubara and Kostolac mines is ofabout the same quality (7.5 GJ/ton) and practically their entire production is used for powergeneration. The production of lignite decreased from 34.1 million tons per year in 1990 to 32million tons per year in 2000. The underground mines produce brown coal (15 GJ/ton) which issold on the market for general purposes.

Generation. EPS has 18 generation plants with a total installed capacity of 7,580 MW. Thisincludes 4,290 MW at six thermal power plants, 2,770 MW at nine hydropower plants and 520MW at three combined heat and power (CHP) plants which use oil and gas. The available capacityof the thermal power plants is only about 76% of the installed capacity due to lack of maintenance,design deficiencies, and war-related damages. Thermal power plants produced 19.1 TWh in 2000,which accounted for 64.5% of total electricity production. The remaining production came frornhydropower plants (34.8%) and CHP plants (0.7%).

Transmission. The high voltage transmission system of Serbia has three voltage levels: 400 kV (9substations and 1,559 km of transmission lines), 220 kV (18 substations and 2,187 km oftransmission lines) and 110 kV (57 substations and 6,445 km of transmission lines). The powergrid is interconnected with power systems in all neighboring countries providing for the exchangeand trade of electricity on a regional basis. The transmission system was heavily damaged duringthe Kosovo conflict in 1999. Although power interconnections with neighboring countries havebeen reestablished, the reliability of the power grid in Serbia is low and requires significaintimprovement in order to ensure a stable supply of imports, that will required to meet about 10% oftotal electricity demand in Serbia in 2001.

Distribution. Distribution of electric energy is the responsibility of ten distribution companiescovering an area of 77,336 km2 (excluding Kosovo). The total number of customers in 1999 was

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3,064,216 including 3,275 customers at voltage levels higher than 0.4 kV. The total installedcapacity in primary distribution substations (HV/MV) was 13,130 MVA and in secondarydistribution substations (MV/0.4 kV) was 13,420 MVA.

(c) Government and International Donor Response

The new Government of Serbia (GOS) was formed in December 2000 following dramatic politicalchanges in FRY in October 2000. In response to the energy crisis, which threatened to cause majordisruption in electricity and heating supply during the winter, the GOS urgently requested andreceived support from the donor community. Initially, donor support focused on providing fuel andelectricity, amounting to about US$100 million, including ongoing programs. The EU allocatedUS$53.2 million for imports of fuel and electricity. In addition, several bilateral donors are fundingvarious components in this program including fuel imports supported by Italy (US$19.5 million),Norway (US$2.2 million), Canada (US$ 1.4 million) and Switzerland (US$1.2 million) and importsof electricity funded by Germany (US$10.8 million) and USAID (US$10.0 million). As ofFebruary 2001, commitments for support of fuel and electricity imports during 2001 amounted toabout US$35 million including imports of fuel to be funded by the EU (US$18.8 million) andSwitzerland (US$1 million) and imports of electricity to be funded by Greece (US$15 million).Finally, an agreement was reached with Russia in December 2000 for the continued supply ofnatural gas to Serbia despite a large debt to Gazprom (see Sector Issues) as long as new deliveriesare paid.

While the need for imports of electricity will remain an important area of donor support in 2001and 2002, most donors have shifted the focus of their programs towards the supply of spare partsand equipment needed for repair and maintenance of power facilities. Projects underimplementation for the supply of spare parts and equipment amount to about US$11.8 million,including projects funded by the EU (US$4.2 million), Switzerland (US$2.8 million), Germany(US$2.3 million), Sweden (US$1.9 million) and Austria (US$0.6 million). Based on theirexpressions of interest, it is estimated that bilateral donors will contribute an additional US$45million for spare parts, equipment and other activities in support of power sector reconstruction.Projects which are currently under preparation amount to about US$21 million, including powergrid equipment to be funded by Canada (US$10 million), spare parts and energy efficiency pilotprojects (USAID - US$5 million), transmission equipment (Switzerland - US$3 million),distribution equipment (Denmark - US$2.2 million) and power plant equipment (Czech Republic -US$0.7 million).

A major investment program proposed by the EU for 2001 aims to stabilize power production,improve reliability of supply and prevent further deterioration of the power system. Activities to besupported under the program include repairs and overhaul of four generating units in thermalpower plants (US$28 million), repairs and/or replacement of essential equipment in open-pit coalmines (US$15 million), reconstruction and rehabilitation of transmission substations and overheadlines (US$20 million) and replacement of distribution substations and cable feeders (US$5million). The program will also include technical assistance (US$2.7 million) to strengthen EPS'capacity for implementation of large rehabilitation projects, introduction of higher electricitytariffs, reduction of non-technical losses and transition of the utility into commercially viable andmarket-oriented operation.

As of April 15, 2001, the Govemment of Serbia increased the price of electricity by 60% andannounced a further increase in June 2001 (40%) and a possible additional increase in October2001 (46%). The price increase was combined with the establishment of new tariffs whichintroduced a block tariff system and eliminated a daytime off-peak discount. The result was a sharp

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reduction of peak load (about 100 MW in May 2001 compared to May 2000) and a flattening of theload demand curve, which reduced generation reserve requirements. The total energy demand,however, did not change significantly.

A critical risk for achieving the Government's and donors' objectives is the lack of financing forequipment installation and other local costs due to the poor financial condition of EPS. Theproposed project will reduce this risk by providing financing for local costs and helping tocomplete some of the most urgent repairs in the Fall of 2001 in order to avoid a repeat of theelectricity shortages and associated blackouts that occurred last winter.

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

Sector issues

The electric power system is now operating at the very edge of safety and with increasing outagetimes of main equipment, which necessitates load shedding and rolling blackouts throughout thecountry. The new Government has already undertaken a major effort with the help of donorresources to prevent a widespread energy crisis, which would endanger basic electricity serviceprovided to industry and commerce, households, public transportation, schools and hospitals.Nevertheless, the accumulated problems in the power sector will require time and very largeresources to resolve. The most important ingredient of a sustainable solution will be steady supportfrom the Government for the reforms in the sector needed to increase prices, commercialize thepower industry and gradually shift responsibilities for the social protection of the poor (currentlyprovided through the subsidized price of electricity) from power companies to the Government.

Strategic choices. The proposed emergency reconstruction project would help restore reliableelectricity supply in Serbia through rapid repair and reinforcement of power facilities at Kostolac Aand Sremska Mitrovica for which necessary equipment funded by other donors has already beensupplied. The urgent repairs funded under this project must be completed before the Winter of2001/2002 to ensure a stable electricity supply and help to meet demand for heating. The projectwill also provide technical assistance to EPS for the implementation of a financial managementsystem and to the Ministry of Mining and Energy in preparing an Energy Policy Statement anddrafting a new Energy Law on the basis of this policy.

The rationale for the project's geographic and technical focus is based on a strategic choice toassist in repairing the largest thermal power unit currently out of operation (Kostolac A2) andreinforcing the critical 300 MVA Sremska Mitrovica transmission substation, which is key for thestable operation of power grid. This choice ensures that Bank funding will have the largest possibleimpact both in the short term and the long term.

Energy Sector Policy. For both the electricity as well as the oil and gas sectors, FRY would be bestserved by expeditious unbundling of the largest vertically integrated monopolies, EPS and NIS.This should be undertaken in line with existing EU directives for the electricity and gas markets.Such a sector restructuring would enhance financial transparency and competition in the sector byallowing third party access to the natural monopoly components. In the short term, new energylaws should be passed introducing a modern regulatory framework supporting the establishment ofan independent regulator(s). Governance should be improved by ensuring that members of Boardsof Directors are professionally qualified. Financial discipline and the reliability of financialstatements would be much enhanced by improving accounting systems and reintroducing annualexternal audits by qualified auditors in accordance with IAS. In the long term, however, good

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governance and financial transparency should come from privatization of a substantial part of thesesub-sectors. Preparation of a new Energy Policy Statement and a draft Energy Law will befinanced under the proposed project's technical assistance component in cooperation with SIDA.

Energy pricing. The energy sector is one of the largest sectors of the Yugoslav economy,consisting of electric power, coal production, district heating, and oil and gas production andimports. The sector plays an important role in the economy both directly and indirectly, accountingfor about 5% of GDP. Total energy consumption is about 10 million tons of oil equivalent, withannual economic costs of about $1.4 billion for electricity, $400 million for petroleum products and$400 million for gas. However, in Serbia proper the prices charged for electricity, district heat andgas supply to households are well below the economic cost of supply, resulting in the accumulationof a quasi-fiscal deficit of about $1.1 billion in 2000.

During the 1990s the sector was to a considerable extent decapitalized: energy prices plummetedduring the period of hyperinflation (1993-1994), rose sharply during 1995-1997, but werethereafter not allowed to keep pace with inflation or international fuel prices. Although as recentlyas 1997 the electricity price was still 3.7 US cents/kWh, by October 31, 2000 the price was merely0.9 US cent/kWh, or about one fifth of the estimated economic cost of supply. Similarly, theOctober 31, 2000 price for district heating in Belgrade for households, schools and hospitals (5.0US cents/m2/month) was only one eighth of the economic cost-covering level.

The impact of this pricing policy on the energy sector was threefold. Firstly, as revenues decreasedenergy sector enterprises invested less and eventually stopped investments altogether.Maintenance was reduced to well below acceptable levels. During the Kosovo conflict NATOtargeted the energy sector, notably the refineries, generation plants, transmission lines andsubstations. As a result there is now a large backlog of reconstruction, deferred investments andmaintenance that needs to be addressed as soon as possible. Whereas investments in an electricpower sector the size of Serbia's would normally be in the range of about $250 million per year, onaverage only about $50 million per year was invested during 1990-2000, most of it during the firsthalf of the decade. Secondly, as energy prices of electricity and district heating dropped, excessiveenergy use was implicitly encouraged, especially since indigenous coal could meet much of thesupply needs. In particular, consumers started to rely on electricity as a primary or supplementalsource of heating, so that household electricity demand increased by about 50% over the lastdecade. At present almost 40% of electricity demand in the winter season is for heating. Thirdly,the lack of adequate revenues for district heating and natural gas distribution companies made itimpossible for these companies to pay for their share of the FRY's gas imports, resulting in a debtof $303 million owed to Russia's Gazprom. Gazprom, in turn, cut back on deliveries, leading toworries in FRY about security of gas supplies. Such concerns would be unfounded if prices (andcollections) were at the appropriate levels, which would also decrease the pressure on the powersystem to provide electricity for heating.

Because this is an emergency project there is no policy conditionality on electricity pricingattached to this Grant. However, as a result of the dialogue between GoS and the Bank starting inDecember 2000, GoS decided to implement major electricity tariff increases; developments in thisfield will be monitored both during implementation of this project as well as under the Bank'sproposed adjustment lending to FRY.

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C: Project Description Summary

1. Project components (see Annex 2 for detailed description):

The proposed project will comprise:

* Repair of unit A2 (210 MW) in thermal power plant Kostolac A;* Reinforcemen, of transmission substation Sremska Mitrovica through its connection to the 400

kV network; and* Technical assistance for (i) improvement of the financial management system of EPS; and (ii)

development of a new Energy Policy Statement and drafting of a new Energy Law for theSerbian Ministry of Mining and Energy.

2. Project costs (see Annex 3 for detailed project costs):

World BankCost Financing

Project Component Category (US$M) % of Total % of(US$M) Grant

A. Thermal power plant Kostolac A 12.3 61.5 3.0 50.0• Boiler and turbine overhaul Physical 7.8 39.0 0.45 7.5. Connection to District Heating 1.9 9.5 0.25 4.2• Thermal insulation 1.1 5.5 0.9 15.0• Unit control system 0.5 2.5 0.5 8.3. Refurbishment of auxiliary systems 1.0 5.0 0.9 15.0B. Substation Sremska Mitrovica 5.2 26.0 2.0 33.3a Civil works Physical 0.9 4.5 0.85 14.2* 400 kV Transformer bay 3.7 18.5 0.7 11.6* 400 kV Transmission connection 0.6 3.0 0.45 7.5C. Institutional development 2.5 12.5 1.0 16.7. Technical assistance Services 2.0 10.0 1.0 16.7. Financial Management System Physical 0.5 2.5 - -TOTAL PROJECT COST1' 20.0 100.0 6.0 100.0Note 1: Estimated costs include contingencies. The average physical contingency is 8% and the averageprice contingency is 3%.Note 2: Contracts financed by International Financial Institutions will be exempted from taxes and duties.

3. Financing plan:

The project's total financing requirements are estimated at US$20.0 million equivalent, including aforeign exchange component of US$14.7 million. The proposed Bank grant of US$6.0 millionwould finance 77.4% of the local cost component and 12.9% of the foreign cost component. EPSwould finance US$2.2 million equivalent, or 11% of the total financing required. A Russiansuppliers' credit for thermal power plant Kostolac A and a Chinese suppliers' credit for substationSremska Mitrovica are financing US$10.3 million equivalent, or 70.1% of the foreign costcomponent. A grant from SIDA (US$1.5 million) for financial management system and associatedtechnical assistance would finance 10% of the foreign cost component.

4. Key policy and institutional reforms supported by the project:

* Preparation of an Energy Policy Statement;* Drafting of an Energy Law;* Improvement of the core policy-making capacities of the Ministry of Energy and Mining;

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* Financial management strengthening of EPS; and* Establishment of a commercial framework for the management and operation of EPS.

5. Benefits and target population:

* Improved reliability and quality of electricity supply with consequent reduction ofblackouts and brownouts and the associated costs to consumers;

* Reduced need for electricity imports;* Savings in the operation and maintenance costs of power plants and transmission

substations;* Improved health, safety and environmental conditions for the population by reducing

shortages of electricity supply; and* Increased employment in the construction industry.

6. Institutional and implementation arrangements:

Implementation Period. July 1, 2001 - December 31, 2002.

Administrative Arrangements. During negotiations agreement was reached with the federal andrepublican authorities that EPS will have overall responsibility for project implementation and willassure that the project will be carried out in accordance with the Project Implementation Plan (PIP).All specific investment activities identified during project preparation will be implemented by EPSexcept a component of technical assistance to the Ministry of Energy and Mining of Serbia whichwill be implemented by the Ministry. A detailed description of the implementation arrangementsfor the project by components is provided in the PIP.

To ensure timely and efficient project implementation, a Project Implementation Unit (PIU) hasbeen established in EPS. The PIU will oversee the implementation of the project and will beresponsible for the technical and administrative functions under the project, including theprocurement of works, goods and services. EPS will maintain until project completion a PIU withfunctions and responsibilities agreed with the Bank and ensure that at all times the PIU (i) isheaded by an experienced Project Manager; (ii) has adequate staff; and (iii) is assisted, asnecessary, by consultants with qualifications, experience, and terms of reference acceptable to theBank.

Procurement. The procurement of works, goods and services of the Bank-financed componentswill be done in accordance with the Bank's procurement guidelines. The project components notfinanced by the Bank would be procured in accordance with national regulations or the co-financing institution's procurement regulations. The detailed procurement arrangements are inAnnex 4. A procurement plan describing the packages and the schedule for the main procurementactions is in Table D of Annex 4. All other procurement information, including consultantselection arrangements and thresholds for procurement methods and prior review is also in Annex4.

Allocation of Funds. Details on the allocation of grant proceeds and the estimated disbursementschedule are in Tables A and B of Annex 5. The proceeds of the grant would be disbursed duringFY02-03 on the following basis:

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* For the repair of thermal power plant Kostolac A, the reinforcement of transmissionsubstation Sremska Mitrovica and the improvement of FMS in EPS: 100% of the contractamount for the works contracts and 100% of contracts for goods; and

* For the technical assistance component: 97% of expenditures for consulting servicesperformed by firms (including auditing services) and 84% of expenditures for consultingservices performed by individuals.

The proposed project is an emergency operation and includes a provision for retroactivefinancingof works to repair the boiler's super heater in thermal power plant Kostolac A, which are anessential part of the project. The structure supporting the boiler's super heater collapsed due toaccumulated fatigue on March 2, 2000. In agreement with the Bank, EPS will be reimbursed up toa limit of US$0.45 million (7.5 percent of the Grant amount) for the costs incurred for repairs inKostolac A after June 2000. Reimbursement will only be available after the project becomeseffective.

Customs Duties and Taxes. The World Bank funds cannot be used to finance local taxes (such ascustom duties, sales tax, income tax, etc.). During the negotiations, the FRY and Republic of Serbiaauthorities indicated that they expected that shortly an amendment to the tax law will be adopted byfederal parliament which would exempt from the sales taxes works, goods and services if they arefunded by grant funds provided by international financial institutions.

Accounting, Financial Reporting and Audit Arrangements. An interim project-specific financialmanagement system has been established at EPS's PIU during project appraisal in May 2001. Theaccounting system will be maintained in accordance with international standards, based onprinciples of double-entry bookkeeping. The Bank has informed the PIU of Bank requirements onmaintaining accounts and records in accordance with International Accounting Standards (LAS).This system is capable of providing accurate and timely information regarding project resourcesand expenditures, including planning, accounting and financial reporting relating to the project.Funding has been provided under the Grant to establish an FMS for EPS as a whole. Once thissystem is established, the interim PIU system will be incorporated into the new EPS system.Terms of Reference for this assignment will be developed by consultants to be funded under theGrant. Training will be provided for the accountant and the procurement officer. Funding for thesetraining activities will be provided from the Grant. Operational procedures and guidelines forproject financial management will be documented in an Operational Manual, encompassing alllevels of project management and administration. A draft operational manual is being prepared bythe PIU.

The PIIJ will recruit independent auditors under terms of reference acceptable to the Bank. AuditedProject Financial Statements will be submitted to the Bank with the audit report six months afterend of each year audited. The cost of the audit will be financed through the Grant. Currently,Deloitte and Touche audit the EPS accounts. At negotiations, it was agreed with EPS that theauditor who audits EPS's accounts will be retained to audit the project accounts as well.

Project monitoring and Bank supervision. Project implementation will be monitored by EPS andthe Ministry of Mining and Energy of Republic of Serbia. During negotiations agreement wasreached that the following documents will be prepared by EPS to facilitate project monitoring:

* Quarterly Project Management Reports (PMRs), which should (i) set forth actual sourcesand applications of funds for the project, both cumulatively and for the period covered bythe report, and projected sources and applications of funds for the project for the three-month period following the period covered by the report, showing separately expenditures

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financed out of the proceeds of the grant during the period covered by the report andexpenditures proposed to be financed out of the proceeds of the grant during the three-month period following the period covered by the report; and (ii) contain an update of theproject cost and procurement plan indicating the progress in project implementation andexplaining variances between the actual and previously forecast implementation targets;

* A Mid-Term Report prepared by EPS and furnished to the Bank by January 1, 2002, whichshould integrate the results of the monitoring and evaluation activities on the progressachieved in carrying out the project during the period preceding the date of report. Thereport would also set out the measures recommended to ensure the efficient completion ofthe project and the achievement of its objectives. Based on this report, a mid-term reviewwould be carried out with the Bank and the Ministry of Mining and Energy by March 1,2002; and

* Annual audit reports of EPS and project financial statements for 2001 and 2002, preparedby independent auditors by June 30, 2002 and 2003, respectively.

The Bank's monitoring of the project will include regular supervision by the Bank's Task Teamwhich would review the project implementation and exchange views with EPS and the Governmentofficials.

D. Project Rationale

1. Project alternatives considered:

The economic cost of electricity supply from the existing asset base is well below the cost ofelectricity imports even when the costs of reconstruction and deferred maintenance are included.Hence, rehabilitation is the least-cost solution. There is no technical alternative to the repair ofhigh voltage transmission facilities because further deterioration of the transmission network wouldcut off consumers from any major source of electricity supply.

To process the project as a normal lending operation would take too long given current conditions.The emergency nature of the energy crisis in Serbia dictates that funds be made available for urgentrepairs of basic power system infrastructure as soon as possible to improve living conditions andmitigate the risk of major electricity shortages during the next winter.

2. Lessons learned and reflected in the proposed project design:

Based on the Bank's experience in post-conflict countries such as Bosnia, particular attention hasbeen paid to:

* Ensure simple and transparent project design;* Adopt realistic implementation and disbursement schedules;* Prepare a detailed procurement plan but use a relatively small number of packages; and* Ensure full support of the Government.

Experience has also shown that, while quick response to a crisis is imperative, it is equallyimportant to identify underlying problems and determine how to resolve them in ways that result inlong-term sustainable solutions. Taking this into account, the project assists EPS in introducing asound financial management system. Additionally, the project helps to improve EPS procurementand project implementation capacity by establishing a PIU with highly competent local staff.Through its prior sector work and project preparation, the Bank has also been instrumental inconvincing GOS to increase the price of electricity.

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3. Indications of grantee commitment and ownership:

The Govemment (GOY/GOS) requested the Bank to coordinate with donors and mobilize urgentlyneeded funding, and to provide early (pre-membership) financial assistance to prepare the groundfor a more ambitious economic recovery and reform program. Based on discussions with theGovernment, the proposed project was included in the list of five high priority projects to befunded under TFFRY. The Government commitment is underscored in particular by steps taken tointroduce a new tariff system, including an increase in electricity prices by 60% effective April 15,2001. In addition, the Government has decided that another increase of electricity tariffs will takeplace as of June 1, 2001 (40%) and may increase tariffs further in October 2001 (46%). If'implemented, this should enable EPS to fully cover its operating costs by the end of 2001.

4. Value added of Bank support in this project:

Through the proposed emergency project, the Bank would provide urgently needed funding for theinstallation of equipment financed from other sources (suppliers' credits) who are not financinglocal cost of works needed for dismantling of damaged equipment and erection of newly suppliecdcomponents. Therefore, the Bank would mitigate a major risk that this equipment will not beinstalled during Summer 2001. In the absence of Bank involvement there will be a repeat of theelectricity shortages and associated blackouts that occurred during the very mild Winter 2000/01,or indeed an even worse situation if the temperatures during Winter 2001/02 are closer to theSerbian winter average.

The Bank brings to the reconstruction process its unique experience in identifying, selecting andimplementing priority investments for reconstruction of basic energy and infrastructure facilities inpost-conflict countries. The Bank will also help to mobilize and target other donor resources foremergency repair of power infrastructure and to coordinate donor activities in this sector.

E: Summary Project Analysis (Detailed assessments and assumptions are in Annex 2)

1. Economic:

A simplified economic analysis has been undertaken as the proposed investments are of anemergency nature projects, rather than new long-term investments. As an emergency project, thebenefits are unusually high, reflecting the considerable disequilibrium of the power sector.Therefore a simplified analysis in which only part of the benefits are quantified is deemed to besufficient to demonstrate the robustness of the project.

The repairs to the Kostolac A2 unit would increase electricity supply by about 300 GWh per year.This would enable EPS to decrease supply disruptions and reduce electricity imports. At aminimum, the value of increased supply would be the equivalent of the price of importedelectricity. Decreasing electricity imports by 300 GWh per year would decrease EPS' costs by $10million per year, resulting in a simple payback period of 14 months.

The reinforcement of the Sremska Mitrovica substation will reduce transmission losses by 29 GWAlhper year, reduce outages due to transmission failure and increase the life of other assets by reducingoverloading of equipment. The benefits associated with avoiding transmission system collapse aredifficult to assess as its not predicable when such a collapse would happen without the proposedinvestment. An estimate of the lower bound of the proposed component can be made by valuingthe benefits associated with decreased losses at import prices. This would result in annual savingsof $1 million to EPS, giving a lower limit on the EIRR of 18%.

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2. Financial:

A financial analysis of the power sector was not feasible due to the lack of reliable financial data.For example, as of the end of 2000 current assets were reported at DIN13.0 billion (US$196million) and current liabilities at Din4.0 billion (US$61 million). In fact, however, currentliabilities are believed to be about Din57.0 billion (US$863 million), taking into account: (i)current liabilities for which no invoice has yet been received (a common practice of suppliersdesigned to avoid paying VAT well before payment is received); and (ii) the enormous portion ofoverdue debt, not including penalties. Total long-term foreign debt outstanding, excluding penaltiesbut including interest, was US$846 million; all such debts were incurred prior to 1990.

The last financial audit of EPS in accordance with international accounting standards covered 1996and 1997, after which EPS went into a steep financial decline. While in 1997 the electricity pricewas still 3.7 US cents/kWh, by October 31, 2000 the price had dropped to 0.9 US cent/kWh, orabout one fifth of the estimated economic cost of supply. However, in April 2001, the newGovemment of Serbia increased the price of electricity by 60% and announced a further 40%increase for June 2001. It is possible that a third increase will take place in October 2001 (46%),just before the Winter season starts. This should enable EPS to fully cover its operating costs bythe end of 2001. EPS' operating loss for 2000 is reported at DinlO.4 billion (US$155 million),while the total net loss taking into account exchange rate losses and asset revaluation was Din39.0billion (US$586 million). The Bank's proposed structural adjustment credits are likely to includecovenants on future electricity rate increases that would aim at EPS achieving full debt servicecoverage by end 2002 and at self-financing part its own investments by the end of 2003.

Fiscal Impact. There would be no fiscal expenditures in association with the project. The fiscalimpact of the project is expected to be positive, since energy imports would be reduced andoperating revenues to EPS would increase due to increased generation. This would reduce the needfor possible Government subsidies to the electric power system and associated coal mines.

3. Technical:

The power systems in Serbia and Montenegro were developed as a part of the integrated powergrid of the former SFR Yugoslavia, which was a full member of the UCTE (formerly UCPTE), theWestem European power system interconnection. The Serbian power industry exported about 20percent of its production in 1990, which amounted to 35.8 TWh. Today, the power industry facesthe consequences of air strikes, lack of maintenance and lack of investments for more than a decadewhich turned Serbia into a net importer of electricity. It is estimated that about 10 percent of totaldemand in 2001 will need to be met by imports of electricity.

The power system is operating at the very edge of safety and with increasing outage times of mainequipment, which necessitates load shedding and rotating blackouts. The need for functioningequipment to operate non-stop has prevented overhauls and regular maintenance. This causesfurther deterioration of all performance indicators, including forced-outage rates in thermal powerplants which increased to 32 percent in 2000. The main power generation facilities are operatingwithout the necessary reserves, which increases the likelihood of major power system instabilitiesand blackouts.

The condition of the high voltage transmission network sharply deteriorated as a result of damagesinflicted by the air strikes in 1999. About 100 km of transmission lines and 22 transformers with atotal installed capacity of 3,700 MVA were damaged or destroyed. Continuous emergency repairsundertaken by EPS kept the system in operation by using all spare parts and materials available and

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cannibalizing equipment. The situation became particularly difficult in the oldest parts of the 220and 110 kV network due to overloading of transformers and transmission lines.

The project's technical design is focused on the most urgent repairs needed to return a 210 MWunit in thermal power plant Kostolac A to operation. This unit was damaged after supportingstructure of its boiler's super heater collapsed in February 2000. All of the equipment needed forthe repair is provided under a Russian suppliers' credit and it is already delivered to the site.However, EPS is not able to fund the dismantling of old equipment, installation of the newequipment and some small civil works associated with the unit repair. The repair of Kostolac Aduring the Summer/Fall of 2001 would significantly reduce the need for imports of electricityduring the next Winter and improve the reliability of supply in Serbia.

The need to import large amounts of electricity underscores the importance of a stable transmissionsystem. The transmission system in Northern Serbia (Vojvodina), however, is facing frequentoverloads caused by bottlenecks in the vicinity of growing load centers, reduced reliability of mainsubstation equipment damaged in air strikes, and disconnection of the 400 kV transmission linebetween Serbia and Croatia after the destruction of the Emestinovo substation in Croatia in 1991.The reinforcement of substation Sremska Mitrovica is critical for ensuring the stable supply ofelectricity in this part of the country, the improvement of overall network reliability and thereduction of transmission losses. The proposed project would provide for the installation of a400/220 kV transformer in Sremska Mitrovica which is already delivered to Serbia and is financediunder a Chinese suppliers' credit.

4. Institutional:

Background. Regulation of the power sector within the FRY is the responsibility of thegovernments of the two constituent republics (Serbia and Montenegro). The new Government ofSerbia has expressed its intention to initiate a thorough reform of the energy sector, in terms bothof introducing new legislation to allow private participation and to delegate economic regulationand energy efficiency policy to independent agencies, and of restructuring the energy market andthe state-owned energy sector enterprises (EPS and NIS). The human and financial resources at thedisposal of the Ministry of Energy and Mining currently fall far short of being adequate for thismajor task, however. At present, the Ministry has only a minimal staff, and this situation isunlikely to improve in the short term due to the new Government's pre-election commitment toreduce the size of the Republican administration. As a result, the Ministry has proposed that itcontract local and international expertise in order to start preparing the Republic's energy sectorreform policy and related legislation. Part of the proposed grant will therefore be allocated to theMinistry of Energy and Mining to finance technical assistance in these tasks.

Prior to establishment of EPS in 1991, the power industry in Serbia was organized in severalsocially-owned generation, transmission and distribution companies, as well as coal miningenterprises. Under the Serbian Electricity Act of December 1989, and the subsequent ElectricityLaw of July 1991, all enterprises involved in the production, transmission and distribution ofelectricity and production of coal were unified into a state-owned, vertically integrated powerutility (EPS). Presently, EPS comprises three companies for coal production, six companies forpower generation, one company for power transmission and ten distribution companies (excludingKosovo). In addition, EPS includes several enterprises for mine-related services and activities, suchas workshops, mining machinery manufacturing, and repair and civil construction.

Corporate Management. Under the 1991 Electricity Law, EPS is required to have a Management

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Board and a Supervisory Board. The Management Board has eleven members (including fouremployees of EPS) and the Supervisory Board has five members (including two employees ofEPS), all of them appointed by the GOS. The Management Board is inter alia responsible forformulating corporate policies and plans, deciding about investments and financial matters andproposing electricity tariffs to the GOS. The Supervisory Board reviews EPS's operation and auditreports and approves the allocation of revenues proposed by the Management Board. The GeneralManager of EPS is appointed by the Minister of Mining and Energy of Serbia. The GeneralManager and directors of eight departments conduct the day-to-day operation of EPS. The eightdepartments are: production and transmission of electricity; production of coal; power systemdispatch; power distribution; development and investments; electricity trade; economic andfinancial; and the legal and personnel department.

Personnel Management. EPS employs about 60,000 people, out of which 26,000 are in two coalmining companies (Kolubara and Kostolac) and 5,000 are in the underground mining company;11,000 are in six power generation companies; 16,000 are in ten power distribution companies;1,500 are in the transmission company; and 500 are at EPS headquarters. Compared to powercompanies of similar structure and size in developed countries, EPS is overstaffed in all segmentsof its operations, and especially so in the mining segment. The overstaffing in EPS is a majorsocial and economic problem caused by decades-old policies of former Governments to mitigatesocial discontent through artificially inflated employment in large state-owned companies.

Financial Management. The financial management function in EPS is under the Director of theEconomic and Financial Department. EPS is required by law to maintain its accounting recordsand draw up financial statements in accordance with current Serbian Accounting Standards, whichare in some areas materially different from Intemational Accounting Standards (IAS). Financialstatements prepared on the basis of lAS differ from the statutory financial statements in that theycontain certain adjustments, not recorded in the company's books, which are necessary to reflectthe true financial position and operational results. The principal adjustments relate to provisionsfor bad debts, the valuation of assets, inventory and debt, the timing of expense recognition,depreciation rates for fixed assets, and provisions for deferred tax. The last audit of EPS accountsin accordance with LAS was performed by Deloitte and Touche for the years 1996 and 1997. Anaudit of EPS for 2000 is expected to be done by Deloitte and Touche. The Grant will providefunding to establish an integrated financial management system for EPS, which will be capable ofkeeping accounts in line with local regulations and also in IAS format. This system will also beable to provide PMRs as required by the Bank and will replace the interim system that has beenestablished.

5. Environmental assessment: Environmental Category [IA [x] B [I C

In accordance with OP/BP/GP 4.01 (Environmental Assessment) the project has been ratedEnvironmental Category B. The reason for this rating is that the physical component of this projectis reconstruction and restoration, and there will be no construction of new facilities, except a shortconnection (1.8 km) between substation Sremska Mitrovica and the existing 400 kV transmissionline which passes near the substation. These operations do not require environmental p.rmits orclearances since they address power facilities already in place. The main environmental issues are:disposal of used equipment and materials; noise (during construction) and public safety. Theseissues will have to be addressed in both the design and operation phases of the project.

As required by the project's environmental rating, an Environmental Management Plan (EMP) wasreceived by the Bank on May 21, 2001. During negotiations, the EMP was reviewed and agreed

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upon. Implementation of the EMP will be monitored as part of normal project reporting or wlhenspecifically requested by the Bank.

The project is being prepared in compliance with all environmental requirements of the Bank.There are no special requirements from the environmental authorities of GOS, since this projectconsists of reconstructing damaged equipment with new modem replacements.

The thermal power plant Kostolac A is located on the right bank of river Danube 20 km from theRomanian border. Because of this, the Bank considered the applicability of OP 7.50 which govemsProjects on Intemational Waterways. That OP applies to any project that involves the use orpotential pollution of intemational waterways. However, it specifically exempts from the nonnalnotification requirement "minor additions or alterations" to existing schemes that "will notadversely change the quality or quantity of water flows to the other riparians." The proposed repairof thermal power unit Kostolac A2 project meets this definition. The flow of cooling water usedand returned by Kostolac A2 (7.6 m3/s) is negligible compared to the average flow of the Danuibe(5,600 m3/s). Furthermore, the project will cover only repair of existing facilities (which werecommissioned in 1980) without any change in the quantity or manner of use of cooling water.

6. Social:

Positive social impacts are anticipated as a result of the restoration of reliable electricity supply tohouseholds, public transportation and buildings (e.g., schools, hospitals), and water supply andwastewater treatment facilities. The project does not involve any relocation of settlements orchanges in land use.

7. Participatory approach:

Primary beneficiaries and other affected groups. This project has been prepared in closecollaboration with GOY, GOS, EPS and local consultants to define the project, assess investmentneeds, prioritize actions, and develop an implementation plan. Preparation also includedconsultation with leading environmental NGO representatives during the Annual Conference of'theYugoslav Energy Association on May 15-17, 2001.

Other stakeholders. Cooperation and coordination with other international donors (e.g., EAR,EBRD, SIDA and USAID) involved in other elements of power system reconstruction andrehabilitation have been emphasized since the beginning of project identification and will continuethroughout its implementation.

F: Sustainability and Risks

1. Sustainability:

The project is expected to reduce the need for electricity imports during Winter 2001/02 by around300 GWh, and to restore reliable electricity supply from the 210 MW thermal power unit KostolacA2 thereafter. The reinforcement of the 400 kV transmission substation Sremska Mitrovica underthis project should ensure a stable operation of transmission network, improve reliability ofelectricity supply in Northem Serbia, reduce transmission losses and facilitate reintegration of theSerbian power system into UCTE. Both project components are essential to the sustainableoperation of the Serbian power system and the elimination of the current energy crisis.

The project is expected to be sustainable provided that EPS is able to become a financially viiableand commercially operated company. This requires tariff adjustments that should enable EPS to

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fully fund operating costs from internal cash generation by the end of 2001 and to be able toservice its revalued debt by the end of 2002. Progress in this area is being made given the tariffincreases announced and implemented by GOS. In addition, EPS has to improve its collectionperformance and significantly to reduce the share of non-cash payments within the collection total.A critical factor for the successful commercialization of EPS is Government support for priceincreases and for the legal discipline needed to deal with collection problems.

2. Critical risks:

Risk Risk Rating Risk Minimization MeasureAnnex 1, cell "from Outputs to Objective"

* Insufficient counterpart financing N * Project components and sub-components prioritized so that themost urgent ones can be financedfrom available funds

* Inefficient coordination between M * Support from the Bank team at thedifferent agencies involved initial stage to set up procedures for

effective implementation andsupervision support thereafter

* Changes in GOY/GOS and/or EPS's M * Selection of project components on amanagement strict priority basis and use of well

staffed and competent PIU

Overall Risk Rating MRisk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N (Negligible or Low Risk)

In addition to the above critical risks, there are three main risks to the successful implementation ofthe proposed project. First is the possible use of funds for less than optimal expenditures. This riskis being addressed through a careful selection and design of all project components. The projectcovers activities which are clearly the most urgent and effective in alleviating the current electricityshortage. The second risk is a delay in project implementation. This risk is being reduced by EPS'and the Bank's joint effort to adopt straightforward solutions to project design and procurementand disbursement methods, and by the establishment of a PIU. A third risk is the large number ofother similar activities which EPS will have to implement in parallel with this project. This riskwill be mitigated through effective coordination provided by the PIU, close cooperation of the PIUwith the Bank and with donors supporting other activities (e.g., EAR), and project supervision byGOS and the Bank.

G: Main Grant Conditions

1. Effectiveness Conditions:(a) The legal opinion from EPS attesting to the validity and binding nature of the GrantAgreement; and(b) The legal opinion from FRY and the Republic of Serbia attesting to the validity and bindingnature of the Guarantee Agreement upon the FRY and the Republic of Serbia, respectively.

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2. Agreements Reached during Negotiations:

(c) EPS will have overall responsibility for project implementation and will assure that the projectwill be carried out in accordance with the PIP;(d) The Ministry of Mining and Energy of the Republic of Serbia will be responsible to carry outactivities related to the preparation of an Energy Policy Statement and drafting of a new EnergyLaw;(e) EPS shall maintain, until completion of the project, an adequately staffed PIU and assign to itresponsibility for overall project implementation and coordination;(f) PIU will be responsible for assisting EPS and the Ministry of Mining and Energy in carryingout all project related procurement, financial management, accounting, reporting and disbursementactivities;(g) EPS/PIU shall prepare quarterly project management reports to facilitate project monitoringstarting with the fourth quarter of 2001;(h) EPS/PIU shall prepare a mid-term review of the project by January 1, 2002 and review saidreport with the Bank by March 1, 2002;(i) EPS shall implement the Environmental Management Plan in a manner satisfactory to theBank, and shall provide the Bank with summary status of implementation (including results fromenvironmental monitoring) as part of normal project reporting; and(j) EPS shall submit to the Bank audit reports for its accounts and the project financial statementsfor 2001 and 2002 by June 30 of the following year.

H. Readiness for Implementation

[x] The engineering design documents for the first year's activities are complete and ready for thestart of project implementation. [ ] Not applicable.[x] The procurement documents for the first year's activities are complete and ready for the start ofproject implementation.[x] The Project Implementation Plan has been appraised and found to be realistic and ofsatisfactory quality.[ ] The following items are lacking and are discussed under loan conditions (Section G):

I. Compliance with Bank Policies

[x] This project complies with all applicable Bank policies.

[ ] The following exceptions to Bank policies are recommended for approval. The projectcomplies with all other applicable Bank policies.

Team Leader: Dejan Ostojic

Sector Manager: Henk Busz

Acting Country Director: Mary C. Sheehan

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Annex 1FR Yugoslavia: Electric Power Emergency Rehabilitation Project

Project Design Summary

Narrative Summary Key Performance Indicators Monitoring and Evaluation Critical AssumptionsA. Sector-related CAS Goal: (Goal to Bank Mission)* Project is part of pre-membership * Power plant Kostolac A2 is in operational * GOS decisions and sector * GOS starting reforms in power

assistance to FRY outlined in the condition (by November 15, 2001). policy statements. sector.Transitional Support Strategy (TSS) * Complete installation of 400 MVA * Electricity tariffs. * EPS remains committed to thefor the FR Yugoslavia. transformer in substation Sremska * Implementation completion project.

* Supports sustainable economic and Mitrovica (by December 15, 2001). report.social development by repairing * GOS issues an Energy Policy Statement * Donors reports.damaged power facilities and helping (by June 1, 2002).restore reliable electricity supply for * Ministry of Mining and Energy prepares athe winter 2001/02. draft Energy Law (by September 1, 2002).

* Supports TSS goal to coordinate with * FMS established in EPS (by December 15,donors and raise urgently needed 2002).funding that will complement a largerenergy program.

B. Project Development Objective: (Objective to Goal)* Help restore reliable electricity supply * 70% of procurement packages awarded by * Quarterly progress * Continued GOS commitment

in Serbia through urgent repair of September 2001. Reports by PIU. and support.generation and transmission facilities * 50% of contracts completed by November * Bank supervision missions. * Continued donors support to theaffected by lack of maintenance and 2001. * Consultations with GOS and power sector.damages. * Contracts with the main FMS consultant EPS.

* Improve financial management and the energy policy consultant signed by * Annual audit of EPS accountssystem of EPS. December 15, 2001. prepared by extemal auditor.

* Support the Serbian Ministry ofMining and Energy in preparing anEnergy Policy Statement and draftinga new Energy Law.

C. Outputs: (Outputs to Objective)* Restored electricity production from * Quarterly production from thermal power * Quarterly progress reports by * Sufficient counterpart

thermal power unit Kostolac A2. unit Kostolac A2 (in GWh) to reach: PIU. financing.* Refurbished power transmission 04/01 01/02 02/02 * Bank supervision and other * Efficient coordination between

facilities anid improved stability of 100 200 250 documentation provided by different involved agencies.transmission network. * Reduction of technical losses in EPS. * Changes in GOY/GOS and/or

* New financial management system in transmission from 4.5% in 2001, to 4% or * Site inspection and EPS's management do notEPS. less in 2002 and thereafter. commissioning documentation. delay project implementation.

* An Energy Policy Statement prepared * Average deviation of bus voltage at 220 * Audit report of EPS 2001 andby the Ministry of Mining and Energy kV and 400 kV substations maintained 2002 accounts.of the Republic of Serbia. within following limit:

2001 2002 200310% 7% 5%

. EPS to install hardware and software forthe financial management system (FMS).

D. Project Components/Sub-components: Project Inputs: Project Reports (Components to Outputs)

* Thermal power plant Kostolac A * US$3.0 million * Project progress reports and * Timely establishment of PIU* Transmission substation S. Mitrovica * US$2.0 million disbursement reports. and implementing agreements.* Institutional development * US$2.5 million * Effective coordination of

various reconstruction andrehabilitation projectsimplemented in parallel.

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Annex 2FR Yugoslavia: Electric Power Emergency Reconstruction Project

Detailed Project Description

Background

Power Generation. The total installed generation capacity, available capacity and electricityproduction in Serbia (excluding Kosovo) are shown in Table A. The generation mix in Serbia isdominated by lignite-fired power plants which represent 56.6 percent of the total installed capacityand accounted for 64.5 percent of electricity production in 2000. The remaining production is fiomhydropower plants (35 percent) and from combined heat and power plants (CHP) which use oil andgas. Low efficiency, technological constraints, and the relatively high cost of their fuel reduced thegeneration of electricity from CHP to very few hours during the winter.

Table A: Electricity Production in Serbia in 2000

Power Plant Installed capacity Available capacity Production (TWh)(MW) (MW)

Thermal Power Plants (TPP)

- TPP Kolubara and TENT 3,160 2,600 16.1- TPP Kostolac and Morava 1,130 660 3.0CHP plants 520 350 0.2Hydropower plants (HPP) l_l- run-of-river plants 1,790 1,790 8.8

E-reservoir plants 980 980 1.5TOTAL 7,580 6,380 29.6

Thermal power plants and associated lignite mines were the most affected by the lack ofmaintenance during the last ten years. It is estimated that the deferred maintenance program willtake three to five years to compensate this shortfall. Other than funding, the main obstacle for thequick recovery of these plants is the expected deficit of energy in the Serbian power system (about10 percent of total demand), which is likely severely to limit opportunities for intensivemaintenance. Therefore, the success of the program will mainly depend on timely specification ofrequired activities, procurement of necessary spare parts and materials, and organization of works.In 2001, the highest risk is related to the availability of funds for installation of equipment suppliedby donors.

Only 76% of the installed thermal generation capacity is available. This is the result of damage togenerating facilities and derating due to lack of maintenance and/or design deficiencies. The 110-MW unit in Kolubara A was damaged during air strikes in 1999 and the 210-MW unit in KostolacA was damaged after the supporting structure of its boiler's supper heater collapsed in March 2000.Also, an old 30 MW unit in Kolubara A is out of operation due to lack of spare parts. Derating ofgenerating capacity accounts for the loss of 200 MW in Kostolac B (29 % of installed capacity) and400 MW in Nikola Tesla (TENT) A and B (14 % of installed capacity). Derating of two 350 MWunits in Kostolac B to 250 MW each is caused by boiler and reheater design problems which willrequire a longer time to resolve. The reduced rating of generating units in TENT A and B is causedby the lack of maintenance and spare parts for repairs.

The average age of thermal power units in EPS is 21 years and 6 units with a combined capacity of426 MW (TENT A2, Kolubara Al-A4 and Kostolac Al) have accumulated more than 200,000hours of operation. In addition, 8 units with a combined capacity of 2,579 MW (TENT Al, A3-A6,TENT B1 and B2, and Morava) have accumulated between 100,000 and 200,000 hours ofoperation, and most of the remaining units have completed close to 100,000 hours of operation

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apiece. Taking these units out of service for repairs, extended maintenance and rehabilitation mayexacerbate the supply shortfall and requires careful planning, possibly requiring an increased needfor electricity imports.

Transmission Network. The median age of transformers and switching equipment in high voltage(400 kV, 220 kV and 110 kV) substations is about 20 years. The condition of high voltagesubstations significantly worsened as a result of damages inflicted by air strikes in 1999. Whilemost of the damage has been repaired, some of it temporarily, the reliability of substationequipment is limited'. As a result, seven 400 kV and 220 kV substations (Beograd 5 and 8, NoviSad 3, Nis 2, Drmno, Krusevac I and Srbobran) will require refurbishment in the next five years.Since the transmission network has not been upgraded for the past 20 years, it has reached capacitylimits in the vicinity of large load centers. The priority investment focuses on two existingsubstations (400/220/110 kV substation Pancevo and 220/110 kV Sremska Mitrovica) and thecompletion of three new substations (400/110 kV Beograd 20, 400/110 Jagodina 4 and 400/110 kVSombor 3). With these investments, it is estimated that during peak load conditions transmissionlosses could be reduced by 20 MW.

Following the repair of transmission line river crossings near Pancevo, which were damaged in1999, the next priority will be construction of a 75 km long 400 kV transmission line SremskaMitrovica - Ugljevik (in Bosnia and Hercegovina). This line would enable interconnection of theSerbian power system with UCTE while the 400 kV Emestinovo substation (in Croatia) is out ofoperation. Also, a 55 km long 400 kV transmission line should be built between the new substationSombor 3 and the existing substation Subotica 3. Both lines would improve the reliability of powersupply in northern Serbia, alleviate voltage problems and reduce losses in this part of the network,as well as improve the stability of pumped storage plant Bajina Basta.

Institutional Development. Technical assistance for institutional development ranks among themost urgent needs in the energy sector. The Serbian Ministry of Mining and Energy needs advisoryservices to help formulate an energy sector policy that will focus on the changes required to thelegal environment to enable sector restructuring and reform. Key issues, such as the relative rolesof competition and regulation, the ownership of sector assets, risk allocation, and the social impactof energy sector reform, need to be addressed urgently. These efforts must be followedimmediately by assistance in the establishment of a new legal and regulatory framework for thesector. Implementation of this framework would follow, with assistance needed to focus on theestablishment of an independent regulatory body and the preparation of relevant secondarylegislation. In parallel to these tasks, EPS needs technical assistance to enable the company toimprove its accounts to intemational standards and in the establishment of effective financialmanagement.

The proposed project is concerned with urgent repairs and strengthening of the power grid neededto restore reliable supply of electricity in Serbia, and with urgent technical assistance to the SerbianMinistry of Mining and Energy and to EPS. It has three components: (i) repair of 210 MW unit inthermal power plant Kostolac A; (ii) reinforcement of transmission substation Sremska Mitrovica;(iii) institutional strengthening of EPS and technical assistance to the Ministry of Mining andEnergy for development of an Energy Policy Statement and drafting a new Energy Law.

1 The poor condition and low reliability of the transmission network in Yugoslavia has a negative impact onthe entire region due to reduced stability of interconnections between regional power systems and forgonebenefits of synchronous operation and electricity trade.

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Project Component 1: Repair of Thermal Power Plant Kostolac A (US$3.0 million)

Thermal power plant (TPP) Kostolac A is located near the city of Kostolac, I 1 km north ofPozarevac, on the right bank of river Danube. TPP Kostolac A consists of two units, 100 MW unitAl (commissioned in 1967) and 210 MW unit A2 (commissioned in 1980). TPP Kostolac A useslignite from open-pit coal mines "Cirikovac" and "Klenovik" which have about 40 million tons ofremaining coal reserves. These reserves should be enough for 16 years of operation of Kostolac Awhich requires about 2.5 million tons of lignite per year. However, the development of the mineshas slowed down since 1990 due to the lack of funding for maintenance of mining equipment andland acquisition. Currently, the mine is able to meet about half of the plant's coal demand.According to EPS's mid-term investment plan, a near-by open pit mine "Drmno" (which servesTPP Kostolac B) should be connected by conveyers to Kostolac A to ensure adequate supply ofcoal for the next 20 years.

During the first decade after its commissioning in 1980, the 210-MW unit A2 was reliable andoperated on average 6,200 hours per year. Table B shows operating hours, number of forcedoutages and duration of outages caused by boiler failures. The increase in boiler failures in the1990s is caused by reduced maintenance of boiler tubes due to lack of funding for spare parts andrepairs. Accumulated fatigue in the structure supporting the boiler's super-heater caused a majorfailure on March 2, 2000. About one quarter of the boiler collapsed as illustrated in photographsgiven in Annex 8.

Table B: Operating Statistics of Thermal Power Unit Kostolac A2

Year 1985 1990 1995 1999Operating Hours 6,811 4,745 3,798 l 3,708Number of Forced Outages 15 20 17 24of which Boiler Outages 2 8 12 14Duration of Boiler Outages 28 h 395 h 505 h 787 h

Given the need to replace all boiler tubes and refurbish the supporting structure, EPS decided to usethe prolonged outage time to do a complete turbine overhaul and to reconstruct the turbine toprovide heat for district heating (DH) system in Kostolac and Pozarevac. The existing DH systemin the two cities is supplied from Kostolac A by using an inefficient (uncontrolled) derivation ofheat from the plant's self-consumption steam collector. The new system will improve theefficiency of the combined heat and power production by deriving steam directly from the outlet ofthe medium pressure turbine. All the equipment needed for the boiler repair and turbine overhauland reconstruction has already been delivered to the site under a Russian suppliers' credit.

The repair of TPP Kostolac A2 under this project will increase the available capacity in the Serbianpower grid by 200 MW, reduce the import of electricity by 300 GWh (an equivalent cost of aboutUS$10 million at the current price of electricity imports) during the next winter and improve theefficiency of district heating system in Kostolac and Pozarevac.

Project Component 2: Reinforcement of Substation Sremska Mitrovica (US$2.0 million)

The reinforcement of transmission substation Sremska Mitrovica includes construction of one 400kV transformer bay, installation of a 400 MVA transformer and associated switchgear at 400 kVand 220 kV voltage levels and construction of a 1.8 km long connection line to the 400 kVtransmission system. The 400/220 kV, 400 MVA transformer has been delivered to the Yugoslavborder (Kladovo) and will be transported to Sremska Mitrovica under the project. All other

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equipment to be installed in the Sremska Mitrovica substation has been delivered to the nearbywarehouse except the 220 kV disconnect switch which will be procured locally by EPS.

The 220/110 kV substation Sremska Mitrovica was built in 1975. Presently, it includes two 150MVA transformers, two 220 kV transmission line bays and seven 110 kV transmission line bays.The 220 kV transmission line Bajina Basta (614 MW pumped storage plant) - Sremska Mitrovica -Srbobran is a bottleneck in the transmission system due to frequent overloading (up to 130%) anda relatively large number of outages (22 in 2000; 18 in 1999; 27 in 1998). The uprating of SremskaMitrovica substation to 400 kV voltage level and increase of its transformer capacity to 700 MVAunder this project will significantly improve stability of the transmission system and reliability ofelectricity supply in major load centers in northern Serbia (Belgrade and Novi Sad). It will alsoreduce transmission losses by 6.3 MW during peak load, which corresponds to an annual saving ofabout 29 GWh (an equivalent cost of about US$I million at the current price of electricity imports).

Project Component 3: Institutional Development (US$2.5 million)

Financial Management System. This project component includes design, supply and installationof a computer-based Financial Management System (FMS) in EPS. An interim project specificfinancial management system has been established at EPS during the project appraisal in May2001. This interim system will be incorporated into the new FMS which will be funded under theGrant. The scope of the FMS will be defined by the consultant to be hired by EPS to preparetechnical specifications and bidding documents for the FMS. Terms of Reference for thisassignment will be developed by consultants to be funded under the Grant.

Technical Assistance. Technical assistance (TA) will include provision of consulting services tothe Serbian Ministry of Mining and Energy and to EPS. TA to the Ministry will focus on theelaboration of a new Energy Policy Statement, with emphases on the reform of the energy sectorlegal and regulatory framework and on the restructuring of the energy market and sectorenterprises. The Energy Policy Statement would be the foundation based upon which a new EnergyLaw would be drafted and future energy sector restructuring would take place, including under theBank's proposed structural adjustment credits. TA to EPS will support the introduction of an FMS.TA for the development of the Energy Policy Statement and the drafting of an Energy Law will becarried out by qualified international consultants supported by a team-of local consultants.

TA for the design, procurement and implementation of the FMS will be carried out by a qualifiedinternational consulting firm. The consulting services will include the review of EPS's businessprocess, definition of FMS functional requirements and development of technical specifications ofan integrated financial management system. TA will also include assistance to the PIU in preparingbidding documents, evaluating bids for the FMS and implementing the system.

The training component of the TA will be provided by international consultants in the areas of theFMS and power sector restructuring. The training will be organized in the form of seminars andworkshops carried out by internationally recognized experts.

Finally, under the TA component a direct funding will be provided for auditing of Project FinancialStatements and preparation of an energy efficiency assessment of the Belgrade district heatingsystem. A direct contract for auditing of Project Financial Statements will be used to retain thesame auditor who audits EPS' accounts. A very small consulting contract will be awarded on asingle-source basis to a local engineering firm (Energoproject) to update the feasibility study ofenergy efficiency improvement in the Belgrade district heating company.

Up to the present, limited technical assistance has been available to the Ministry of Energy andMining as follows: (a) The EBRD is financing an update of a 1997 restructuring study of EPS (US$

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200,000); and (b) USAID is financing two cooperative agreements with NARUC (the US NationalAssociation of Electricity Industry Regulators), and the US Energy Association. Under thesecooperative agreements (US$250,000 each), these two organizations will co-ordinate workshopsand advice to the Ministry on the design of energy regulatory agency and on energy efficiencypolicy, respectively. The TA under the proposed Bank project would take full advantage of theinputs provided under these other assignments.

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Annex 3FR Yugoslavia: Electric Power Emergency Reconstruction Project

Estimated Project Costs

Table A: Project Cost Summary

___________________________________ Project Cost Bank FinancedProject Component Local Foreign Total Million % of Bank

(million US$) US$ Financing

A. Thermal power plant Kostolac A 1.95 9.35 11.30 2.60 43.31. Boiler and Turbine Overhaul 0.40 7.30 7.70 0.40 6.72. District Heating 0.20 1.40 1.60 0.20 3.33. Unit Thermal Insulation 0.80 - 0.80 0.80 13.34. Unit Control System 0.15 0.30 0.45 0.45 7.55. Refurbishment of Auxiliary Systems 0.40 0.35 0.75 0.75 12.5B. Substation Sremska Mitrovica 1.75 2.75 4.50 1.75 29.21. Civil Works 0.70 - 0.70 0.70 11.72. 400 kV Transformner Bay 0.65 2.60 3.25 0.65 10.83. 400 kV Transmission Connection 0.40 0.15 0.55 0.40 6.7C. Institutional Development 0.40 1.80 2.20 0.90 15.01. Technical Assistance 0.30 1.50 1.80 0.90 15.02. Financial Management System 0.10 0.30 0.40 -Total Base Cost 4.10 13.90 18.00 5.25 87.5

Physical Contingencies 0.90 0.60 1.50 0.55 9.2Price Contingencies 0.30 0.20 0.50 0.20 3.3

Total Project Cost 5.30 14.70 20.00 6.0 100.0

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Annex 4FR Yugoslavia: Electric Power Emergency Reconstruction Project

Procurement Arrangements

All Bank-financed procurement will be in accordance with the Bank's guidelines for "Procurementunder IBRD Loans and IDA Credits (January 1995 as revised in January and August 1996,September 1997, and January 1999)". Procurement of consultancy services under the technicalassistance component would follow the Bank's Guidelines for "Selection and lEmployment ofConsultants by World Bank Borrowers (January 1997 as revised in September 1997 and January1999)". Table A provides the details of the procurement arrangements for main expenditurecategories, including goods, works and services. A procurement plan detailing the packaging andestimated schedule of the main procurement actions is in Table D of this Annex.

Table A: Project Costs by Procurement Arrangements(in US$ million)

Procurement MethodExpenditure Category ICB Other NBF Total Cost1. Works1.1 Civil Works 0.85 0.501 1.35

(0.85) (0.85)1.1 Equipment Installation 3.554 0.50' 4.05

(3.55) (3.55)2. Goods and S&I2.1 Goods (equipment) 0.60 11.502 12.10

(0.60) (0.60)2.2 IT Systems 0.50' 0.50

3. Consulting Services3.1 Technical Assistance 1.00 1.003 2.00

(1.00) (1.00)TOTAL 6.00 14.00 20.0

(6.00) (6.0)ICB International Competitive Bidding.NBF = Non Bank-Financed.S&I = Supply and Installation.Figures in parenthesis are the amounts to be financed by the Bank.All figures include physical and price contingencies.Note 1: Local costs financed by EPS.Note 2: Equipment financed by suppliers' credits.Note 3: FMS and consulting services financed by SIDA (admninistered by the Bank).Note 4: This component includes retroactive financing of US$0.45 million for the completion of boilerrepair in thermal power plant Kostolac A.

All procurement under the project will be conducted by EPS. In May 2001, a Bank missionperformed a Procurement Capacity Assessment of EPS. The main findings were discussed and anAction Plan was agreed with EPS. The company was rated high-risk from a procurementstandpoint. Therefore, the PIU's procurement capacity needs strengthening to ensure satisfactoryproject implementation. To achieve this goal, the following key actions should be taken:

* EPS needs training in procurement under IBRD Loans and IDA Credits. This training will beprovided as a part of the Project Review Workshop, which should be conducted by September2001.

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* EPS should use technical consultants (MVV) contracted under the EU Energy Program in 2001for preparation of bidding documents, evaluation of bids and project implementation; and

* A PIU which was established in EPS on May 15, 2001 should be fully staffed and operationalthroughout the project implementation.

The proposed project is an emergency recovery operation and includes a provision for theretroactive financing of boiler repair in thermal power plant (TPP) Kostolac A, which is anessential requirement of the project. The boiler failure in TPP Kostolac A occurred on March 2,2000 and payments made by EPS to the contractor (Termoelektro) for the boiler repair after June2000 are eligible for reimbursement up to the limit of US$0.45 million in aggregate (7.5 percent ofthe Grant amount) per OP 12.10. The contractor started the repair in April 2000 and completedabout 70 percent of works excluding tubes welding. However, EPS paid only about 10 percent ofinvoices submitted by the contractor and approved by EPS due to the poor financial condition ofthe company. In April 2001, the contractor stopped all works demanding to be paid in order tocomplete repairs. Given the degree of and type of works completed and remaining specializedservices to be performed (welding of boiler tubes) EPS would have to use direct contracting withthe same contractor even if Termoelektro accepts to cancel its existing contract with EPS datedApril 6, 2000. Therefore, the Bank has approved on an exceptional basis the use of retroactivefinancing for this contract only.

Except for the provision of US$0.45 million for retroactive financing and US$0.1 million forinternational shopping for station batteries, EPS will procure the works related to TPP Kostolac Aand transmission substation Sremska Mitrovica through a Minor Works (MW) method. The PIUhas received a copy of a sample document for minor works.

Table B provides the details of the procurement of consulting services (costing about US$2.0million) under the Institutional Development component. An international consulting firm will behired (following the QCBS method) to assist the Serbian Ministry of Mining and Energy (MME) inpreparing an Energy Policy Statement and drafting an Energy Law. The QCBS method will beused to select and hire experienced technical consultants for design and procurement of the FMS tobe funded under the SIDA grant. An international consulting firm will be hired (following the SFBmethod) to provide training in th