Document o f The World Bank FOROFFICIAL USEONLY Report No: 27006- PL PROJECTAPPRAISAL DOCUMENT ONA PROPOSEDGRANT FROMTHE GLOBAL ENVIRONMENTFACILITY INTHEAMOUNT OFUS$ 11MILLION TO THE REPUBLIC OF POLAND FORA POLAND GEFENERGY EFFICIENCY PROJECT September 17,2004 Infrastructureand EnergyDepartment Europeand CentralAsia Region This document has restricteddistribution andmay be usedbyrecipients only inthe performance o ftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective August 30,2004) Currency Unit = New Polish Zloty (PLN) PLN1.0 = US$0.270 US$l.O = PLN3.705 FISCALYEAR January 1 - December31 ABBREVIATIONS AND ACRONYMS BGK Bank Gospodarstwa Krajowego CHP Combined Heat and Power Plant DH District Heating DHW Domestic Hot Water DHE District Heating Enterprise EE EnergyEfficiency EPSC EnergyPerformance Service Contract ESCO Energy Service Company ESMAP Energy Sector Management Assistance Program FFL Facility Liability Limit GEF Global Environment Facility GFA Guarantee Framework Agreement H C M HighCost Measures HEECP Hungary EnergyEfficiency Co-Financing Program HOB Heat-Only Boiler IFC International Finance Corporation KEEP Krakow EnergyEfficiency Project KFPK Krajowy Fundusz Poreczen Kredytowych MoEL Ministry o f Economy and Labour MoF Ministry o fFinance MPEC Municipal District Heating EnterpriseinKrakow POE ESCO ESCO Subsidiary o f MPEC TMP Thermo Modemization Program UNFCCC UNFramework ConventiononClimate Change Vice President: Shigeo Katsu Country ManagerDirector: Roger W. Grawe Sector Manager: Henk Busz Task Team Leader: Peter Johansen FOROFFICIAL USEONLY POLAND POLAND .GEF Energy EfficiencyProject CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE ................................................................. 1 1. Country andsector issues.................................................................................................... 1 2. Rationale for Bank involvement......................................................................................... 1 3. Higher levelobjectives to which the project contributes .................................................... 1 B. PROJECTDESCRIPTION ................................................................................................. 2 1. LendingInstrument............................................................................................................. 2 2. Project development objective andkey indicators.............................................................. 3 3. Project components (see Annex 3, 4 and 5 for additional details) ...................................... 3 4. Lessons learnedandreflected inthe project design............................................................ 5 5. Altematives considered and reasons for rejection .............................................................. 6 C. IMPLEMENTATION .......................................................................................................... 7 1. Partnership arrangements.................................................................................................... 7 2. Institutionaland implementationarrangements.................................................................. 7 3. Monitoring and evaluation of outcomes/results .................................................................. 8 4. Sustainability....................................................................................................................... 8 5. Critical risks andpossible controversial aspects............................................................... 11 6. Grant conditions andcovenants ........................................................................................ 12 D. APPRAISAL SUMMARY ................................................................................................. 13 1. Economic and financial analyses ...................................................................................... 13 2. Technical ........................................................................................................................... 14 3. Fiduciary........................................................................................................................... 15 4. Social................................................................................................................................. 16 5. Environment...................................................................................................................... 16 6. Safeguard policies............................................................................................................. 17 7. Policy Exceptions and Readiness...................................................................................... 17 Annex 1: Countryand Sector or ProgramBackground ......................................................... 18 Annex 2: Major RelatedProjects Financedby the Bankand/or other Agencies .................25 This document has a restricted distribution andmay be used by recipients only in the performance of their official duties I t s contents may not be otherwise disclosed . (withoutWorld Bank authorization. . Annex 3: ResultsFrameworkandMonitoring ........................................................................ 26 Annex 4: DetailedProjectDescription ...................................................................................... 31 Annex 5: ProjectCosts............................................................................................................... 39 Annex 6: ImplementationArrangements ................................................................................. 41 Annex 7: FinancialManagementandDisbursementArrangements ..................................... 42 Annex 8: Procurement ................................................................................................................ 49 Annex 9: EconomicandFinancialAnalysis ............................................................................. 55 Annex 10: SafeguardPolicyIssues ............................................................................................ 72 Annex 11:ProjectPreparationand Supervision ..................................................................... 73 Annex 12: Documentsinthe ProjectFile ................................................................................. 74 Annex 13: Statementof Loansand Credits .............................................................................. 75 Annex 14: Country at a Glance ................................................................................................. 76 Annex 15: STAPTechnicalReview and GEFFocalPointEndorsementLetter ..................78 MAP IBRD30019 POLAND GEFENERGYEFFICIENCY PROJECT PROJECT APPRAISALDOCUMENT EUROPEAND CENTRALASIA ECSIE Date: September 16,2004 Team Leader: Peter Johansen Country Director: Roger W. Grawe Sectors: District heating andenergy efficiency Sector ManagerKIirector: Henk Busz services (100%) Project ID: PO70246 Themes: Climate change (P);Other urban development (P);Pollution management and environmental health (S) Environmental screening category: Partial Assessment Safeguard screening category: B Global Supplemental ID: PO70246 Team Leader: PeterJohansen LendingInstrument: Specific Investment Loan Sectors: District heatingandenergy efficiency Focal Area: C-Climate change services (100%) Supplement FullyBlended?: N o Themes: Climate change (P) For Loans/Credits/Others: Total Bank financing (US$m.): 0.00 Pronosedterms: FSL BORROWING COUNTRY'S FIN. 53.50 0.00 53.50 INTERMEDIARY/IES Total: 53S O 11.oo 64.50 ResponsibleAgency: Bank Gospodarstwa Krajowego A1Jerozolimskie 7 PO Box 41 00-955 Warszawa. Poland Project implementationperiod: Start November 1,2004 End: December 31,2010 Expectedeffectiveness date: February 1,2005 Expectedclosing date: Does the project depart from the CAS incontent or other significant respects? Re$ PAD A.3 [ ]Yes [XINO Does the project require any exceptions from Bankpolicies? Re$ PAD D.7 [ ]Yes [XINO Have these beenapproved by Bank management? [ ]Yes [ IN0 [s approval for any policy exception sought from the Board? c ]Yes [IN0 Does the project include any critical risks rated "substantial" or "high"? Re$ PAD C.5 [ ]Yes [XINO Does the project meet the Regional criteria for readiness for implementation? Re$ PAD D.7 [XIYes [ ] N o Project development objective Re$ PAD B.2, TechnicalAnnex 3 The objective o f the proposedproject is to increase public andprivate sector investments in energy efficiency inbuildings. The project will achieve this by: 1) Overcoming the riskbarriers inthe financial markets inhibitingcommercial bank participationinenergy efficiency project financing; 2) Demonstratingthe feasibility o fpackagedinvestments inhigher-cost energy efficiency measures inbuildings andincreasing acceptance of energy performance contracting mechanisms inPoland; and 3) Stimulating the demandfor energy efficiency services inthe buildings sector and increasing awareness and capacity o f commercial banksto originate andimplement loan transactions for EEinvestments. Global Environment objective Re$ PAD B.2, TechnicalAnnex 3 The project i s consistent with the objectives o f GEF Operational Program 5: Removal o f Barriers to EnergyEfficiency and Energy Conservation. Section 5.7 o f OP5 includes support for activities that leadto sustainable results that demonstrate local, national and global benefits through removal o fbarriers. Project description [one-sentence summary of each component] Ref: PAD B.3.a, Technical Annex 4 The proposedproject consists o f three components, as described below: (i)partial guarantee; a (ii)capitalgrantfacility;and(iii) a technical assistance. Partial Guarantee coverage for energy efficiency project financing (a GEF partial guarantee o f US$5.7 million): A partial guarantee facility with US$5.7 millioninreserves will be established with GEF funds as a risk-sharing mechanismthat willprovide commercial bankspartial coverage o frisk exposure against loans made for energy efficiency projects for buildings throughout Poland. The Guarantee i s expected to leverage about US$39.0 million intotal investment by commercial banks participating inthe program, for approximately 390 projects ranginginsize from US$25,000 to $500,000. Capital Grant Facility (a GEF grant o fUS$2.0 million): The Grant Facility will support investments o fUS$6.67 million inbundledEEprojects inthe Krakow region. Eligible projects must consist o fbetween 30 and 75 % ofhighcost measures (HCM, i.e. those measureswith paybacks inexcess o f 6 years). The capital grant facility will providepartial grants equivalent to 30 percent o f total project cost to POEESCO payable uponcompletion o f installation. The flat cost-sharing structure will require that longer-payback projects (over 10years) include some portion o f end-user co-financing inorder to makethe project economically attractive for ESCO and lenders. LocalBanks andPOEESCO are expected to contribute US$4million o fthis investment,andclient co-financing is expected to equal US$.67 million oftotalproject cost o f the packaged investment. Technical Assistance (a GEF grant o fUS$3.3 million): Technical assistance will beprovided for several barrier removal activities, including: support for the deployment o f the guarantee mechanism andbuildingthe capacity o fBGKto administer the guarantee; support to POEESCO inthe development oftheperformance contractingmodelinthe Krakowregionandto buildits pipeline o fpotential investments; provision of trainingto local banks; activities to increase awareness and demand for efficiency investmentsamong buildingowners including municipalities; and collection o fproject monitoring data andbroad dissemination o fresults. Which safeguard policies are triggered, ifany? Ref: PADD.6, TechnicalAnnex 10 Environment Assessment. Inaccordance with World Bankpolicy on Environmental Assessment (OP/BP/GP 4.01), the project has beenrated Category B. There are no adverse major environmental issues associated with this project. The project is specifically targeted to improve energy efficiency. Project components will reduce fuel consumption and/or encourage less polluting fuel use which inturnwill improve local air quality (dust, sulfur dioxide andnitrogen oxides) andreduce greenhouse gas emissions (carbon dioxide). Significant, non-standard conditions, if any, for: Re$ PAD C.7 Loadcredit effectiveness: The following events are specified as additional conditions to the effectiveness o fthe Grant Agreement: (a) The Grant ImplementationAgreement betweenMoEL andBGKhas beenexecuted. (b) The Project ImplementationPlan(PIP), satisfactory to the Bank, has been adopted by BGK. (c) BGKhas receivedLetterso fIntent from at least two commercialbanks statingthat they expect to be able to sign a Guarantee Framework Agreement with BGKwithin a period o f 3 months from the expected date o f effectiveness. Covenants applicable to project implementation: Financial Covenants (i) BGKshall maintainaloss rate onnon-performing loans o fthe participating banks supported by the Partial Credit Guarantee Facility not exceeding 15% o fthe cumulative guarantee liability commitment o f BGKbythe end o f 2004 and thereafter untilcompletion o fthe Project. The loss rate on non-performing loans will be calculated on a cumulative basis as percentage o f actual amounts paid out for called guarantees adjusted by amounts recovered, divided by cumulative guarantee liability, Le., actually disbursedloan amounts coveredwith guarantees. (ii) BGK shall maintainto amaximumliability-to-reserves ratio o f 1.5:1duringthe first two years o f the guarantee program. A project review will be made inthe first quarter o f Year 3 (between 25 and27 months o f effectiveness). Thereafter, following an evaluation o f the performance duringthe first two calendar years, the Recipient shall cause BGK to adjust this target ina manner satisfactory to the Bank with the objective o f achieving a liability to reserve ratio o f 31. A. STRATEGIC CONTEXT AND RATIONALE 1. Country and sector issues An enormous potential for cost-effective improvements inenergy efficiency (EE) inthe building sector with associated environmental benefits remains relatively untapped in the Krakow region and throughout Poland. The building sector has been an underserved market for efficiency investments for a variety o f reasons, and successful efforts to increase penetration rates o f EE technologies and practices would yield significant long-term economic and environmental benefits for building owners and the economy at large. Measures such as high-efficiency windows and insulation can last 15-20 years, yielding environmental benefits well beyond the end date o f the project. The need to improve EE and to safeguard the environment has been a cornerstone o f Poland's energy and environmental policy since 1990. Although substantial success in supply-side EE programs has already been achieved nationwide, it i s widely recognized that substantial additional improvements inend-use energy efficiency and inair quality can still be achieved. The Government o f Poland's Energy Policy and Strategy calls for energy security through cost- effective supply o f energy, at socially acceptable prices and in an environmentally sustainable manner in line with the EU strategy for the energy sector. The Government has supported the development o f several additional market-based energy efficiency initiatives accelerated by: (i) major reforms in energy pricing pursued since 1991 which resulted in the gradual phase-out o f consumer subsidies and adoption o f appropriate pricing rules to ensure that energy prices gradually reach an economic level, and (ii) tighter enforcement o f environmental standards to improve air quality and relatedhigher environmental user charges andpenalties. 2. Rationalefor Bankinvolvement The proposed GEF project will promote economic efficiency, facilitate the development o f an environmentally sound energy sector in the Krakow region and Poland, and help implement mechanisms to enhance participation o f commercial banks and other private investors on a sustainable basis. It strongly supports the implementation o fthe energy-environment agenda that helps cities to develop and implement action programs for compliance with the air pollutiodurban air quality directives o f the EU. It will build upon the extensive IBRD support which established an energy service company (POE ESCO) subsidiary o f the district heating company (MPEC) in Krakow to provide energy efficiency services on a commercial basis. The Project will also build capacity in the financial and energy service sectors, leading a more sustainable, commercially viable energy efficiency industryinPoland. 3. Higher level objectives to which the projectcontributes The project supports the CAS objectives o f enhancing private sector-led growth andjob creation and achieving environmental sustainability. The project would achieve this by: (i) establishing the financing mechanisms and incentives that will improve the availability o f local private sector bank funding for energy efficiency projects as well as increase end-user demand for energy efficiency and (ii) improving energy efficiency throughout the heat supply chain by reducing the energy intensity o f end-user (building sector) systems. The project also supports the overarching economic themes o f market determination o f capital allocation, market and institutional efficiency, and the shift o f the role o f the state/municipality from direct participant in the economy to that o f a facilitator. The project would result inimproved air quality by reducing the energy intensity o f the buildingsector and thus reducing fuel consumption at the source, as well as promoting cogeneration and use o f natural gas. The environmental benefits achieved by the project are closely linked to the EU accession standards, which are also set as an important development benchmark in the CAS. The Government also has a challenge to absorb EU structural funds over a three-year period following accession inMay 2004. The proposedproject could play a role in developing investment projects, especially in critical areas o f the economy such as the cooperative housing sector, that could be co-financed with structural funds. The project is consistent with the objectives o f GEF Operational Program 5: Removal o f Barriers to EnergyEfficiency and Energy Conservation. Section 5.7 o f OP5 includes support for activities that lead to sustainable "win-win" results that demonstrate local, national and global benefits through removal o fbarriers. B. PROJECTDESCRIPTION 1. LendingInstrument A GEF Grant will be used to fund (i)a Partial Guarantee Facility o f US$5.7 million, (ii)a Capital Grant Facility o fUS$2 million and (iii) a TechnicalAssistance Grant o fUS$3.3 million. The Partial Guarantee Facility was chosen as an appropriate mechanism to overcome the fundamental barriers present in the financial sector inPoland, namely, reluctance o f commercial banks to provide long-term financing, lack o f adequate collateral among borrowers, in particular ESCOs and housing cooperatives, and perception o f high risk by lenders. The guarantee will bring more commercial financing into the market and, with it, greater discipline in terms of project structuring and accountability. The partial guarantee will provide local banks adequate security to make loans while avoiding the moral hazard o f a full guarantee, which can lead to investments in much riskier projects. As banks gain experience with the actual portfolio performance o f efficiency investments (real risk o f defaults), the level o f partial guarantee coverage required to overcome their perceived risk may decrease. Ultimately this financing may extend to pureproject fundingwhere project cash flow is the only security neededby the bank The choice o f the Capital Grant Facility was made to demonstrate the commercial viability and increase acceptance of bundling high cost measures with lower cost measures by partially financing the greater up-front costs o f measures such as windows and insulation. The Capital Grant will also help POE ESCO demonstrate the performance contracting model for buildingsin the Krakow region, thus increasing acceptance o f this type o f financing model which has generally not beenoffered to the buildings sector inPoland. The TechnicalAssistance Grant will be utilized to overcome the information barriers present in the market by buildingcapacity within the financial sector regarding EE lending and utilization o f the tools made available by the project to reduce the Finance Barriers, to increase awareness and demand by building owners, including municipalities, for new investments in EE, to aid in the development and dissemination o f the ESCO performance concept, and to collect and disseminate project monitoring and performance data throughout the country. 2 2. Project development objective and key indicators The objective o f the proposed project i s to increase public and private sector investments in energy efficiency inbuildings. The project will achieve this by: 1) Overcoming the risk barriers in the financial markets inhibiting commercial bank participation inenergy efficiency project financing. 2) Demonstrating the feasibility o f packaged investments in higher-cost energy efficiency measures in buildings and increasing acceptance o f energy performance contracting mechanisms inPoland. 3) Stimulating the demand for energy efficiency services in the buildings sector and increasing awareness and capacity o f commercial banks to originate and implement loan transactions for EE investments. Key performance indicators: (see Annex 3) Key outcome-level performance indicators for the Development Objectives (DO) ratings related to the project include: Number o f transactions relating to EE projects/ESCOs in the Polish marketvolume of debt financing relating to EEprojects/ESCOs inthe Polish market Numbero fEE/ESCO projects larger than $250,000 Number o f firms involved in energy efficiency investment activitiesKey output-level Performance indicators for the Implementation Progress (IP) ratings related to the GEF project include: Energysavings resultingfrom guaranteed loans Emissions reductionsresultingfrom guaranteed loans Numbero fguarantee transactions Guarantee claims paid Net outstanding exposure Loanvolume supported by guarantee Total annual investment inEEprojects supported by guarantee Energysavings resulting from grant financing Total co-financing contributed by buildingowners in POE ESCO projects supported by grant Numberandvolume o fprojects for which performancecontractingmodel was used 3. Project components (see Annex 3,4 and 5 for additional details) The proposed project consists o f three components, as described below: (i) partial guarantee the facility; (ii) the capital grant facility; and (iii) technical assistance. Partial Guarantee Facility for energy efficiency project financing (a GEF grant of US$5.7 million): A partial guarantee facility with US$5.7 million in reserves will be established with GEF hnds as a risk-sharing mechanism that will provide commercial banks partial coverage of 3 risk exposure against loans made for energy efficiency projects for buildings throughout Poland. The guarantees will cover 50 to 70 percent o f loan principal, and will be arranged through a number o f banks who will each have entered into a Guarantee Framework Agreement (GFA) with Bank Gospodarstwa Krajowego (BGK). The program will target the building sector generally, and will focus on multi-family (including cooperative) housing, schools and hospitals. The program will also encourage lendingto ESCOs usingperformance contracting as a financing structure. From the beginningBGK will target a reserves to liabilities ratio o f 1:1.5 meaning that BGKwill guarantee The Guarantee facility will leverage about US$39.0 million in total investment by commercial banks participating in the program, for approximately 390 projects ranging in size from US$25,000 to $500,000. Capital Grant Facility (a GEF grant of US$2.0 million): The Grant Facility will support investments o f US$6.67 million in bundled EE projects in the Krakow region. In order to be eligible for support a project must consist o f between 30% and 75 % high cost measures (HCM, i.e. those measures with paybacks in excess o f 10 years). The capital grant facility will provide partial grants equivalent to 30 percent of total project cost to POE ESCO payable upon completion. The flat cost-sharing structure will require that higher-payback projects (over 10 years) include some portion o f end-user co-financing in order to make the project economically attractive for ESCO and lenders. Local Banks and POE ESCO are expected to contribute US$4 million o f this investment, and client co-financing i s expected to equal US$.67 million o f total project cost o f the packaged investment. For Technical Assistance (a GEF grant of US$3.3 million): Technical assistance will be provided for several barrier removal activities, including: support for the deployment o f the guarantee mechanism and building the capacity o f BGK, which is a state-owned development bank that falls directly under the Ministry o f Finance, to administer the guarantee; support to POE ESCO inthe development of the performance contracting model inthe Krakow region and to build its pipeline o f potential investments; provision o f training to local banks; activities to increase awareness and demand for efficiency investments among building owners including municipalities; and collection o f project monitoring data and broad dissemination o f results. Additional information on all components i s presented inAnnex 4. Table 1: Indicative Costs and FinancingPlan Yo of % of GEF Private Total GEF Financing Sector Guarantee- Commercial Barrier Removal Financin $54.5 84% $5.7 $48.8 Grant 10% $2.0 18% $4.7 4 Barrier Removal 3. GEF Technical and Capacity Assistance Building $3.3 5yo $3.3 30% $0.0 Total Project Costs $64.5 100% $11.00 100% $53.5 Total Financing Required $64.5 100% $11.00 100% $53.5 4. Lessons learned and reflected in the project design The Small and Medium Scale Enterprise (SME) program and the Hungary Energy Efficiency Co-Financing Program (HEECP) o f the International Finance Corporation (IFC) have demonstrated an innovative approach to overcoming incremental risk and the leveraging o f GEF funds, and key elements of these programs have been incorporated into the project design. The key lessons learnedfrom the experiences o fthe IFC programs include: Strong capabilities in financial flows management and administration should be the main characteristic o fprimary and secondary executing agencies. Risk sharing arrangements among project stakeholders (ESCOs, end-users, and commercial banks) are critical to sustainability and replicability o f the project model. Use o f a guarantee framework agreement (GFA) establishes strong linkages between guarantor and banks, and allows banks to develop an EE "product" in anticipation of a projected volume o f transactions. This provides more confidence to bank management that the effort expended indeveloping new loan business will be rewarded with a large number o f transactions. Negotiation o f risk coverage by GEF guarantee facilities should be adopted whenever possible, and a fee should be assessedfor service provided to ensure market incentives guide decision making. Partial guarantees avoid some o fthe moral hazard often associated with full guarantees. Another lesson learned from the HEECP as well as other market-based non-grant mechanisms i s the need for a strong technical assistance program. Provision o f financial support mechanisms or new products i s usually not enough, as market participants are entering into a new field in most cases. Lack o f understanding o f deal structure i s an especially critical bamer in energy efficiency financing, as well as the hightransaction costs associated with small projects. In the HEECP program, the IFC acts as the guarantor. The Poland-GEF Energy Efficiency Project i s different in that the guarantor's responsibilities are assumed by BGK, a local institution. Thus, local capacity is being created, along with the potential for knowledge transfer for future programs and replication. The performance o f the Thermo Modernization loan program -- a subsidized government loan program designed to increase energy efficiency investments for heating systems and building envelopes -- managed by BGK has yielded several lessons that can be readily applied to the GEF guarantee program. The proposed guarantee program improves on the Thermo Modernization 5 Program program generally by placing fewer constraints on borrowers and participating banks, while at the same time appropriately sharing the transactional risk. A more market-oriented approach is taken in the current design. For example, equity requirements are not fixed by the program (though individual banks may have such requirements); all types o f commercial entities, including ESCOs and vendors, are eligible. In addition, the technical assistance component provides up-front cost support for banks. The guarantee program also helps to lower transaction costs and improve flexibility by providing for a portfolio guarantee structure. This structure will allow banks to introduce smaller loans to BGK with minimal approval procedures, in order to bring transaction time and costs down. Various linkages between the GEF partial guarantee and the TM program have been developed to leverage the potential synergies and BGK's experience, including: common eligibility criteria; common approach to audits and review; working with banks active inthe TM program; cross-marketing o f the programs; and buildingon the capacities o f program stakeholders. The capital grant facility design reflects lessons leamed from many demand-side management programs inNorth America and Europe, many o f which have focused on market transformation effects. Experience with financial incentives has shown that they are often helpful in speeding market penetration o f high-cost measures in the building sector, and will increase consumer acceptance o f both the energy performance contracting model and in the viability o f bundling highcost measures withlower-cost measures as apackagedinvestment. 5. Alternatives considered and reasons for rejection The following alternatives were considered for the key project components and eventually rejected: For the Guarantee component: Development of a line-of creditoperation to support energy efficiency investments through financial intermediaries to support energy efficiency investments. Experience with World Bank projects in the ECA region involving credit lines, including for energy conservation, indicates that such projects have not been an effective mechanism to overcome financial market barriers, and that such programs have suffered from slow disbursements or cancellation o f funds. This was due to reluctance o f banks to extend long-term financing, and lack o fmarketing and development capacity. Exclusive use of guarantee by POE ESCO in the Malopolskie Voivodship duringfirst three years. Originally, it was considered to limit the guarantee support to POE ESCO project activities inthe Malopolskie Voivodship. However, based upon the POE ESCO business plan the demand for commercial bank financing for their projects alone would comprise only a small fraction o f the intended guarantee volume. In addition, both BGK and commercial banks expressed a strong desire to roll out the guarantee on a national basis from the beginning. For the Capital Grant Facility: Subsidy to end users for installation of specijk measures. This approach tends to be more expensive to implement, and does little to create a market for energy service contracting. This alternative was also rejected because it does not allow flexibility in developing optimal project design which packages multiple measures and attractive financing options. 6 Subsidy to end users to secureJinancing for ECMs. There are already several programs in Poland that provide subsidized financing for energy efficiency projects such as the TMP program. Additional subsidies o f the type provided inthis program are not needed. C. IMPLEMENTATION 1. Partnershiparrangements BGK is prepared to manage the guarantee program, and to execute a Guarantee Framework Agreement with at least one commercial bank based on activities completed during project preparation. The first draft GFA i s currently under negotiation between BGK and a commercial bank. BGK will receive additional training in the early stages o f project implementation, especially regarding procurement and reporting issues. BGK will hire a procurement consultant, retroactively financed, to prepare the implementation o f the TA component. 2. Institutionalandimplementationarrangements BGK, a state ownedbank established in 1924', will be the executing agency andwill beresponsible for coordinating the implementation o f the overall project and will directly implement the guarantee facility component. BGK will act as an agent o f the Government o f PolandMinistry o f Economy and Labour (MoEL), who will be the grant recipient. Overall Project Management. The Special Funds Department at BGK will be responsible for all activities related to the GEF Grant, including procurement, disbursement and accounting. BGK will hire a financial officer responsible for financial accounting and reporting related to the project. For the project purposes the implementing team will design and implement a special I T system to maintain the project cost and monitor guarantees issued. The new system for monitoring o f guarantees shall be ready prior to disbursement for the Partial Guaranty Facility Component. BGK will also prepare a Project Implementation Plan including an operational manual for the project with a section on accounting and financial matters. BGK will enter into cooperation with three to four participating banks on the basis o f separate Guarantee Framework Agreements. These participating banks will actually originate the loans to the borrowers for eligible energyefficiency projects. Flow of funds. Project funds will flow from: (i) Bank, either via a single Special Account the which will be replenished on the basis o f SOEs or by direct payment on the basis o f direct payment withdrawal applications; or (ii) the commercial Bank loans as contributions, or (iii) own contribution o f final beneficiaries (beneficiaries o f energy efficiency projects). The GEF funds for the Guarantee Facility will be transferred directly to the Guarantee Facility Account held in BGK and earningbank deposit interest on behalf o f the MOEL. BGK will receive authorization to manage the Account including inter alia payments for called guarantees and recovery o f amounts paid under called guarantees. ' Thepresent activities o f BGK include the ones stipulated inthe Banking L a w as well as special purpose tasks assigned by the Ministryo f Finance or through legal acts including inter alia managing o f special funds (e.g. the NationalHousingFund,the National Credit GuaranteeFund,the Thermomodemization Fund,and the Student Loans and Credits Fund). 7 Strengths and weaknesses. The concept has significant strengths due to: (i) experience o f the BGK staff inimplementation of Bank financed projects and government projects including the successful National Loan Guarantee Fund, (ii) unqualified audit reports issued by BGK the auditors, and (iii) strong organizational and financial capacity o f BGK as reputable bank overall to manage this type o f project. A minor weakness i s BGK's inexperience in implementing a TA program and achieving compatibility with World Bank procedures as exemplified in a slow preparation o f an IT system for Partial Credit Guarantee Facility Component. 3. Monitoringand evaluationof outcomes/results ProposedActivities. A strongparticipatory program is beingprepared to inform the public and to engage key stakeholders. The public participation program will include: (i)information sharing activities; and (ii) consultative participation activities at two levels: at the program level or a class o f potential customers, and at the individual project level. The intention i s to reach out to the various stakeholder groups to provide them with adequate information about the project and how it will affect them. The public participation program will listen to stakeholder concems, and incorporate them as appropriate into the design and implementation o f the overall program. Keystakeholder groups are: Direct beneficiaries: these include the owners and occupants o f buildings o f different types (e.g. housing cooperatives, businesses, and public service facilities such as schools, hospitals, and governments). Other affected groups: these include building industry associations, building design professionals, manufacturers o f building equipment and materials, building retrofit contractors, financial organizations serving the building industry (banks, mortgage companies, etc), and buildingcode officials and inspectors. Other stakeholders: these include local advocacy groups (buildings,housing, energy, and environmental issues), officials and key staff o f the city and voivod (regional) governments, and memberso fthe architectural and engineering community. 4. Sustainability The project aims to engage local financing sources, especially commercial banks, through lending to the building sector, especially the housing cooperatives sector which is currently underserved. The project will also build awareness o f energy efficiency financing and capability to implement energy efficiency investments in Poland, leaving behind a self-sustaining energy efficiency industry. Several hndamental conditions for a strong energy efficiency market exist inPoland, including: (i) tariffs,bothforheatandelectricity,thathavebeenrationalizedtoattaincostrecovery; energy (ii)relativelyhealthyfinancialsector;and(iii) a improved interest rates inmost areas o f lending. A downward movement o f energy tariffs is not likely, given Poland's probable accession to the European Union; higher tariffs will o f course improve the financial performance o f all energy efficiency projects. Currently the banking sector i s relatively healthy financially and there is adequate liquidityinthe markets. Interest rates have dropped steadily over the past several years and inflation, as well as the currency, are stable. Other macroeconomic conditions, such as GDP growth, are not as favorable but have less impact directly on the demand for energy efficiency improvements. 8 The project will build on these fundamental conditions and introduce concepts and financial mechanisms that will provide for greater awareness o f and access to traditional energy efficiency financing. The guarantee facility will help develop a sustainable market for energy efficiency finance through development o f capacity within local financial institutions and through addressing the perceived risk in lending to the sector that i s currently impeding increased investment. Like the Hungary HEECP program, it i s expected that the requirement for risk sharing will decrease as transaction volume increases and default levels remain stable and low. Lower guarantee percentages and eventually lending without guarantees will signify a high degree o f sustainability. The existence o f a relatively successful guarantee program for Small and MediumEnterprises -- Krajowy Fundusz Preczen Kredytowych (KFPK) -- operated by BGK will improve the chances o f a sustainable market for energy efficiency inPoland. KFPK i s a guarantee program designed for loans made to SMEs. Building on the procedures and lessons learned from KFPK will help BGK launch a successful EE guarantee program earlier, with early-stage focus on the particulars o f EE lending and marketing. The Capital Grant Facility will demonstrate the efficacy o f bundling high-cost and low-cost measures into larger projects with reduced payback periods, in the Krakow region through the activities o f POE ESCO. The approaches o f POE ESCO, employing a performance contracting model, are replicable for other entities inPoland. The project will create significant expertise and institutional capacity in Poland through the following activities: (i)development o f procurement capacity and energy efficiency demand analysis (mainly in Malopolska Region) through TA; (ii)development o f energy efficiency finance and contract structuring capacity at commercial banks and BGK, through TA; (iii) transactional experience at commercial banks and BGK through loan origination and execution o f guarantee agreements; (iv) EE project audit experience through T A associated with both POE ESCO and the guarantee program; (v) development o f increased project experience at POE ESCO, through increased deal flow associated with the Capital Grant facility as well as TA training. All o f this experience and increased capacity will remain in country, creating sustainability within the energy efficiency sector. Exit strategy The final exit strategy for GEF funds will depend on the success o f the project. The Government, the World Bank, in consultation with GEF, will finalize the exit strategy in Year 4 o f project implementation. Ifmonitoring and evaluation reports indicate that program objectives are being met and there is continued demand for the partial guarantee from commercial banks, then available reserves in the guarantee fund shall remain in the account controlled by BGK and the program shall continue based upon terms specified ina final agreement between the World Bank and the GOP inthe last year o f GEFproject implementation. If performance has not met project goals, the uncommitted funds (defined as those funds not committed or encumbered to any outstanding loans or committed via existing framework agreements with participating banks) in the reserve account may be transferred from BGK to the Ministry of Economy for use in other climate change related projects in Poland. However, in doing so, funds for administration and management o f the remaining commitments must also be allocated to BGK. 9 The implications for each GEF grant modality are discussed below. GEF Capital Grant Facility. The US$2.0 million capital grant modality will be most likely fully disbursed by Year 4 o f the project. Iffunds are not used by POE ESCO during the three-year exclusivity period, remaining balances will be transferred to the Partial Guarantee Reserve Account managed by BGK. GEF Partial Guarantee. The US$5.7 million guarantee reserve account granted to the MoEL and managed by BGK,net of actual losses and recovered funds, would be permanently granted to the Government o f Poland to continue the guarantee program. BGK and the Government will set future targets for budgets, guarantee percentages, new GFAs and other program operating determinants in Year 4 for the post-project period. Any future closure o f the program would require transfer o f all uncommitted fimds in the reserve account to other eligible energy efficiency activities. Sufficient reserves will be required to remain in the account to cover (i) outstanding contingent liabilities (based on outstanding principal for loans which are guaranteed and not closed by participating banks); and (ii) operating costs o f BGK for the remainder o f the "guarantee period" (defined as that period ending when outstanding guarantee equal zero). It i s assumed that no hnds will disbursed by the Bank for management fees after closure o f the project. As liabilities are reduced, reserve funds can be released to other activities. BGK would be required to continue reporting performance o f the program to the Government. 10 5. Critical risks and possiblecontroversialaspects FromOutputs to Objective Higher energy prices do not motivate service 1. Implement energy efficiency measures providers and consumers to implement consistent with the project's economic mergy saving investments M circumstances. 2. Continue Bank involvement inEnergy Sector Dialogue, including pricing reforms ncreased lending from commercialbanks to M 1. Aggressively market program through use o f 3Eproject sponsors andbuildingowners TA; provide trainingto FIs, BGK and EE loes not occur despite presence o f guarantee. businesses to develop pipeline 2. Demonstration and dissemination o f early project experience o f POE ESCO 3. Sign multiple GFAs to increase number o f banks offering loans using guarantee product and number o f potential customers applying for loans 4. Allocate additional TA to increase capacity and familiarity o f local banks ifrequired hfficient numbers o f creditworthy building S 1. Increase guarantee percentage o ftotalprlncipal )wners are not submitting loan applications 2. Increase marketing to public sectoriwider coverage o f marketing to increase demand Zapital grant does not buy down payback N 1. World Bank will review component after one nough to make projects financially attractive year to determine if grant amounts or procedures need to be adjusted 2. Focus energy audits and proposals on larger projects with multiple measures 3. Encourage POE ESCO to include electrical energy savings inprojects to bringdown paybacks to more attractive levels lemandcreation and capacity building M 1. Begin TA assistance inthis area early on and :fforts do not convince buildingowners to review after one year mter into EEperformance contracts with 2. Dissemnate results early from representative 3cos projects 3. Provision o f TA to other market actors? FromComponentsto Outputs 3GK unable to negotiate multiple GFAs N 1. Assist BGKthroughTA to identify andtrain additional local banks in guarantee program 2. Aggressively market program infirst two years Localbanks unwilling to pass through S 1. Train several localbanks inearly phase o f benefits o f guarantees to customers and program in EE finance, guarantee structure unable to originate deals 2. Aggressively marketguarantee programto potential borrowers POE ESCO unable to generate sufficient deal M 1. Use TA funding to buildcapacity among flow for grant applications building owners and assist municipalities in developing RFPs 2. Assist POE ESCO indeveloping larger projects through aggregation 3. Use TA funds for audits and weatherization studies to ramp up deal flow quickly 11 Risk I RiskRating I RiskMitigationMeasure Investments supported through project do not N 1. Eligibility criteria limitinvestments to proven yieldprojected levels ofenergy savings technologies Materials suppliers abuse market by M 1. Worldbank procurement procedures are increasing prices followed for Grant fundedprojects 2. Grant Administrator monitors unitpricing for windows and insulation and rejects grant applications that exceed these bylarge margin OverallRiskRating M 6. Grant conditionsandcovenants FinancialCovenants (i) BGK shall maintain a loss rate on non-performing loans o f the participating banks supported by the Partial Credit Guarantee Facility not exceeding 15% o f the cumulative guarantee liability commitment o f BGK by the end o f 2004 and thereafter until completion o f the Project. The loss rate on non-performing loans" will be calculated on a cumulative basis as a percentage o f actual amounts paid out for called guarantees adjusted by amounts recovered divided by the cumulative guarantee liability i.e. actually disbursed loan amounts coveredwith guarantees. (ii) BGK shall maintain to a maximum liability-to-reserves ratio o f 1.5:l duringthe first two years o f the guarantee program. A project review will be made in the first quarter o f Year 3 (between 25 and 27 months o f effectiveness). Thereafter, following an evaluation o f the performance during the first two calendar years, the Recipient shall cause BGK to adjust this target in a manner satisfactory to the Bank with the objective o f achieving a liability to reserve ratio o f 3: 1. "Liability-to-reserves ratio" will be calculated as actual guarantee liability outstanding divided bythe balance on the Guarantee FundAccount. Other FMcovenants BGK will maintain a financial management system both for itself and the project acceptable to the Bank. Additionally BGK will be responsible to cause POE ESCO and Participating Commercial Banks to maintain a sound accounting and financial management system for project transactions and entity. The BGK andParticipating Commercial Banks as entities andthe project financial statements, SOEs and Special Account and the Guarantee Facility Fundwill be audited byindependent auditors acceptable to the Bank and onterms o freference acceptable to the Bank. The annual audited statements and audit reports together with the Management Letter will be provided to the Bankwithin six months o f the end o f each fiscal year. BGK shall not draw down reserves for use as operating funds at any time during project implementation without the prior written approval o f the Bank. EffectivenessConditions The following events are specified as additional conditions to the effectiveness o f the Grant Agreement: 12 (a) The Grant ImplementationAgreement between M o E L and BGKhas beenexecuted. (b) The Project Implementation Plan (PIP), satisfactory to the Bank, has been adopted by BGK. (c) BGK has received Letters of Intent from at least two commercial banks stating that they expect to be able to sign a Guarantee Framework Agreement with BGK within a period o f 3 months from the expected date of effectiveness DisbursementConditions (a) Disbursements on the Guarantee Facility Component shall be conditioned upon the readiness o f the IT system to monitor the guarantees issued together with the underlying loanportfolio. (b) Disbursementson the Grant Facility Component shall be conditioned uponthe execution of the POE ESCO-GEF Grant Implementation Agreement between BGK and POE ESCO. D. APPRAISAL SUMMARY 1. Economicandfinancialanalyses Economic(see Annex 4): [ ] Cost benefit [ ] Cost effectiveness [XIIncrementalcost [ 3 Other (specify) The project i s expected to produce incremental benefits of 1.4 million tonnes of COz emissions reductions through US$61.5 million in investments in energy efficiency in buildings at an incremental cost to GEF o f US$8.O/tonne COz, or US$29.35/tonne C. Detailed analysis o f the incremental costs and the global environmental benefits o f the project are provided inAnnex 9. Financial(seeAnnex 4 andAnnex 5): Financial Aspect of the GuaranteeProgram The partial guarantee program will be backed by a reserve fund o f US$5.7 million that will be disbursedto BGK in several tranches over the first three years. Disbursementswill be based on the facility liability limits inthe initial GFAs and it i s anticipated that the first disbursement will be for US$3.0 million. It is anticipatedthat a second GFA will be signed inYear 1, allowing for a second disbursement o f US$2.0 million to reserves. A third and final disbursement of US$0.7 million will be made inYear 3 pendingpositive review by World Bank and BGK. Reserves will back partial guarantees o f between 50 percent and 70 percent o f loan principal. It i s anticipated that approximately US$2.5 million in loan transactions will be concluded in Year 1, increasing to US$6.0 million inYear 3 and US$9.0 million inYear 6. Total loan volume over the six-year period is expected to be US$39.0 million, with an additional 20 percent o f equity financing, for a total project financing volume of US$48.75 million. Average loan size i s expected to be US$lOO,OOO, for a total o f 390 transactions. The default rate assumed for this 13 program i s 7 percent, and will be reviewed after Year 2 to determine actual risk levels in the market and program. Total losses over the six-year period are expected to be US$1.6 million. An assumed recovery rate o f 10% o f loss payments is used. With approximately US$1.6 million o f interest income reinvested in reserves, the net balance o f reserves at the end o f the project period will be US$5.8 million, representing a net gain o f two percent total. The balance in the reserve account will be sufficient to sustain continued guarantees inthe post-project period. BGK Operating Costs The costs o f managing the GEF Project will be incremental to BGK's existing operations. Program operating costs are budgeted at an average o f about US$280,000 per year through the project period, for a total o f US$1.7 million. Some annual increases will occur in staffing and overhead in years 2 or 3, depending on deal volume. Decreases will likely occur later in the program. Guarantee fees will start at about US$25,000 in Year 1 and ramp up as deal volume increases, to average about US$70,000 per year. World Bank has agreed to pay a flat fee o f US$1.3 million to BGK from GEF funds to cover most o f the operating costs, with the balance o f operating costs paid from guarantee fees. The management fee as a percent o f operating costs will be approximately 80 percent over the project period, therefore there is some risk to BGK if (i)doesnot generate sufficient guarantee fees; or (ii)administrationcosts arehigherthan it expected. Fiscal Impact BGK is a state-owned development bank that falls directly under the Ministry o f Finance. Any guarantee liabilities undertaken by BGK in excess o f a 1:l ratio will result in a contingent liability for BGK, and thus some risk. The anticipated risk to BGK i s low during the first two years, when the program i s beginningto ramp up and transaction volume will likely not allow for a liability to reserve ratio exceeding 1:l. Figure 3 in Annex 9 shows how the deal flow increases and the risk exposure increases along with it. At a 3:l ratio, actual losses (in terms o f default rate) would have to exceed 33 percent before BGK would have impact to its balance sheet. Such a rate is highly improbable. At a ratio o f 1.5:1, the actual default rate would have to exceed 67% inorder to create an impact onBGK's balance sheet. Risk management for BGK will be primarily in the form o f managing the Facility Liability Limits (FLLs)negotiatedwith eachcommercialbank. 2. Technical Use of Technologies. This project will support investments in proven energy technologies. Technologies eligible for both the guarantee and grant components are familiar to the engineering and construction trades in Poland and are widely available in Poland. POE ESCO and other entities will be encouraged to focus on proven methods for maximizing savings to be generated for each client, without tryingleading edge technologies. Energy Savings Versus Building Retrofit Measures. An important issue i s whether a specific technology i s beingused because o f its energy savings or as part o f general buildingrenewal, or both. This issue occurs especially regarding installation o f new windows in buildings. The capital grant facility, which is specifically geared toward demonstrating bundled investments including high-cost measures, i s applicable only for comprehensive projects where high-cost 14 measures comprise a maximum o f 75 percent o f total project cost. Building owners, through technical assistance activities, will also be educated about the value o f comprehensive retrofit projects which cut deeply into energy consumption. 3. Fiduciary The financial management arrangements o f the project are acceptable to the Bank, with exception o f the I T system for management of the guarantees issued with underlying loan portfolio. The readiness o f the I T system for management o f the guarantees issuedtogether with underlyingloan portfolio relating to Partial Risk Guarantee Facility is a disbursement condition for this component. Legal andImplementationArrangements The Government o f Poland's Ministry o f Economy and Labour (MoEL) will be the recipient of the US$11 million dollar grant. A Grant Agreement will be signed between the World Bank and MoEL. M o E L will deposit funds from the GEF Grant with BGK, who will act as Guarantee Manager and Executing Agency. A GEF Grant Implementation Agreement will be signed between M o E L and BGK. BGK will serve inthe following roles as Executing Agency: manager o f the Guarantee Facility; administrator o f the Capital Grant Facility; administrator o f the technical assistance activities; coordinator o f the entire project. A Project Agreement between the World Bank and BGK will specify the various tasks and responsibilities o f BGK. BGK will assume all fiduciary responsibilities for the use o fthe GEF grant funds. BGK will enter into Guarantee Framework Agreements (GFA) with several qualified banks to govern the relationships and set the responsibilities o f each party in entering into individual loan guarantee agreements. The World Bank designated staff in cooperation with BGK will need to assess each prospective participating bank in conformity with the World Bank's Operational Policy 8.30 and Europe and Central Asia Region Financial Intermediary Lendingguidelines; and confirm their eligibility to participate inthe project. BGK i s required to obtain the World Bank's no objection to any selected participating bank. All participating banks will have to hlly meet the qualification criteria within the time period provided for project implementation in order to take part inthe project. One o f the prospective participatingbank has been positively assessedby the World Bank staff. In addition, BGK and POE ESCO will enter into a Grant Implementation Agreement and individual Capital Grant Agreements for each grant made to POE ESCO under the Capital Grant component. The Grant Implementation Agreement between BGK and POE ESCO will govern: (i) Capital Grant; (ii) the guarantees made for POE ESCO project loans; and (iii)technical assistance grants made to POE ESCO. A diagram o fthe legal and implementation arrangements is enclosed inAnnex 6. Prior Review World Bank is responsible for review of the following: For the GuaranteeProgram: review and approval o f (i) Guarantee Framework Agreements; all (ii) firsttwoloanguaranteeagreementsundereachGFA. the 15 For the Capital Grant Facility: review and approval o f (i) first three grant applications; (ii) the any grant application requesting a grant o fUS$400,000 or more. For the Project Management Unit ofBGK: (i) review o fBGK's PMUannual operating budget and business plan for the following fiscal year at least one quarter prior to end o f current fiscal year; budget should be agreed upon and approved by World Bank at least one month prior to beginning o f next fiscal year; (ii) review and approval o f any request for extraordinary use o f funds from the reserve account, for example, if program earnings are insufficient to cover operating costs at any time. 4. Social There are no critical social issues related to the project. The project will make electricity and heating services more affordable in the areas targeted by the project, and therefore no social hardships are anticipated as a result o f the project. Improved thermal insulation o f dwellings could substantially lower heating requirements, and in conjunction with regulation devices and metering and consumption-based billing procedures household expenditures for heat andhot water could thus bereduced considerably. Duringmid-termreview, the World Bank, BGK and POE ESCO will review the achievements so far. Stakeholder consultations will provide important inputs into decision making about the course o f action during the last part o fproject implementation. As part o f its marketing and consumer-relations activity, POE ESCO will conduct a consumer satisfaction survey each year. During project implementation, the World Bank will review the terms o f reference o f such a survey and agree with POE ESCO on any additional survey activity that will be requiredto assess the project impacts, as well as the mechanisms that will be used to follow up on the surveyresults inproject implementation. 5. Environment In accordance with World Bank policy on Environmental Assessment (OP/BP/GP 4.01), the project has been rated Category B. There are no adverse major environmental issues associated with this project. The project is specifically targeted to improve energy efficiency. Project components will reduce fuel consumption andor encourage less polluting fuel use which in turn will improve local air quality (dust, sulfur dioxide and nitrogen oxides) and reduce greenhouse gas emissions (carbon dioxide). Replacement o f materials and equipment may lead to dust and noise. Replacement o f old insulation may involve asbestos, and assurances were provided that any new insulation materials are acceptable underPoland's commitments to the Montreal Protocol. The Guarantee Framework Agreements used in the guarantee facility specifically address requirements for originating banks to comply with World Bank and Polish Government environmental regulations. An EMP has been prepared, providing environmental guidelines for the implementation o f the Capital Grant by POE ESCO. It focuses on institutional arrangements and institutional capacity 16 for environmental screening, environmental analysis, and the environmental regulatory framework which i s in place or would be necessary to assure POE ESCO subprojects receive a level o f scrutiny that is: (a) in compliance with Polish environmental policies, procedures, and regulations, and (b) consistent with World Bank environmental policies andprocedures. 6. Safeguard policies Safeguard Policies Triggered by the Project Yes N o Environmental Assessment (OP/BP/GP 4.01) X [I NaturalHabitats (OP/BP 4.04) [I X Pest Management (OP 4.09) [I X Cultural Property (OPN 11.03, beingrevised as OP 4.11) 11 X Involuntary Resettlement (OP/BP 4.12) [I X Indigenous Peoples (OD 4.20, beingrevised as OP 4.10) [I X Forests (OP/BP 4.36) [I X Safety o f Dams (OP/BP 4.37) [I X Projects inDisputedAreas (OP/BP/GP 7.60)* [I X Projects on InternationalWaterways (OP/BP/GP 7.50) [I X 7. Policy Exceptions and Readiness 1.a) The engineering design documents for the first year's activities are complete and ready for the start o f project implementation. 1.b) Not applicable. 0 2. The procurement documents for the first year's activities are complete and ready for the start of project implementation. 3 . The Project Implementation Plan has been appraised and found to be realistic and o f satisfactory quality. 0 4. The following items are lacking and are discussed under loan conditions (Section G): * By supporting theproposedproject, the Bank does not intend toprejudice thefinal determination of theparties' claims on the disputed areas 17 Annex 1: CountryandSector or ProgramBackground POLAND: POLAND - GEFEnergyEfficiencyProject Sector-relatedCountryAssistance Strategy (CAS) goal supportedby the project: 0 Enhancingprivate sector-led growth and employment creation Documentnumber: R2002-0210 Dateof latestCAS discussion: December 10,2002 Dateof CAS Progress Report:August 25,1999 The project supports the CAS objectives o f enhancing private sector-led growth andjob creation and achieving environmental sustainability. The project would achieve this by: (i) establishing the financing mechanisms and incentives that will improve the availability o f local private sector bank funding for energy efficiency projects as well as increase end-user demand for energy efficiency and (ii)improving energy efficiency throughout the heat supply chain by reducing the energy intensity o f end-user (building sector) systems. The project also supports the overarching economic themes o f market determination of capital allocation, market and institutional efficiency, and the shift o f the role o f the state/municipality from direct participant in the economy to that o f a facilitator. The project would result in improved air quality by reducing the energy intensity o f the buildingsector and thus reducing fuel consumption at the source, as well as promoting cogeneration and use o f natural gas. The environmental benefits achieved by the project are closely linked to the EU accession standards, which are also set as an important development benchmark inthe CAS. GlobalOperationalStrategy/ProgramObjectiveaddressedby the project: The project is consistent with the objectives o f GEF Operational Program 5: Removal of Barriers to Energy Efficiency and Energy Conservation. Section 5.7 o f OP5 includes support for activities that lead to sustainable "win-win" results that demonstrate local, national and global benefits through removal o fbarriers. Main sector issues andGovernmentstrategy: An enormous potential for cost-effective improvements in energy efficiency in the building sector with associated environmental benefits remains relatively untapped in the Krakow region and throughout the greater Poland area. The building sector has been an underserved market for efficiency investments for a variety o f reasons, and successful efforts to increase penetration rates o f EE technologies and practices would yield significant long-term economic and environmental benefits for building owners and the economy at large. Materials such as high- efficiency windows and insulation can last 15-20 years, yielding environmental benefits well beyond the end date o f the project. The strategic importance of implementing further energy efficiency measures both on the supply as well as the demand side is well documented in sector work completed by the Bank and other studies. As an example, annual losses o f heat in housing due to insufficient insulation alone amount to over US$1.75 billion in Poland. Assuming average simple payback o f 7 years, the total market for building insulation amount is about US$12 billion. Based on average heating 18 costs, this would translate into approximately 223 petajoules o f heat savings and about 13 million tons o f C02 emissions reductions annually. While market-based incentives for energy efficiency are increasing, many serious financial and institutional barriers and market failures are preventingthe realization o f the savings potential in thismarket. These barriers andmarket failures inPolandinclude: Local banks are not familiar with end-use energy efficiency projects for buildings and are reluctant to provide financing. They have also had little or no experience in lending to ESCOs and thus are not familiar with the energy performance contracting model. Some banks are interested in the performance contracting model offered by ESCOs, but inmost casesESCOs do not sufficient assetsto provide comfort to the bank. Consumers and banks are less aware of financial options and benefits o f energy savings, andhave the perceptionthat committed funds for EEprojects carry very highrisks. Projects are relatively small and transaction costs are high. Generally, building owners lack capital for any required investments and are not sufficiently creditworthy to attract commercial financing at acceptable terms. Scarce financial resources among building owners force a focus on a minimum first cost and hence only rudimentary levels o f energy efficiency are currently considered by buildingowners. Various subsidy mechanisms have, to a certain extent, spoiled the market for commercial financing o f energy efficiency projects in Poland, particularly amongst municipalities. Local governments have had the expectation that if they simply wait long enough some form o f subsidy will be eventually obtained. The track record o f many loans to the cooperative housing sector has been poor, reinforcing the perception o f highriskby banks for loans for improvements inbuildings. New approaches and financing mechanisms are thus needed to help bridge the knowledge and financing gap between local banks and building owners. Any new approach must harness the incentive o f building owners to undertake end-usecost-effective energy efficiency measures in a sustainable manner and must align with the institutional incentives o f local banks to finance these commercially viable measures. Local banks were surveyed duringpreparationvia a formal solicitation requestinginformation on EE lending experience and a description o f how they would market the program and generate deal flow. The survey showed that most banks are currently not lendingto the sector, with a few exceptions. While liquidity exists in the financial sector, most banks are not lending to energy efficiency projects, and especially to buildings, for reasons stated above (lack o f understanding o f EE financing and ESCOs, perception o f high risk, etc.). Generally speaking, the housing sector i s considered by most banks as high risk, and it is often avoided. The multi-family housing sector i s especially problematic due to changes in the law which have created uncertainty with regard to buildingownership. Therefore most banks perceive greater credit risk inthis sector. Indeed, there are some structural problems inseveral sectors, including the health care sector, which may limit lending to projects even with the existence o f a guarantee. Only two o f the banks surveyed have any experience with lendingto ESCOs, and therefore exposure to the sector i s still very limited. 19 The need to improve energy efficiency and to safeguard the environment has been a cornerstone o f Poland's energy and environmental policy since 1990. Although substantial success in supply-side energy efficiency programs has already been achieved nationwide, it i s widely recognized that substantial additional improvements in end-use energy efficiency `and in air quality can still be achieved. The Government o f Poland's EnergyPolicy and Strategy calls for energy security through cost- effective supply o f energy, at socially acceptable prices and in an environmentally sustainable manner in line with the EU strategy for the energy sector. The Government has supported the development o f several additional market-based energy efficiency initiatives accelerated by: (i) major reforms in energy pricing pursued since 1991 which resulted in the gradual phase-out o f consumer subsidies and adoption o f appropriate pricing rules to ensure that energy prices gradually reach an economic level, and (ii) tighter enforcement o f environmental standards to improve air quality and related higher environmental user charges and penalties. O f particular relevance to the GEF project is the TMP, in place since 1996. This subsidized government loan program i s designed to increase energy efficiency investments for heating systems and building envelopes. Managed by BGK, the T M program provides a 25% reimbursement o f principle for qualifying loans meeting eligibility requirements. While this program has led to over US$14.8 million in investments in improved efficiency in Poland, the results achieved have been far below original government goals due to several program design flaws and un-addressed keybarriers, including the previously mentioned highperceived risk and consequent high rejection rates o f loan applications by lenders and high transaction costs associated with applications for T M projects. The proposed GEF project will promote economic efficiency, facilitate the development o f an environmentally sound energy sector in the Krakow region and Poland, and help implement mechanisms to enhance participation o f commercial banks and possibly private investors on a sustainable basis. It strongly supports the implementation o f the energy-environment agenda that helps cities to develop and implement action programs for compliance with the air pollutiodurban air quality directives o f the EU. It will build upon the extensive BRD support which established an energy service company (POE ESCO) subsidiary o f MPEC in Krakow to provide energy efficiency services on a commercial basis, and will overcome several keybarriers leading to improved implementation o fthe T M loan program. The proposed project will also support the Government in meeting its international obligations. Poland ratified the UNFramework Convention on Climate Change (UNFCCC) on July 28, 1994 and submitted the National Communication in 1996, agreeing to limit greenhouse gases (GHG) emissions to the 1988 level in the year 2000 through measures aimed at encouraging economic efficiency and rational use o f energy. As the potential for reducing energy consumption (and in turn COZ emissions) in space heating is largely related to the improvement of heating devices and the quality o f building insulation, priority has been accorded to the public and residential sectors. This priority i s reflected inthe project design. 20 Sector issues to be addressed by the project and strategic choices: Overcoming Barriers to Energy Efficiency The technical, economic, and environmental benefits to Poland o f improving the energy efficiency o f buildings and their energy sources are well substantiated. The technologies for effecting substantial improvements in energy efficiency in buildings are widely available with proven effectiveness. Detailed case studies o f energy efficiency retrofits o f typical large residential buildings have shown that many energy efficiency projects could yield attractive financial returns if they were not burdened with risk premiums and the absence o f longer-term financing in local capital markets. As a result o f these "financing gap" barriers, many such projects remain unimplemented throughout Poland. Barriers related to the lack of financing from commercial channels are compounded by market factors such as low awareness and risk perception. Polish case studies and have identified the following barriers to energy efficiency project development in the building sector. They are identifiable barriers and risks that will be addressed by the project and whose elimination will be monitored during project implementation: (a) Financing Barriers. Many Polish building owners and other active participants in the market, including ESCOs, have insufficient access to project financing for up-front investment costs for energy efficiency retrofit projects. Some o fthe reasons for this are: 0 Most building EE projects will have a payback o f greater than 6 years. While loan maturities are increasing, the typical current commercial loan term i s about 3-5 years, which i s too short for repaying the loan from the energy savings. Such a short repayment horizon `skims the cream' and puts further deep cuts in energy use out o frange. 0 Many building owners, while having reasonably good credit, do not have adequate capital to provide either equity co-financing or adequate security sufficient to receive long term loans from the fairly risk-averse banking sector. Most banks require collateral well inexcess o f 100%o fthe loan value. 0 Domestic banks have not yet initiated comprehensive or long-term lending programs for energy efficiency projects. Moreover, the domestic financial institutions are generally not familiar or adept at analyzing the financial aspects o f energy efficiency projects, and hence even less willing to extend credit for these projects. 0 Commitment Risk. Disbelief inthe possibility o f savings and fear o f disruption to building occupants stall energy management actions that might otherwise be fundable. Commercial banks and building owners often perceive too much risk to enter into financing arrangements based on energy management programs from ESCOs. Building owners and commercial banks have never benefited from this type o f mutual commitment before and assuming new risks and endeavors by definition threatens their conventional methods o f operation and risk sharing. (b) High Transactions Costs. Energy efficiency projects are relatively small and can carry high transaction costs for lenders and end-users, especially when using new and 21 unfamiliar procedures such as energy performance contracting. Especially where the annual benefits are considered small, building owners are reluctant to incur these costs. This barrier is evidenced in the poor performance o f the TMP, where highupfront costs for end-users and complex procedures limited participation. These design flaws are being addressed in the proposed GEF project by reducing upfront costs and simplifying approval procedures inthe guarantee program. (c) Inadequate Information. While the energy conservation community in Poland i s well aware o f energy efficient technologies and renovation measures, the buildingowners, the occupants and the local banks lack information about the financing aspects o f energy- saving investments, the implementation experiences o f others, and the ability to use energy savings to finance some buildingrenewal. Strategic Choices To overcome the barriers above and help the market develop both quickly and in a sustainable manner, the following strategic choices have been made to overcome the three major market barriers identified above: Choice of Markets- Energy Efficiency Projects and Clients in the Building Sector. The Project i s focused on the buildings sector because o f the significant savings potential, the lost opportunities not currently being financed, the prospect o f leveraging and improving upon current efforts to improve EE in buildings, positive alignment with the government priority to improve efficiency in the public and residential sectors, and the total replication potential. The current efforts to improve efficiency in Poland, specifically through the TMP, can be vastly improved with the successful operation o f the Poland-GEF Energy Efficiency project and, inthe absence o f the project will continue to have limitedimpact incapturing efficiency gains. At least inpart, the lack o f success o f the TMP is due to failure to address the fundamental problem o f lack of collateral for loans. The project will address efficiency in energy consumption in buildings all through the supply chain for residential housing, municipal/state clients, as well as for private enterprises; from source (high-efficiency boilers and cogeneration) to distribution (high-efficiency heat exchangers) to end-use (lighting, windows, insulation, HVAC). This flexibility will allow building owners and ESCO to design potential investment projects from a comprehensive perspective and capture short-term as well as longer-term savings. Choice of ESCO Mechanism to reduce transaction costs. The ESCO model i s particularly appropriate in Poland as many building owners are not in a position to structure or finance projects on their own, nor do they have the technical expertise required to deliver necessary energy savings. The ESCO model i s proven in many countries as, with adequate support and access to financing, ESCOs can play the role of project aggregators and financiers. The credibility o f the ESCO lies in the fact that it pre-finances the investments and guarantees the energy savings. Buildingowners will receive structural improvement as well as benefits from a more energy efficient and comfortable building in exchange for an agreed-upon series o f payments to the ESCO based upon actual energy cost savings realized. There i s a growing number o f ESCO firms active in Poland (approximately lo), with several attempting to finance projects and use performance contracting as a business model. However, current investment in 22 the building sector is limited. Several o f these firms are targeting the building sector but had little success indeveloping viable financing structures, due mainly to bank reluctance to enter the sector fully. Choice of Utility Based ESCO in Krakow. MPEC, the parent company o f POE ESCO, has already established a strong image as being a utility that sees its long-term interest in helping consumers to reduce their utility bills, rather than just trying to increase sales. POE ESCO has already signed energy saving contracts worth over US$l,OOO,OOO, and its projected value o f efficiency contracts through 2009 i s over $24 million. However, the market has developed at a slow pace, and it is felt that additional demonstration o f the ESCO approach may be needed. The effectiveness o f the current assistance from the IBRD project in Krakow will be greatly increased through the implementation o f the project, which will, in turn contribute to a greater likelihood o f replication o f energy efficiency buildingretrofits. Choice of Funding Instrument-Partial Guarantee. The partial guarantee was chosen as appropriate mechanism to overcome the fundamental barriers present in the financial sector in Poland, namely, reluctance o f commercial banks to provide long-term financing, lack of adequate security among borrowers and perception o f high risk by lenders. The guarantee will bring more commercial financing into the market, and with it, greater discipline in terms of project structuring and accountability. The partial guarantee will provide local banks adequate security to make loans while avoiding the moral hazard o f a full guarantee, which can lead to investments in much riskier projects. As banks gain experience with the actual portfolio performance o f efficiency investments (real risk o f defaults), the level o f partial guarantee coverage requiredto overcome their perceived risk may decrease. Ultimately this financing may extend to pureproject fundingwhere project cash flow i s the only security needed by the bank Commercial bank participation in the guarantee program is key to achieving success and leverage of GEF funds. Many o f the local lenders have indicated that credit support from BGK might allow them to serve market segments whose needs are not being fully addressed, and that the partial guarantee may have an impact on rate and tenor as well. Several also indicated that they would likely develop new products around the guarantee program, dedicating staff to this new lending area. The mechanisms proposed under the project are intended to be a credit risk management tool for participating banks and to substitute for other fixed asset collateral typically requiredby banks, thus allowing banks to offer more finance on more attractive terms for energy efficiency projects. Choice of Funding Instrument-Capital Grant: The choice o f the Capital Grant Facility was made to demonstrate the commercial viability and increase acceptance o f bundling high cost measures with lower cost measures by partially financing the greater up-front costs o f measures such as windows and insulation. Building owners have had difficulty obtaining financing for these measures due to unfamiliarity with the financial performance o f the packaged investments. The Capital Grant will also help POE ESCO demonstrate the performance contracting model for buildingsinthe Krakow region, thus increasingacceptance o fthis type o f financing model which has generally not been offered to the buildings sector in Poland. The grant will also encourage development o f larger projects through bundling o f smaller projects, thus driving down unit equipment and development costs. Due to the high concentration o f ownership among building 23 owners in Krakow, acceptance by a few decision-makers for implementation o f large projects will have a significant impact on penetrationrates and overall savings. As experience is gained with energy performance contracting, it is anticipated that banks would be able to finance creditworthy owners and ESCOs without the added benefit o f the capital grant. Choice of Funding Instrument-Technical Assistance: The technical assistance will be utilized to overcome the information barriers present in the market by building capacity with in the financial sector regarding EE lending and utilization o f the tools made available by the project to reduce the Finance Barriers, to increase awareness and demand by building owners, including municipalities, for new investments in EE, to aid in the development and dissemination o f the ESCO performance concept, and to collect and disseminate project monitoring and performance data throughout the country. Choice of Executing Agency and Guarantee Manager. Based upon the market analysis performed duringproject preparation, BGK i s the best choice to act as guarantor and manager of the guarantee facility. As the prime state bank o f the government, BGK has the credibility and financial strength requiredto reassure the commercial banks that guarantees will be honored, and has the additional benefit o f significant experience with energy efficiency lending through the TM Program and experience inthe operation of the KFPK guarantee program since its launch in 1996. Furthermore, BGK has the required expertise, organizational structure and financial management system needed for operation o f the project, and has a strong network o f local banks that have participated in the KFPK program. BGK has expressed its desire to be a guarantor only, not a project financier, thus eliminating a potential conflict o f interest. The proposed GEF guarantee will use and strengthen BGK's existing procedures, information systems, and operational experience with the KFPK guarantee program to improve implementation performance. BGKs linkage to the TM program will provide additional financing and generation o f transaction deal flow GEF guarantee program. 24 Annex 2: Major RelatedProjectsFinancedby the Bank and/or other Agencies POLAND: POLAND - GEF Energy EfficiencyProject Latest Supervision Sector Issue Project (PSR) Ratings (Bank-financed projects only) Implementation Development Bank-financed Progress(IP) Objective (DO) 1.Improve EnergyEfficiency in Krakow EnergyEfficiency S S Malopolslue Voivodship Project (Ln70570, ongoing) 2. Environmental management 1. Environment Management HS H S Project (Ln3190; completed) 3. Improved efficiency o f district 2.1 Heat Supply Restructuring H S H S heating systems, reduction of air & Conservation Project(Lns. pollution emissions from small district 3378/79/81/82-POL; completed) heatingplants 2.2 Katowice Heat Supply and S S Conservation Project (Ln.3809- POL; completed) 4. Reduction of greenhousegases 3. GEF Coal-to-Gas Conversion S S (GHG) from small HOBS Project (TF 028665 & TF023647) (ongoing) 5. Modernizationofpower 4. Power Transmission Project transmission infrastructure (Ln.3959-POL) (ongoing) 6. HardCoal Sector Restructuring SECAL I(completed) 7. Use ofrenewable energy resources, 6. Geothermal & Environment reduction of air pollution & GHG Project (Ln7015 & TF023679) emissions from small HOBS (ongoing) Other development agencies 25 Annex 3: ResultsFrameworkandMonitoring POLAND: POLAND - GEF EnergyEfficiencyProject ResultsFramework PDO OutcomeIndicators Use of OutcomeInformation hercoming the riskbarriers inthe )Number o ftransactions andvolume o f Outcome Indicators will provide the .nancial markets inhibiting commercial lebt financing to EEprojects /ESCOs inthefacility managers, the World Bank, t ank participation in energy efficiency 'olish market and the GEF with basic information roject financing. I)Number and volume o ftransactions from which canbe determined: 1) the ising other relevant vehicles accessible to eve1o f growth inthe energy 3E projects /ESCOs inthe Polishmarket efficiency market inPoland, 2) hether the level o f financing for I energy efficiency projects i s increasing, 3) whether the ESCO model i s accepted by the market, and )emonstrating the feasibility o fpackaged ) Number o f EEiESCO projects larger 4, if the demandfor higher cost ivestments inhigher-cost energy han $250,000 energy efficiency projects is ffciency measures inbuildings and increasing. icreasing acceptance o f energy erformance contracting mechanisms in 'oland. ltimulating the demand for energy ) Numbero f firms involved inenergy ffciency services inthe buildings sector :fficiencyinvestment activities nd increasing awareness and capacity of !)Number andvolume o fEEiESCO ommercial banks to originate and ransactions developed without GEF mplement loan transactions for EE rssistance nvestments. r ) Number and volume o f pipeline 3EIESCO projects IntermediateResults(3 yr.) ResultsIndicatorsfor Each Use of ResultsMonitoring (One per Component) Component 'he Guarantee facility will leverage ) Sumber o f GFAs signed D e t e m n e uhether the facility i s JS$16.3 millionintotal investment by !) Sumber o f transactions operating effectively and meeting ommercial banks participating inthe expectations for deals financed. Irogram, for approximately 130projects !)Disbursements into GF account anging insize from US$25,000 to I)Guarantee claims paid ;500,000. I) Ket resen'es (comes from ab0i.e 7 BGK e\,erage) I) Set outstanding exposure ') Project Liabilities to reserves ratio I) Loanvolume supported by guarantee 26 0) Energy savings resulting from uaranteedloans rating effectively and meeting ectations for deals financed. Energy savings resulting from grant expectations for deals financed. 27 m z 2 3 d 4 0 d m 0 W 0- ", m 0 W 10 2 2 s-2 N m W 0 2- d d W- m 3 3 m m t-4 d W m =In W 2 w, N 2 W s-2 W m c\1 d 0 2 W m d Y, m 2 3 3 00 v, N :-u, 3 W N W m W d 2 m W 2 2 3 N* - 0 0 1 a -2 E 5h a 2 W l Y 13 w Y a ccd $ s E E v, c'! E E m c'! 3 00 3 64 3 9 10 9 3 5E c? 3 64 iD 64 64 64 E E v, c'! E E m "! 3 0 m 3 64 ": 3 9 v, 5E 9 3 e 3 64 v, CA 64 64 E E d d c'! E In E 10 0 00 B B ". 6.4 5E 2 B 64 2 64 3 64 d CA E E 0 E 09 3 b 8 8 2E b 64 v! B 3 vr 64 64 64 E ? B m E 0 Q 8 6E 00 E c? Q r- E 10 3 m 64 v, -64 CA 3 64 E m E 00 d E 3 c'! 64 m 2 3 CA N - 64- 0 2E E v, 0 E 69 2 64 0 34"#9 rl rl f 8 Y + e, m E> - a x 5 3 Y Y 3 a e a e 0 m a e a e a e a e a e a e Annex 4: DetailedProjectDescription POLAND: POLAND - GEFEnergyEfficiencyProject A. Overview. The proposed project consists o f three components: (i)the Partial Guarantee; (ii)the Capital Grant facility; (iii) Technical Assistance. Total investment expenditures including physical and price contingencies amount to US$64.5 million. By Component: ProjectComponent 1 - US$54.5 million I.Partialguarantee The partial guarantee i s a risk-sharing mechanism that will provide commercial banks with partial coverage o f risk exposure against loans made for energy efficiency projects throughout Poland. The guarantee will directly support financing o f EE projects by (i) addressing credit risk and transaction structuring barriers to EE finance, and (ii)engage and build capacities o f commercial financial institutions to provide financing for EE projects on a commercially sustainable basis. The expected amount o f loans that can be supported by the guarantee program i s U S 3 9 . 0 million over the project period, with additional co-financing from project sponsors bringingthe total investment to US$48.8 million. The BGK guarantee will be a first loss, subordinated recovery guarantee. The GEF funding o f US$5.7 million will be placed in a guarantee reserve account and will be paid out to participating banks in the event o f a loss or default. The amount paid out will be equal to the amount o f outstanding principal times the guarantee percentage, and will not cover accrued interest or other fees owed to the bank. The lending banks will also pursue recovery procedures in the event o f default, and will pay to BGK any monies recovered after first satisfying its own receivables. The guarantee will support loans ranging from several thousand dollars in the case o f portfolio transactions (no minimum size), to approximately $715,000 in the case o f standard transactions. The range o f maximum guarantee liabilities assumed by BGK under different procedures i s shown in the table below; the maximum i s US$500,000. The average size o f loan assumed for projections i s US$lOO,OOO; based on this the program will support 390 transaction during the project period. BGK will act as guarantor and will enter into agreements with commercial banks who will originate transactions. BGK will not guarantee its own loans. The GEF partial guarantee program design i s based inpart on documentation, terms, conditions and procedures established by BGK in its successful KFPK guarantee program, in place since 1996. The GEF partial guarantee program will use a set o f unique guarantee agreements between BGK and participating banks to reflect the distinct requirements o f this program; these agreements have been developed using terms consistent with the existing "Cooperation Agreement" and "Loan Guarantee Agreement'' used by BGK with FIs. Under the GEF guarantee program, BGK will enter into Guarantee Framework Agreements (GFA) with three to four participating banks. The GFA will govern the relationship between the parties and specify, inter alia: eligibility conditions; liability limits under the GFA; approval procedures and liability limits under the different approval procedures; and loan appraisal and post-closing reporting procedures. It i s recommended that some guarantee capacities be maintained uncommitted to allow additional banks to independently initiate a guarantee request to BGK transaction-by-transaction; this will allow new bank relationships to be developed and thus expand program market coverage and impacts. Leverage and Key Guarantee Terms. The amount o freserves supplied by the GEF to guarantee EEloans will be approximately US$7.3 million($5.7 million plusaccumulated interest earnings). BGK has agreed to ultimately adopt an upper limit o f 3:l as the ratio o f outstanding guarantee liabilities to existing 31 reserves. (See Annex 5 for further discussion o f this topic.) BGK i s not obligated to reach this level o f exposure but understands the importance o f achieving leverage o f GEF funds, and will therefore use its best efforts to maximize loan transactions originated through the guarantee program. The level o f loan transactions will also be a function o f the percentage o f guarantee coverage offered by BGK to the participating banks, which will be between 50 percent and 70 percent depending on the type o f loan. This percentage represents the amount o f outstanding principal that the guarantor must cover in the event o f default. Key terms o f the guarantee program include the following: 0 Guarantee percentage: 50% o f principal for portfolio and simplified procedures; maximum o f 70% for standard procedure; 0 Maximum guarantee term: 10 years; 0 Maximum single transaction guarantee limit: $500,000; 0 Guarantee fee pricing: one-time up-front fees based on guarantee liability - range o f 1.2% to 2.0% (see Annex 10); 0 Recovery: BGK subordinate to lendingbank; 0 Credit and approval procedures: Standard, simplified and portfolio - see below; Additional details are provided inthe PIP. Credit Approval Processes. The GEF partial guarantee program will also use credit risk analysis underwriting procedures established under the KFPK program but revised to reflect underwriting and credit analysis requirements and criteria specific to EE lending. The GEF partial guarantee program will utilize three different approval procedures reflecting the guarantee sizing: (i) standard procedure, (ii) simplified procedures, for guarantees up to US$250,000 in liability, and (iii) portfolio procedure, for guarantees up to US$lOO,OOO inliability. Each procedure has a different level o f review and maximum guarantee that can be assumed by BGK. BGK has similar procedures for KFPK; however, this program has higher limits for guarantees under the simplified and portfolio procedures. It i s anticipated that more transactions can qualify under these two procedures, allowing for more aggressive origination of loans. The table below shows the maximum liability limits and general characteristics o f the three procedures. IGEFMax. ~~~~ ~ Approval I Characteristics Procedure Max. Guarantee Liability Liability Standard 1,500,000 Euro US$500,000 Requires case by case guarantee credit approval by BGK Simplified 100,000 Euro US$250,000 Allows for rapid approval o f loans up to set guarantee limit Portfolio 50,000 Euro us$loo,ooo Allows for automatic inclusion, on authority of the participating bank, o f small transactions less limit The emphasis o f this project component i s on credit risk management, not risk avoidance, and BGK has acknowledged that the WB/GEF funds are available to be put at risk to cover first losses with the GEF partial guarantee program. BGK will work with participating banks to improve quantity and quality o f deal flow, and will get assistance in developing additional credit analysis procedures and capabilities. Finally, BGK will take a proactive role inproject development, including finance and credit structuring. These activities and approaches must be balanced with prudent, proactive risk management. Overly aggressive expansion o f guarantee commitments could possibly be counterproductive if it i s at the expense o f risk control. The program will promote not only aggressive marketing efforts in the early 32 stages but significant focus on training o f BGK and bank staffs, in order to improve the quality o f deal flow. Inaddition to training, risk management strategies will be employed. Eligibility and Priority Sectors. The guarantee program targets EE inbuildings. The primary definition o f eligible EE transactions i s investments in projects and equipment aimed at improving efficiency of energy use inbuildings. Specific eligible investmentsinclude: 0 Improvement o f the buildingenvelope; 0 Investments in district heating sources and heat network systems provided that at least 50% o f the heat supplied i s used for space conditioning and domestic hot water inbuildings; 0 Improvementsto buildingmechanical heatingventilation and air conditioning (HVAC); Improvementsto interior and exterior buildinglighting; 0 New projects; that is, projects where investments have not already begun and where a baseline of previous energy consumption can be calculated. Eligible EE projects include, but are not limited to, EE projects also eligible for thermo-modernization program financial support. Projects must also have an estimated simple payback period o f less than or equal to 10 years, and all costs and savings must be confirmed by BGK through a verification audit. Investments must be for new projects, not refinancing existing projects, and for projects using proven technologies which are developed with competent energy audit/feasibility studies and include energy savings monitoring plans. All end-user sectors are eligible but the WB/GEF has designated the housing sector and public buildings as priority areas. BGK i s directed to place increased emphasis on supporting loans these types o f loans, such as loans for buildings owned and operated by gminas, hospitals and schools. If sufficient lending to these priority sectors i s not materializing, the WB may modify the TA expenditure plan to increase penetration o f EEinvestments into these sectors Use of Existing BGK guarantee capacitiesfor EE Projects. The existing KFPK guarantee program has broad definitions o f eligibility, by type o f borrower and type o f capital investment. EE projects are eligible for additional guarantee coverage under this program in co-financing capacity. Therefore, BGK can supplement the capacities o f the GEF partial guarantee program with additional guarantee capacities o f its own under the KFPK program. This supplementation could apply to larger single projects, as the maximum single transaction exposure i s EURl.5 million, allowing, with a 50% guarantee, support for loan transactions up to approximately PLN12 million in size. This feature may be important as a significant portion o f the EE project market i s for thermal and cogeneration plants and district heating system upgrades with total costs inthis range. Set-asidefor POE ESCO Lending. The partial guarantee program will be operated nationwide, available to all eligible borrowers through the selected FIs. At the same time, this program has a mandate to support commercialbank financing for POE ESCO's projects. Out o f its total guarantee capacity (defined as uncommitted reserves times 1.5, during the first two years), BGK will reserve US$2.0 million in capacity for POE ESCO. This will be possible given the schedule o f disbursements and the leverage capacity. For example, ifBGK enters into two GFAs with total facility liability limits o f US$5.0 million, this would result in reserves disbursement o f US$5.0 million and a total guarantee capacity o f US$7.5 million. BGK would then have ability to enter into an additional GFA o f US$2.5 million without additional reserves and without exceeding its prescribed upper guarantee limit. POE ESCO will be required to bring a lendingbank, subject to BGK approval, to enter into a GFA with BGK. After one year, BGK will not be obligated to maintain the set-aside; however, POE ESCO may participate in the guarantee program at any time duringthe project period. The figure below shows the flow o f funds and guarantee arrangements for a typical transaction under the guarantee program. 33 Figure 1: Guarantee Structureand Flow of Funds Special Reserve Fund IIII Legal Agreements - Partial III Loss payment Guarantee guarantee j to lender claim GFA & LGA II i r II III 0 IT Participating Banmender Loan Loan Default Repayment event Borrower (end- Energy Efficiency Investment - (Project-) Cash flow from Energy Savings I Investment I Investmentldisbursement =b Repayment ---------+ Partialguarantee - Guaranteeclaimpayment 34 GuaranteeProgram Management and Responsibilities of BGK. BGK will act as manager o f the program as well as guarantor. GEF grant funds will be placed in a special reserve account created by BGK and disbursed amounts will be maintained under the supervision o f BGK. The funds remain the property o f the Government o f Poland, but are managedby BGK according to the regulations specified inthe PIP and ImplementationAgreement. BGK will: (i)ensure compliance with the PIP and Implementation agreement; (ii) and monitorreview accounts, provide management reports, audits, and annual operating budgets for the PMU; (iii) monitor performance based on established targets and indicators; (iv) negotiate and enter into GFAs; (v) approve individual guarantees; (vi) enforce and assist in recovery with respect to defaulted loans. World Bank supervision or approvals will be required for aspects o f (ii), and (iii), (iv)above. ProjectComponent2 US$6.7 million - 11.CapitalGrantFacility The capital grant facility will make partial payments to reduce the up-front costs o f high-cost energy efficiency measures (>lo-year payback) in the building sector, in order to bring more projects into the payback range where they are financeable, and to convince building owners that the performance contracting model pursued by POE ESCO i s viable. The grant facility will also play a critical role in promoting the packaging o f low- and high-cost measures in the same projects, thus demonstrating the effectiveness of packaging multiple measures. POE ESCO will be the exclusive applicant to the capital grant facility for the first three years o f the program. If funds are not exhausted during that period, the World Bank will reallocate the remaining funds to the Guarantee Reserve Facility. Some o f the key parameters and criteria for cost-sharing by the grant facility are described below. Additional details are provided inthe PIP. EligibleProjects. Eligible projects include those: (i) involving energy efficiency retrofits inthe building sector; (ii) simple payback periods between six and 15 years; and (iii) with projects containing qualifying high-cost measures (HCMs). Qualifying HCMs in a given project case may include, but are not limited to: windows; insulation; heating system upgrades (improvements o f boilers, heat exchangers); improvements o f heat distribution piping. Extensions o f the district heatingnetwork are eligible provided they result in replacement o f low-efficiency heat-only boilers. HCMs must have lifetime o f at least fifteen years, and must represent at least 30% and not more than 75% o f total project cost for the project to qualify. End-user co-financing may be applied to the cost o f HCMs for the purpose o f determining this ratio, if necessary. End-user co-financing i s required in cases where payback i s greater than 15 years, in order to bringthe payback below 15 years. Projects or measures that will not be eligible for the grant will be: measures that are not permanently installed and can be easily removed; extensions o f improvements o f the district-heating grid unless these are included in a larger package o f ECMs, and result in the retirement o f HOBS;projects where savings are attributable to usage changes in the facilities that are not the result o f installation o f automation or sensors that permit greater control over energy consumption; projects where activities primarily involve repairs andlor maintenance o f existing equipment, as opposed to replacement o f inefficient equipment; projects involving new buildings. In addition, projects with performance contract terms o f more than 10 years will not be eligible. Project costs and grantfunding. Qualifying projects must have a pre-grant simple payback between six and 15 years. Payback i s calculated as total cost divided by annual savings. Total project cost will include equipment, installation, and a standard markup for ESCO services. The standard markup i s 26.5 percent and i s included to ensure that POE ESCO recovers costs in its project estimates. The minimum project size for consideration i s $250,000, with no maximum project size. Individual projects may be 35 bundled or aggregated if there is a common financing package for all projects. The maximum grant size i s $500,000. Minimumgrant size i s $75,000, or 30% o f project cost. The maximum and minimumaward levels will be reviewed after the 1'' year to determine market response to the grant offering. The grant amount will be 30 percent o f total project cost. The flat cost-sharing structure will require that higher-payback projects, such as those over 10 years, include some portion o f end-user co-financing in order to make the project economically attractive for ESCO and lenders. Conversely, projects that include more lower-payback measures (such as lighting) will be rewarded. This structure i s intendedto ensure that ESCO and end-users incorporate as many lower payback measures as possible in a bundled fashion rather than focusing solely on higher cost building renewal measures.. Similarly, potential projects must first have considered the cost-effectiveness o f weatherization measures, especially for window replacement, prior to investment in new measures. The cost o f weatherization measures can be included in the overall project cost. Weatherization studies will be reviewed by BGK's auditors to determine effectiveness. POE ESCO projects (after inclusion of GEF grant) must be commercially attractive for (i) ESCO and the client -- as measured by NPV and IRR (above ESCO's opportunity cost of capital); and (ii) commercial bank financing. As such, end-user co-financing i s requiredin some form, whether up front or over a few years, to ensure that project economics are commercially attractive to both the POE ESCO and end user (as described above). Some projects may not require end-user financing if payback periods are low enough. Though the grant amount will be based on total project costs, the grant itself will be used to purchase only goods and works associated with the project. The grant will not pay for overhead or profit o f the ESCO. The grant will pay for high-cost measures and their installation, which will be a minimumo f 30% of total project costs. For example, in a project o f $250,000, including overhead markup, the goods and works component will be $197,628. The minimum amount o f high-cost measures will be $75,000. The grant will be the same -- $75,000 - and will be disbursed against submission o f invoices from POE ESCO. In order to allow reasonably steady cash flow during project implementation, disbursement can be made against all invoices at a rate of 37.95% o f total net of VAT. (Net goods and works * 37.95% = grant amount: $197,268 * 0.3795 = $75,000.) Assuming 7% VAT on all expenditures, this will imply that 35.5% (for convenience: 36%) o f the gross invoiced amount can be financed. Program Review. All o f the criteria and other terms are subject to review at one-year intervals as part o f overall project monitoring and evaluation. Project participants will be consulted for feedback to determine if changes are necessary. ProjectComponent 3 US$3.3 million - 111. Technical Assistance The GEF technical assistance component will be US$3.3 million. This will be divided into four main categories o f activities (with approximate allocations): 1. Support for the guarantee program and PMU US$1.2 million 2. Support for POE ESCO USS0.4 million 3. Monitoring, evaluation & regional cooperation US$0.4 million 4. Management fee, BGK US$1.3 million The proposedactivities under each o fthe categories listed above are shown inthe following table. 36 Sub-component Guarantee Program Task Cost Cost 1 Audits & Engineering Review $360,000 2 Guarantee ProgramMarketing, Training and Support $840,000 2a Guarantee Program Marketing $250,000 2b FI Training $128,000 2c EE Business Support $250,000 2d BGK Training $100,000 2e General Program Support (Direct Costs) $112,000 Subtotal for Guarantee Program $1,200,000 POEESCO 3 Audits andWeatherization $125,000 4 Create Demand $200,000 Municipality demand analysis and procurement 4a plan $150,000 4b Seminars and awareness building $50,000 5 Training & Cooperation, DocumentationiM&E Support $75,000 5a Study tour organization and training $33,000 5b M&E Support $18,000 5c Study tours - POE ESCO reimbursement $24,000 Subtotal POE ESCO TA $400,000 Monitoring and Evaluation Monitoring & Evaluation, Dissemination of Results, 6 Regional Cooperation $330,000 6a Baseline confirmation $30,000 6b Midterm review and dissemination of results $250,000 6c M&E, Final Review $50,000 7 RegionalCooperation $70,000 Subtotal M&E $400,000 BGK ManagementFee $1,300,000 Total TA Costs $3,300,000 Each o f the items inthe table i s described below. Guarantee Program and PMU. 1. Audits and VeriJication Review: it is expected that a large number o f guarantee transactions will occur during the program period. TA funds will be used to cost-share with lending banks the cost o f verifying borrower audit information as a form o f loan due diligence. The estimated average cost-share per verification audit i s approximately US$500. Furthermore , some funds may be used to cover audit costs for borrowers -the details o f this issue will be clarified inthe Project Implementation Plan. 2. Guarantee Program Marketing, Training and Support: this component o fthe TA plan is critical to the success o f the project. Early-stage marketing and promotion o f the guarantee facility to borrowers and banks will be done through seminars, advertising and promotional literature. Consultations and training for FIs (both prospective and existing program participants) will be conducted in order to develop EE finance capacity among the banks and encourage more lending to the building sector. In some cases, assistance to banks to set up EE finance units within the banks, with training on contracts, EE credit procedures, and assistance on developing EE finance marketing plans will help create additional deal 37 flow, Businesses involved in energy efficiency project development and equipment sales will also receive TA to build capacity to ensure a pipeline o f transactions for consideration under the guarantee program. This TA will include assistance in developing creditworthy finance and contractual structures for projects, and assistance in structuring and arranging multi-project finance and vendor finance debt facilities. As part o f training, BGK staff at headquarters and branches will receive EE finance training and assistance in building internal capacity. Finally, included in the budget i s an allocation for direct costs associated with managing the PMU, such as procurement consultants, procurement training and financial audit o f the program. POE ESCO 3. Audits and weatherization. To assist POE ESCO in developingprojects, some TA will be used to pay for project audits and weatherization studies. Weatherization costs will be supported at 100% o f the total cost up to a maximum o f US$l,OOO per building. As a condition o f eligibility for grant funds, POE ESCO must demonstrate examination o f the possibility o f weatherization as a low-cost alternative to buildingretrofits, and TA funds will cover these costs. Other audits will be conducted by POE ESCO to prepare applications for grant funding and to prepare more detailed audits later in the project cycle for contract and implementation requirements. TA funding can support the full cost o f the audit, as performedby thirdparty auditors, up to a maximum o f US$5,000 per audit. The TA funds used for audits will act as a sort o f revolving fund or contingent grant; in cases where audits lead to project implementation, POE ESCO will pay back the grant funds to BGK, which can be used in future projects for the same purpose. 4. Demand Creation: The intention o f this TA item i s to help POE ESCO raise capacity and awareness among regional municipalities in understanding the need for energy efficiency services. Many municipalities do not have capacity to prepare detailed energy demand estimates for public buildings,nor the associated procurement. This TA will pay for experts in energy demand analysis and public procurement to assist city officials develop procurement plans and tendering documents that will result for potential business for POE ESCO and others. 5. Training and Cooperation: POE ESCO can benefit by learning best practices and developing cooperative arrangements with other ESCOs in Central and Western Europe. Inaddition, some support will be provided to POE ESCO to help it in preparation o f documentation and analysis for GEF monitoring purposes. M&E, Regional Cooperation 6. Monitoring and Evaluation and Information Dissemination. Program evaluation will occur in three phases - baseline confirmation, mid-term review, and final review. Because o f the time lag, this will likely be broken into two contracts. Part o f the initial contract will include dissemination ofresults o fthe program after mid-term review. This may also help incontinuedmarketing o f the guarantee program. 7. Regional Cooperation. During the first two years, a regional cooperation conference may be organized to gather together ESCOs, FIs, guarantors and government officials from various countries such as Hungary, Croatia, CzechRepublic and others to share lessons learned from similar activities. BGK Management Fee. A flat fee will be paid to BGK to cover part o f its operating costs. This will supplement the income BGK will have from the guarantee fees. In budgeting for TA activities, some flexibility is recommended to preserve funding for tasks and assignments as they are identified and evolve during program operations. This flexibility can be accomplished by: (i) not committing a l l available TA hnds inthe initial contracts, (ii) the TA contract in for ESCOs and EE businesses, keeping a relatively high ratio o f task order funds to monthly retainer funds, and (iii)considering increase of TA funding from reserve interest earnings, ifproductive additional uses are identified and agreed to by the World Bank. 38 Annex 5: ProjectCosts POLAND: POLAND GEF EnergyEfficiencyProject - Financing a. Guarantee Reserves 5.7 5.71 b. Project Financing 48.8 48.8 Subtotal, Partial Risk Guarantee 48.8 5.7 54.5 2. GEF Capital Cost Grant a. GEF Grant 2.0 2.0 b. Project Financing 4.7 4.7 Subtotal, Capital Cost Grant 4.7 2.0 6.7 3. GEF Technical Assistance a. Guarantee and program support Audits & Engineering Review 0.08 0.36 0.44 Program Marketing, Training & Support 0.18 0.84 1.02 b. POEESCO Audits and Weatherization 0.03 0.13 0.15 Demand Creation 0.03 0.20 0.23 Training & Cooperation 0.01 0.06 0.07 Documentationand M&E 0.01 0.02 0.02 c. NGOs Monitoring, Evaluation & Dissemination 0.04 0.33 0.37 Regional Cooperation 0.01 0.07 0.08 d. BGK Management Fee 1.30 1.30 Subtotal, Technical Assistance 0.4 3.3 3.7 Total Project Costs 53.8 11.0 64.8 Total Financing Reauired 53.8 11.0 64.81 39 Consulting Services Training Miscellaneous Capital Reserve Management Fee 40 Annex 6: ImplementationArrangements POLAND: POLAND - GEFEnergyEfficiencyProject Figure 2: Legal and Implementation Arrangements _ _ _ _ _ _ _ _ _ _ _ _ _ _Agreement GEF Grant - - - - - - Pro)ect Agreement ------- ____________________--------------- GEF Grant Implementation Agreement Energy Savings Commercial Contrac Loans 41 Annex 7: FinancialManagementandDisbursementArrangements POLAND: POLAND - GEF EnergyEfficiencyProject Financial Management Assessment The initial financial management assessment was performed during the project's pre-appraisal mission in March 2003. It was finalized during the appraisal mission in November 2003 and updated in September 2004 prior to Board presentation. The financial management arrangements o f the project are acceptable to the Bank with exception o f the IT system for management o f the guarantees issued with underlying loan portfolio. The readiness of the IT system for management o f the guarantees issued with underlying loan portfolio relating to Partial Guarantee Facility i s a disbursement condition for this component. Country Issues. In September 2003 the Bank initiated Country Financial Accountability Assessment (CFAA) for Poland to provide updated information on public sector financial accountability arrangements and help to develop a program for reforms and capacity building to improve transparency and accountability with respect to the use of public funds. The draft report was prepared and sent to Government for consultation in June 2004. However since the Project will be implemented mainly in private sector the identified risks will have low to moderate impact on the project arrangements. In2002, the Bank conducted a ROSC Accounting & Auditing review. The ROSC report on Accounting & Auditingprovides a description and overview o f standards and practices inPoland. While there is no regulatory obligation in Poland to apply International Accounting Standards, the amended Polish Accounting Regulations (PAR) in force commencing 2002 have moved to be more in line with International Financial Reporting Standards (IFRS). However there are still some differences. The application and enforcement o f accounting standards in some public entities should be improved and so that the entities can present reliable financial results for investors and other users. The implementation of amended Accounting Act effective January 1,2002 should be carefully monitored. Past experience shows that the proper application o f the accounting regulations has not always been fully achieved. The quality o f the audits i s unequal and in some cases unsatisfactory. These risks will be taken into account while designing the auditing arrangements in respect o f the grant funds, Guarantee Facility Account and Participating Banks. However specific risk related to the banking sector i s lower than for other sector of the Polish economy due to effective banking supervision and additional reportingrequirements for banks. Strengths and Weaknesses The significant strengths that provide a basis for reliance on the project . financial management system include: (i)the experience o f BGK staff in implementation o f Bank- financed projects (Rural Development Project), and government projects including successful National Loan Guarantee Fund, (ii) the unqualified audit reports issued by BGK auditors, and (iii) overall strong organizational and financial capacity o f BGK as a reputable bank to manage this type o f project. The weakness i s identified in slow preparation o f the IT system for the Partial Guarantee Facility Component. Implementing Entity. BGK i s a state-owned bank established in 1924 on the basis o f the decree issued by the President o f Poland. The operation o f BGK is based on the Banking Law. Activities o f BGK include the ones included in the Banking Law, and additionally special purpose tasks assigned by the Ministry of Finance or the legal act including inter alia managing of the Special Funds (e.g. National Housing Fund, National Credit Guarantee Fund, Thermo modernization Fund, Student Loans and Credits Fund). BGK will enter into cooperation with three to four participating banks on the basis o f the Guarantee Framework Agreement. These participating banks will actually originate the loans to the borrowers for eligible energy efficiency projects. 42 The World Bank Staff, in cooperation with BGK, will need to assess each prospective participating bank in conformity with the World Bank`s Operational Policy 8.30 and Europe and Central Asia Region Financial Intermediary Lending guidelines; and confirm their eligibility to participate in the project. BGK is required to obtain the Bank's a no objection to any selected participatingbank. All participating banks will have to fully meet the qualification criteria within the time period provided for project implementation in order to take part in the project. One o f the prospective participating bank has been positively assessedby the World Bank staff. Funds Flow. Project funds will flow from: (i) Bank, either via a single Special Account which will the be replenished on the basis o f SOEs or by direct payment on the basis o f direct payment withdrawal applications; or (ii) the commercial Bank loans as contribution, or (iii)own contribution o f final beneficiaries (borrowers o f energy efficiency loans). The GEF funds for the Guarantee Facility will be transferied directly to the Guarantee Facility Account earning bank deposit interest, held by BGK on behalf o f the MOELSP. BGK will receive delegation for managing the Account including inter alia payments for called guarantees, and recovery o f amounts paid under called guarantees. The rules for management o f the Fund are to be defined in the Project Implementation Agreement to be signed by MOEL and BGK. Staffing. The project will utilize the existing staff in the finance and accounting department, which will account for each transaction to be paid from the Special Account or via Direct Payment. Additionally, BGK will recruit (preferably internally) the Financial Analyst and Administrative staff responsible for accounting for counterpart funding, reporting and monitoring o f the guarantees issued. The BGK staff has adequate educational background and experience. The TOR for staff i s included in the draft Project Implementation Plan. Accounting Policies and ,Procedures. BGK accounting books and records are maintained on an accrual basis. However, for the purpose o f the project, the cash method will be utilized for the Guarantee Facility Account and the rest o f the project. Project financial statements will be presented in USD (sources and uses o f funds Special account) and PLN (financial statement o f the Fund). BGK has in place a set of accounting procedures and internal controls including authorizationand segregation o f duties. Additionally, BGK will prepare the project financial-accounting section in the Project Implementation Plan, including: the procedures, roles and the responsibilities o f the staff, accounts used for the project accounting, typical accounting treatment, the agreed formats o f the FMR, and the TOR for project audit. Internal Audit. There i s an Internal Audit Department in BGK which reports to the BGK management. The annual work plan i s prepared by the Internal Audit Department and approved by the Management Board and the President Council. The work plan includes the following areas: (i)compulsory money laundering, (ii)testing o f the internal control, (iii)review o f procedures for new products, (iv) loan portfolio verifications. The Department i s also responsible for control o f the Special Funds managed by BGK. The Internal Audit Department follows up on recommendations given by the Department and by NIK and GINB. However, the Internal Audit Department does not follow up on extemal audit issues, which are assigned to the Finance and Accounting Department. External Audit. BGK i s audited by an external auditor from international network. The auditors issued an unqualified opinion on the 2003 BGK financial statement. The audit was carried out in accordance with the Polish Auditing Standards and the financial statements were prepared in accordance with Polish Accounting Regulations. The project financial statements o f the GEF Energy Efficiency Project including also the reports on Guarantee Facility Account shall be audited on annual basis. The GEF Grant will finance the cost of project audit. The project's audit shall be performed in accordance with auditing standards, on terms of 43 reference, and by an independent auditor, all o f which are to be acceptable to the Bank. It was agreed that for the audit o f the project's financial statements, acceptable auditing standards are International Standards on Auditing (ISA) as issued by the International Auditing and Assurance Standards Board (IAASB) of the International Federation o f Accountants (JFAC). The terms o f reference for the project audit should also include the preparation of a management letter including the issues and recommendation relating to the accounting procedures, accounting system, internal control and other matters which auditor considers significant. The agreed terms of reference are attached to the Minutes o f Negotiations. The World Bank has recently been conducting formal assessments o f audit firms operating in Poland with a view to determining those acceptable to the World Bank. In addition the project's auditors would be required to have banking experience. The Recipient and BGK will consult first with the World Bank prior to the selection o f the project's auditors. Inrespect ofthe audit and annual financial statements of BGK, consistent with previous World Bank- financed operations, the BGK will provide the Bank with a copy o f BGK's: (i) annual report containing a summary balance sheet, summary off-balance sheet statement, summary profit and loss account, and auditor's opinion on the abbreviated financial report to shareholders; and (ii)detailed H1 balance sheet, H3 profit and loss account, and audit opinion thereon. POE ESCO and the Participating Banks would provide the Bank with a copy o f the audit report including audited financial statements. The audit reports will be provided to the Bank within six months o f the end of each fiscal year and also at the closing o f the project. In case the Project starts in the second half o f the year, there i s possibility to combine this first period with the next year upon agreement with the Bank. Audit Report Due Date Entity-Audit report of BGK,POE ESCO, and Within six months o f the end o f each fiscal each participating commercial bank year and also at the closing o f the project Project Financial Statement including reports Within six months o f the end of each fiscal on Guarantee Facility Account year and also at the closing o f the project Reporting and Monitoring. Financial Monitoring Reports (FMRs) will be used for project monitoring and supervision and the formats o f these are included in the draft operational manual. BGK will produce a full set o f FMRs every three months throughout the life o f the project within 45 days after the end o f the quarter. Formats o f FMRswere agreed and will be included inthe negotiation package. BGK will report on project components including counterpart funds provided by commercial banks or borrowers, and Guarantee Facility Account. BGK will be responsible for monitoring o f the loan portfolio and the consolidation o f the reports received from Participating Commercial Banks and POE ESCO into the one consolidated FMR. In addition the World Bank will monitor the financial results o f the BGK and ParticipatingBanks on annual basis. Annual Project Financial Statement for the annual audit purposes will be prepared for each fiscal year during the Project life and at the closing date o f the Project. Annual Project Financial Statement will include: 0 Project Sources and Uses o f Funds 0 Uses o f Fundsby Project Activity 0 Special Account Statement e Reports related to Guarantee Facility Account 0 Summary of Statements o fExpenditures 44 Information Systems. BGK uses the software program designed for banking sector which i s supported by additional modules. For the project purposes the implementing team will use existing accounting system to record the use o f GEF funds (coming through the Special Account, direct payments etc) supported with IT module for preparation o f FMRs.In addition BGK will develop IT module which will keep track of guarantees issued, underlying portfolio o f loans issued by commercial banks. This IT module will enable to have value o f generated loans for energy efficiency projects, current valuation o f guarantee liability exposure to BGK and the Guarantee Facility Account. The IT system will be developed in-house by BGK. Impact of Procurement Arrangements. A procurement assessment was performed by a World Bank Procurement Specialist and contained highrisk assessment o f BGK capacity. Inorder to mitigate the risk the following actions are required including inter alia employment o f procurement consultant, participation in the procurement training, performance o f the periodic ex-post review by the Bank o f 1 in 5 contracts during the supervision missions every 6 months, preparation o f Project Implementation Plan by the Grant effectiveness. The detailed description and conclusions with regard to the procurement arrangements and the procurement capacity assessment are included inAnnex 8. Disbursement Arrangements. Bank funds will be disbursed under the Bank's traditional procedures including SOEs and direct payments. Supporting documentation for SOEs, including completion reports and certificates, will be retained by the BGK and made available to the Bank during project supervision. Disbursements for expenditures above the SOE thresholds will be made against presentation o f full documentation relating to those expenditures. There i s no plan to move to periodic disbursements. Grant disbursements for Higher Cost Measures under Energy Efficiency Contracts will finance the underlying goods, materials and installation services. Grant disbursements shall also be made to finance Technical Assistance. With regard to Guarantee Facility Component the disbursements will be made in a form o f direct payments to the Guarantee Facility Account on the basis o f approved Guarantee Framework Agreements and on the basis o fthe agreed ratio o f guarantee liability to reserve ratio. The GEF Grant will be processed in accordance with the Policy Amendment to the Application o f the Disbursement and Trust Fund Policies to GEF-supported Energy Efficiency and Renewable Energy Guarantee Funds. The project i s therefore subject to the following conditions that have been embodied in the legal agreements: (a) the Bank would have a right to request audits o f the guarantee fund throughout the duration o f the Bank's supervision o f the GEF-financed project; (b) the guarantee fund would not be subject to the Bank's procurement guidelines (except for broad considerations o f economy and efficiency) but would be subject to the Bank's financial management guidelines throughout the duration o f the Bank's supervision o f the GEF-financed project; (c) the management o f the fund would be composed o f professionals with qualifications and experience satisfactory to the Bank; (d) the fund would be managed in accordance with operational and financial policies, and on the basis of a constitutive andor statutory instrument, acceptable to the Bank; (e) the management o f the fund would exercise satisfactory control over the use o f the fund; and (0 the Bank would have the right to require the recipient to repay the grant to the Bank, ifthe recipient breaches any o f the foregoing conditions, except for such amount o f the grant as i s needed to meet the recipient's obligations under guarantees issued and existing prior to the recipient receiving the Bank's repayment notice. Disbursement on the basis o f SOEs will be used for expenditures incurred on all contracts which do not require the Bank's prior review. For all other contracts, disbursements will be made based on full documentation. The table A presents the maximumthresholds for usingSOE procedures. 45 Table A: SOE Thresholds ExpenditureCategory SOE threshold inUSD 1.Supply& InstallationofEquipment 200,000 2. Goods 200,000 3. Works 200,000 4. Consultants' Services 100,000 for firms 50,000 for individuals 5. Training I 6. ProjectManagement 7. PartialCredit Guarantee Facility Not applicable 0 Management Fee. The GEF grant will finance Management Fee to BGK.The term Management Fee means the fee to be paid to BGK on a monthly basis pursuant to the annual Project Management Budget as agreed upon by the World Bank. The Management fee will be paid to BGK on a monthly basis pursuant to the agreed Project Management budget. Before October 31 in each o f its fiscal years, BGK shall fumish to the Bank the proposal o f annual Management Fee for the next year, on the basis o f forecasts prepared by BGK and satisfactory to the Bank. The Bank will review and if acceptable approve the presented proposal or will call for adjustments. The disbursement o f the Management Fee will be done on monthly basis from Special Account to BGK in agreed monthly amounts. The replenishment o f the Special Account for such fee payments withdrawals would be made on the basis o f SOEs, which in this case would consist o f a statement by BGK explaining that this payment was part of the agreed upon budget allocation as set forth in the project management budget for a certain period. 0 RetroactiveJinancing. The GEF Grant will also finance payments made for expenditures prior to the date o f the signing o f the Grant Agreement but after April 1, 2004, in an aggregate amount not exceeding $100,000, made in respect o f preparation costs included in the Consultant Services and Project Management categories. The expenditures must be agreed with the World Bank before incurred. 0 Special Account (SA). MOELSP will open a Special Account and the Guarantee Facility Account specifically for this project, at BGK, which shall include appropriate protection against set-off, seizure and attachment. Withdrawal applications for the replenishments o f the Special Account will be sent to the Bank monthly or at least every three months regardless o f the activity during the period or the size o f the Special Account. Replenishment applications must include reconciled, detailed bank statements as well as other appropriate documents (e.g. SOE or source documentation). The bank statement must indicate both the opening and closing balances o f the Special Account for the period covered by the expenditures claimed, and likewise, indicate all transactions and activity on the account during the period. The reconciliation statement must also explain any discrepancies (surplus or shortage o f funds) and the status o f any previously deducted expenditures. Incase there i s no need for replenishment o f the Special Account the application should be also sent on at least a quarterly basis, with the indication that no replenishment i s needed and the application is sent for recovery of the Special Account. Such recovered amount can be later requested for replenishment with a new application without any additional SOE. The Authorized Allocation will be set at US$1.1 million option assuming direct transfer o f grant funds into the Guarantee Facility Account. The interest earned on the Special Account will be at the disposal o f MoELSP; however, they should be used for the project and added to the guarantee reserves. 46 The disbursement allocation o f the GEF Grant showing categories o f disbursement, amounts and percentages to,be financed under each category, i s presented inthe Table B below. Expenditure Category Amount inUS$ million FinancingPercentage 1.Supply & Installationof 0.80 36% Equipment 2. Goods 0.60 36% 3. Works 0.60 36% 4. Consultants' Services 1.93 100% for foreign consulting firms and foreign individual consultants and 83.5% for local consulting firms and local individual consultants, including 100% of eligible social charges 5. Training 0.035 100% 6. ProjectManagement: (a)Management Fee 1.30 100% (bo Goods 0.035 82% 7. PartialCredit Guarantee Facility 5.7 100% TotalProject Costs 11.oo For thepurposes of the above tables: (a) the term 'Iforeign expenditures" means expenditures in the currency of any country other than that of the Grant Recipient for goods supplied under the S&I contractfrom the territory of any country other than that of the Grant Recipient; (b) the term "local expenditures" means expenditures in the currency of the Grant Recipient; orfor goods supplied under the S&I contractfrom the territory of the Grant Recipient. Action Plan (Agreed with Borrower).As noted earlier, the financial management arrangements o f the project should be strengthened prior to disbursement for Partial Credit Guarantee Facility component. The following i s an agreed Action Plan for BGK to strengthen its financial management system. Action Responsibility Dead1ine 1 Preparation of the IT system to monitor the BGK Disbursement guarantees issued together with underlying loan condition portfolio. The readiness of the systemi s condition of disbursement for the Guaranteecomponent. 47 SupervisionPlan. Duringproject implementation, the World Bank will supervise the project's financial management arrangements intwo main ways: (i) review the BGK'sRequest for no objections to selected participating banks, (ii)review o f the project's quarterly financial management reports as well as the entity's and project's annual audited financial statements and auditor's management letter; (iii) duringthe Bank's supervision missions, review the project's financial management and disbursement arrangements (including a review o f a sample o f SOEs and movements on the Special Account) to ensure compliance with the Bank`s minimumrequirements, and (iv) review underlying books and records o f the POE ESCO and Participating Banks to check eligibility o f expenditures and initiated loans loan, to application o f internal control procedures. As required, a Bank-accredited Financial Management Specialist will assist inthe supervision process. 48 Annex 8: Procurement POLAND: POLAND - GEF EnergyEfficiencyProject A. General Procurement for the proposed project would be carried out in accordance with the World Bank's "Guidelines: Procurement Under IBRD Loans and IDA Credits" dated May 2004; and "Guidelines: Selection and Employment o f Consultants by World Bank Borrowers" dated M a y 2004, and the provisions stipulated in the Legal Agreement. The general description o f various items under different expenditure category are described below. For each contract to be financed by the Loadcredit, the different procurement methods or consultant selection methods, the need for prequalification, estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank project team in the Procurement Plan. The Procurement Plan will be updated at least annually or as required to reflect the actual project implementationneeds and improvements ininstitutional capacity. Procurement o f Goods and Works: Goods and Works procured under this project, would include goods and civil works for energy efficiency measures. The procurement will follow the below described methods and will be done using (i) the Bank's Standard Bidding Documents (SBD) for all ICB and Commercial Practices, estimated to cost equal or more than US$200,000 equivalent; and (ii) Invitation to Quote used for ECA Region, modified to needs o f procurement o f works, for contracts following Commercial Practices, estimated to cost less than US$200,000 equivalent, Procurement methods: For Goods and Works, including Supply & Installation, estimated to cost equal or more than US$ 350,000 equivalent: International Competitive Bidding. For Goods and Works, including Supply & Installation, estimated to cost less than US$ 350,000 equivalent: Commercial Practices, using the following two methods: (1) a specific contract; and (2) a rate framework contract, as definedbelow. Commercial Practicesfor a specific contract shall consist in obtaining at least three quotations, when possible fiom suppliers or contractors located inat least two eligible countries. Commercial Practicesfor a rateframework contract shall consist in obtaining at least three quotations, when possible from suppliers or contractors located in at least two eligible countries. This method can be based on (i) for a single item; or (ii) for a list o f selected items; or (iii) for a list o f selected rate rates rates items plus discount on commercial price list. Under this procedure, POE ESCO would annually publisha procurement notice (internationally where possible) inviting bidders for rate bids for standard items of goods and works. The bidders would be asked to indicate unitprices for single items, or for a list o f items, or for a list o f items with the bidders' commercial price list discount, without any assurance o f firm deliveries as the quantities are not known at the time o f invitation. The unit prices shall remain valid for, say, one year. Incase contracts based on item rate, rate bids would be requested separately for each standard item of goods or works and without specifying firm quantities to be procured. The Borrower would finalize item rate framework contracts with the first three lowest responsive bidders for each invited item o f goods or type o f works that are within 15% o f the lowest responsive bid. Incase o f the contract based on the item rate list, POE ESCO would invite bidders to quote their rate prices for a list of standard items o f goods or 49 works, which are common for and can be offered by a number o f firms. POE ESCO would provide its estimates o f quantities for each item on the list. The Borrower would finalize rate framework contracts with the first three lowest responsive bidders for each invited list of item o f goods or type of works that are within 15% o f the lowest responsive bid. Incase the contract is based on the item rate list with commercial price list discount POE ESCO would invite bidders to quote their rate prices for a list including its best estimated amounts o f different standard items, which can be offered by a number o f firms. In addition, the bidders would offer a discount rate for the remaining items o f their commercial price list. In evaluation, both the total price o f item list and a discount would be taken into consideration. The Borrower would finalize rate framework contracts with the first three lowest evaluated responsive bidders for each invited list o f item o f goods or type o f works that are within 15% o f the lowest evaluated responsive bid. Procurement volume o f discounted items would not exceed more than 20% o f the overall procurement volume under the rate framework contracts. POE ESCO would conclude contracts for specific items o f goods or works under the rate framework contracts when demand arises duringthe contract period and obtain the equipment and works from one of the three firms that has a rate framework contract with POE ESCO, on terms and conditions specified in the rate framework contract. By use o f rate framework contracts, POE ESCO will not have to negotiate contract terms with each supplier. This approach would allow the POE ESCO to limit the frequency o f tendering to not more than twice a year and to benefit from the economies o f scale. Selection of Consultants : The consulting services that shall be provided by firms would include with regard to (i)the Guarantee Program: verification audits, financial audit, marketing and training, monitoring and evaluation and dissemination o f results o f the Program, and review o f regional cooperation with regard to the similar programs; and (ii)POE ESCO: TA to create demand for its projects, training, monitoring and evaluation support, energy audits, and weatherization design, The consulting services that shall be provided by individual consultants would include with regard to (i)the Guarantee Program: verification audits and employment o f the procurement specialist; and (ii) POE ESCO: energy audits, and weatherization design. OperationalCosts: The project shall finance the Management fee for BGK to cover its incremental operational costs related to management o f the Project.The Project shall also finance training cost of transportation, accommodation, per diem and interpretation services and cost o f training courses and study tours for BGK staff, ParticipatingBanks' staff, and energy efficiency businesses. Others: The Partial Guarantee Facility o f US$ 5.7 million shall be used to extend guarantees to commercial banks for partial coverage o f risk exposure against loans made for energy efficiency projects for buildingsthroughout Poland. The guarantees will cover 50 to 70 percent o f loan principal, and will be arranged through a number o f participating banks who will each have entered into a Guarantee Framework Agreement with BGK. Retroactive financing i s foreseen up to US$lOO,OOO. Advance procurement: yes. B.Assessment ofthe agency's capacityto implementprocurement FinancingArrangements: The Ministryo f Economy, on behalf o f the Government o f Poland shall be the Recipient o f the GEF Grant. BGK shall be the Executing Agency for the GEF Grant. BGK will administer GEF-financed three Project Components. In addition to implementing the Technical Assistance Component, BGK, as a financial intermediary, shall provide partial guarantees to commercial banks financing energy efficiency projects and shall transfer the GEF funds on a grant basis to POE 50 ESCO, a subsidiary o f MPEC Krakow, the Bank's Borrower for the Krakow Energy Efficiency Project. POEESCO i s an autonomous commercial enterprise inthe public sector. POE ESCO, as a Beneficiary of the GEF Grant funds, shall use these funds to co-finance higher cost energy efficiency measures. Implementing Agency and PMU BGK shall be the Implementing Agency responsible for procurement under the Project. BGK will operate this project from, and establish the Project Management Unit (PMU) within, its Special Funds Department, which will be responsible for ensuring that all procurement related to Capital Grant and Technical Assistance activities i s designed and undertaken in conformity with the Bank's Guidelines and Project Implementation Plan. No procurement activities are foreseen under the Partial Guarantee Facility Component. For the Capital Grant Component, POE ESCO shall be responsible for ensuring that procurement i s conducted in conformity with the Bank's Guidelines and Project Implementation Plan, by usingMPEC Krakow to conduct procurement on its behalf taking advantage o f the existing procurement capacity at MPEC Krakow. An assessment o f the capacity o f the ImplementingAgency to implement procurement actions for the project has been carried out by Elzbieta Sieminska in April 2003. The assessment reviewed the organizational structure for implementing the project and the interaction between the project's staff responsible for procurement Officer and the Ministry's relevant central unit for administration and finance. The assessment o f the Implementing Agency capacity (BGK) to conduct procurement was found to be low, and the procurement risk i s rated as "high." This i s despite assessing the procurement capacity o f MPEC Krakow, which will conduct procurement for POE ESCO, the Grant Beneficiary, as high. This will allow to mitigate risk subject to undertalung actions as includedinthe below overall remedial action plan, which i s needed to mitigate the procurement risk, and which, comprises the following actions: (i) BGK shall employ an individual consultant, experienced in the Bank's procurement, especially in selection and employment o f consultants, to enable efficient start o f the Project, by the Board Project presentation. The consultant may be transferred later to a permanent procurement staff o f P M U if such need arises. S/he will provide the on-job training to a permanent procurement staff already employed by PMU. The Bank shall consider BGK's request to retroactively finance the cost o f this consultant under the TA Component. (ii)in addition to the already employed procurement officer, BGK shall employ hisher administrative support by the time o f Grant effectiveness. In case if BGK i s able to employ a skilled procurement specialist, the assignment o f the procurement consultant may be adjusted down according to the Project needs. (iii)BGK shall establish the Project Management Unit with the management, procurement, financial and disbursement staff by the Grant effectiveness. (iv) Inaddition to the on-job training received from the procurement consultant, the procurement officer shall attend a course on the Bank's selection and employment o f consultants as well as a procurement o f goods and works course as available. (v) The Bank's Standard Request for Proposals for QCBS and LCS methods and Bank's Standard BiddingDocuments for ICB method shall be used. (vi) Initiating a Project Launch Workshop before the Grant effectiveness, as part o f the project implementatiodcapacity building initiatives, especially in procurement, to train the BGK's and POE ESCO's staff and provide refreshing training to MPEC's Krakow staff. (vii) Periodic ex-post review by the Bank o f 1 in 5 contracts duringthe supervision missions every 6 months. (viii) Project Implementation Plan to be prepared by the Grant effectiveness. Additional specific actions, related to Capital Grant Component: (1) POE ESCO enters into agreement with MPEC Krakow for MPEC Krakow to conduct procurement procedures for POE ESCO. (ii) Preparation and agreeing with the Bank upon the model Bidding Documents for procurement o f goods, works and supply & installation contracts with use o f Commercial Practices before the first procurement with use o fthese methods. 51 It is proposed to reassess the procurement capacity during the Supervision Missions and revise, as appropriate. C.Procurement Plan The Borrower, at appraisal, developed a Procurement Plan for project implementation which provides the basis for the procurement methods. This plan has been agreed between the Borrower and the Project Team on July 6, 2004 and i s available at BGK inWarsaw, Poland It will also be available inthe Project's database and in the Bank's external website. The Procurement Plan will be updated in agreement with the Project Team annually or as required to reflect the actual project implementationneeds and improvements ininstitutional capacity. Two Project components, Capital Grant and Technical Assistance involve procurement. Capital Grant Component, Goods and Works, including Supply and Installation: The GEF Project will co-finance multiple subprojects o f various type and size. These subprojects shall be prepared over the implementation period o f the GEF Project and may include different numbers o f packages. Depending on the subproject, these packages may include procurement o f goods, works or supply & installation contracts. To the extent possible packages for procurement. o f goods of similar nature, which are needed for different subprojects, shall be grouped into larger packages to use economy o f scale in procurement. However, the minimum procurement package shall be equivalent to US$250,000. With the largest contracts be procured through ICB procedure, most o f packages will likely be appropriate for procurement with use o f Commercial Practices (defined below). Technical AssistanceComponent, Consulting Services and Training: Consulting services are required to: support the deployment o f the guarantee mechanism and to build the capacity o f BGK to administer the Project components and Grant funds; support POE ESCO in the development o f the performance contracting model in the Krakow region and to build its pipeline o f potential investments; provide training to local banks; increase awareness and demand for efficiency investments among building owners; and to collect project monitoring data and broad dissemination of results. Non-procurement items: Partial Guarantee Facility USS5.7 million SOEbasedtraining courses US$35,000 BGK Management Fee US$1.3 million D. FrequencyofProcurementSupervision In addition to the prior review supervision to be carriedout from Bank offices, the capacity assessment o f the Implementing Agency has recommended twice a year supervision missions to visit the field to carry out post review o fprocurement actions. 52 Attachment 1 Details of ProcurementArrangement involvinginternationalcompetition. - 1. Goods andWorks and nonconsultingservices. (a) List of contractPackagesthat will be procuredfollowing ICB and Direct contracting: - 3 1 4 5 6 17 8 19 Contract Estimated Procurement P-Q Domestic Review Expected Comments (Description) cost Method Preference by Bank Bid-Opening --F- [th.US%] (yeslno) (Prior/ Date - G,W,S&I for NO Applicable Prior EE measures ICBLUSD only for under the 6 700,OO 350 0002 goods Capital Grant (total) as needed for Facility - GEF High Cost G,W,S&I for 2 ooo,oo NO Measure Grant EE measures (GEFfin.) CP