Document of The World Bank FOROFFICIALUSEONLY Report1.a: 47748-A .J PROJECTAPPRAISAL DOCUMENT ONA PROPOSED INTERNATIONALBANK FORRECONSTRUCTIONAND DEVELOPMENT PARTIALRISKGUARANTEE INTHEAMOUNTOFEURO60MILLION (USD78 MILLIONEQUIVALENT) FORTHE PRIVATIZATIONOF THE POWERDISTRIBUTIONSYSTEMOPERATOR OPERATOR1 ISISTEMITTE SHPERNDARJESSHA (OSSH) IN ALBANIA April 14,2009 SustainableDevelopmentDepartment SouthEastEuropeCountryManagementUnit EuropeandCentralAsia Region This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwisebe disclosedwithout World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate EffectiveFebruary 2009) CurrencyUnit = Lek Lek 102 = US$1 US$1.3 = 1 C Z K 1 = US$0.04 FISCAL YEAR January 1 - December31 ABBREVIATIONS AND ACRONYMS AMM Albanian Market Model APL Adaptable Program Loan CAS Country Assistance Strategy COOP1 Cooperazione Internazionale - ItalianBilateral Aid Agency DSO Distribution System Operator EBRD EuropeanBank for Reconstructionand Development EC EuropeanCommission ECSEE Energy Community of South East Europe EIB EuropeanInvestmentBank EIRR Economic Internal Rate of Return EMP Environmental ManagementPlan ERE ElectricityRegulatory Entity ETSO EuropeanTransmission System Operators EU EuropeanUnion FDI Foreign Direct Investment GOA Government o f Albania IAS InternationalAccounting Standards IASB InternationalAccounting StandardsBoard IFC InternationalFinance Corporation IFRS InternationalFinancial Reporting Standards KfW Kreditanstalt fur Wiederaufbau KESH AlbanianElectricity Corporation METE MinistryofEconomy, Trade andEnergy OSSH The company that carries out the separately licensed functions o f the DSO and RPS PSGRP Power Sector Generationand Restructuring Project RPS RetailPublic Supplier SEE South East Europe SPA Share Purchase Agreement TSO Transmission System Operator USAID United States Agency for International Development VAT Value Added Tax WPS Wholesale Public Supplier Vice President: Shigeo Katsu Country Director: Jane Annitage Country Manager Camille LampartNuamah Sector Manager: Ranjit Lamech Task Team Leader: Demetrios Papathanasiou Guarantee Team Leader Farida Mazhar FOROFFICIAL USE ONLY ALBANIA Privatizationof the Power DistributionSystem Operator Table of Contents Page I STRATEGICCONTEXTANDRATIONALE . ................................................................. 1 A. Country and sector issues.................................................................................................... 1 B. Rationale for Bank involvement ......................................................................................... 3 C . Higherlevelobjectives to which the project contributes.................................................... 4 I1. PROJECT DESCRIPTION ............................................................................................. 5 A. Privatization of OSSH......................................................................................................... 5 B. Project development objective andkeyindicators.............................................................. 6 C. The Partial Risk Guarantee................................................................................................. 7 D. Lessons learned and reflected inthe project design............................................................ 8 E. Alternatives consideredand reasons for rejection .............................................................. 9 I11 . IMPLEMENTATION ...................................................................................................... 9 A . Partnership arrangements.................................................................................................... 9 B . Institutionaland implementation arrangements................................................................ 10 C . Monitoringand evaluation o f outcomesh-esults................................................................ 11 D. Sustainability..................................................................................................................... . . . 11 E . Criticalrisks andpossible controversial aspects............................................................... 12 F. Loadcredit conditions and covenants............................................................................... 15 IV . APPRAISAL SUMMARY ............................................................................................. 15 A. Economic and financial analyses...................................................................................... 15 B. Technical........................................................................................................................... 16 C. Fiduciary........................................................................................................................... 16 D. Social................................................................................................................................. 16 E. Environment...................................................................................................................... 17 F. Safeguardpolicies............................................................................................................ 17 G . Policy Exceptions and Readiness...................................................................................... 17 This document has a restricted distribution and may be used by recipients only in the performance of their official duties.Its contents may not be otherwise disclosed without World Bank authorization. ANNEXES Annex 1:Country and Sector Background .............................................................................. 18 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies .................29 Annex 3: Results Framework and Monitoring ........................................................................ 31 Annex 4: The PRGTerm Sheet and Contractual Structure ................................................... 33 Annex 5: Electricity Regulation and Regulatory FrameworkBackstoppedby the PRG 39 .... Annex 6: Implementation Arrangements ................................................................................. 47 Annex 7: Economic and FinancialAnalysis ............................................................................. 49 Annex 8: Safeguard Policy Issues .............................................................................................. 52 Annex 9: Project Preparation and Supervision ....................................................................... 54 Annex 10: Documents inthe Project File ................................................................................. 55 Annex 11:Statement of Loans and Credits .............................................................................. 56 Annex 12: Country at a Glance ................................................................................................. 57 Annex 13: Maps ........................................................................................................................... 59 ALBANIA PRIVATIZATION OFTHE DISTRIBUTIONSYSTEM OPERATOR PROJECT APPRAISAL DOCUMENT EUROPE AND CENTRAL ASIA ECSSD Date: April 14,2009 Team Leader: Demetrios Papathanasiou Country Director: Jane Armitage Sectors: Power (100%) Sector Director: Peter D.Thomson Themes: Regulation and Competition Policy Sector Manager: Ranjit Lamech (P) State enterprise h a n k restructuring and privatization (P) Project ID: P112242 Environmental screening category: C Lending Instrument: Partial Risk Guarantee ProjectFinancingData [ 3 Loan [ICredit [ ]Grant [XIGuarantee [ ] Other: Amount of guarantee: 60 million (US$78 million equivalent) Proposed terms: PRG o fup to a maximumterm o f eight years Proposed Risk Coverage: The PRG will backstop the Government of Albania's debt obligation to a commercial bank, the L/C Issuing Bank, to compensate the privatized Distribution System Operator (OSSH) for loss o frevenues resulting from a change or repeal of, or non-compliance by, the Albania Electricity Regulatory Entity(ERE) or the Government ofAlbania o f certain provisions ofthe pre-agreed regulatory framework. Source Local Foreign Total BORROWEWRECIPIENT 0 0.00 0 CEZ Equity 0.00 132 132 INTERNATIONALBANKFOR 0.00 (78) (78) RECONSTRUCTION AND DEVELOPMENT (PRG) Total: 132 132 Borrower: Ministry o f Finance Blv. Deshmoret e Kombit Nr. 1,Tirana Albania ResponsibleAgency: CEZ, CEZ a. s. Duhova 1444/2,140 53 Praha 4 Czech Republic Project implementationperiod: Start May 2009 EndDecember 2016 Expected effectiveness date: May 2009 Expected closing date: December 31,2016 Does the project depart from the CAS incontent or other significant respects? Ref:PAD LC. [ ]Yes [XINO Does the project require any exceptions from Bank policies? Ref: PAD I K G. []Yes [XINO Have these been approved by Bankmanagement? []Yes [ IN0 I s approval for any policy exception sought from the Board? [ ]Yes [XINO Does the project include any critical risks rated "substantial" or "high"? Ref: PAD IILE. [XIYes [ ] N o Does the project meet the Regional criteria for readiness for implementation? Ref: PAD IKG. [XIYes [ ] N o Project Development Objective: The objective of the proposed PRG operation i s to facilitate the privatizationof OSSHinthe context of a new RegulatoryFramework. It will be achieved through enabling the Government o f Albania (GOA)and CEZ o f the Czech Republic to implement the PrivatizationAgreements for OSSHunder the new regulatory framework. Project Description: The proposed PRG will backstop the GOA'Sdebt obligation to a commercialbank (the L/C IssuingBank) that has, onbehalf of GOA,paidunder a Letter o f Credit (L/C) that may be drawnby the privatized OSSH upon the occurrence of a GuaranteedEvent to compensate OSSH for a resulting loss of revenue. The Guaranteed Events would be a change, or a repeal, by GOAor the EnergyRegulatory Authority EREof, or a non-compliance by EREwith the provisions of the pre-agreed regulatory framework relating to the: (i) Distribution System Operator tariff service formula ;(ii) RetailPublic Supply service tariff the formula; and (iii) tariff approvals. timely The policy on environmental assessment is not triggered bythe proposedPRG. No physical works (either rehabilitationor new investments) will be supported by the PRG andtherefore the Environmental Assessment Category i s C. Guarantee Effectiveness: Execution, delivery, and effectiveness o f all privatization agreements, eachina form and substance satisfactory to lBRD including the conclusiono f a Guarantee Agreement betweenthe L/C Issuer and IBRD, aProject Agreement betweenthe privatizedOSSHand BRDand anIndemnityAgreement between IBRD and Albania. Covenants applicable to project implementation: The privatized OSSHwill provide reports (including audit reports) andother Project information, and make warranties and representations and covenanted undertakings, including inrespect o f compliance with applicable environmental laws and relevant Bank Guidelines and requirements relatingto corrupt practices. ALBANIA Privatizationof the PowerDistributionSystem Operator STRATEGIC CONTEXT AND RATIONALE A. Country and sector issues 1. Albania has successfully maintained macroeconomic stability over the last 10 years with steady growth and low inflation. Growth has been above 5 percent annually in all but one of the last ten years, and inflation below 5 percent in all years. Such sustained growth resulted in upgrading Albania to the group o f middleincome countries in2007. Despite the global financial challenges, 2008 growth remained at around 6 percent. However, sustaining high growth rates and maintaining macroeconomic stability will prove more challenging in the future amid the global economic crisis and deterioration in the productive capacity and financial position of the electricity sector. The first signs o f adverse trends come from declining remittances and a decrease inbank deposits since October 2008. The growth rate therefore, i s likely to fall below 2 percent in2009. 2. Inrecent years therehasbeena gradual improvement inthe fiscal deficit from 6.6 percent o f GDP in 2002 to 3.2 percent in2006, although itjumped to 5.6 percent in2008. The gradual fiscal consolidation has resulted from a combination of improving revenue administration and reduced interest payments and has contributed to a sustained decline in public debt from 62 percent at end 2003 to 55 percent in 2007. The increases in the deficit in 2007 (to 3.8 percent, from 3.2 percent in 2006) and 2008 are largely due to increased public investment, and can therefore potentially be reduced in later years. The government has proposed a 2009 budget deficit o f 4.2 percent o f GDP, based on an optimistic GDP growth scenario o f 6 percent, and aiming to complete most of the Durres-Kukes-Morine road works while pursuing another round of wage and pension increases. However, more conservative calculations and factoring in likely slower growth, show that the spending commitments in the drafl budget are likely to imply a deficit o f closer to 5 percent of GDP. Potential difficulties in financing such a deficit, and given the government's stated commitment to contain it at around 4 percent of GDP, imply potential budget adjustmentsduringthe year. 3. High and rising current account deficits in 2007 and 2008 arose mainly fkom the acceleration of public investment and high electricity imports, and food and commodity prices. These trends, combined with a slowdown in remittances, led to an estimated 2008 current account deficit of 13 percent of GDP. In 2009, this trend is expected to reverse, following the drop of food and oil prices, and the decline in imports as aggregate demand (consumption and public investment)falls, which should more than offset the impact on exports o f a less favorable external environment. Part o f the increase in the current account deficit in 2008 has been financed by a rise in Foreign Direct Investment (FDI), and ongoing privatizations may help to maintain a reasonable flow o f FDIeven in2009. However, medium-termFDI flows will depend on a strong reform agenda. Inthis respect, the privatization o f Albania's electricity Distribution System Operator (OSSH) is akey development for the country. 4. The most significant risks to growth and macroeconomic stability arise from the ongoing recession in large parts of the world economy and the financial position and electricity supply capacity o fthe state owned electricity producer (KESH). Albania's internal electricity generation capacity is today about 95 percent dependent on hydropower. Duringyears with low rainfall, the combination of dry weather, below-cost retail tariffs, high network losses (technical and non- technical), poor collection rates, and growing demand, means that KESH can maintain electricity supply at a loss, or implement extensive load shedding. An extraordinary dry period in 2007 resulted inboth supply shortages and financial losses. In2008, when only relatively dry weather continued until December, KESH improved the supply situation, but continued to accumulate losses and debt. At the same time, inpreparation for privatization reform, KESH was unbundled and a new distribution company was established to handle the network operations o f electricity distribution and the retail public supply service. 5. At the root o f the problems o f the electricity sector inAlbania has been the distribution division o f KESH, recently incorporated as a separate company: the Distribution System Operator (OSSH). The distribution side o f electricity systems not only provides the physical interface between electricity supply and end-users, but also the commercial part of the financial transactions with electricity users. Electricity consumption i s billed and cash collected from customers at the distribution level, and then allocated and transferred to the transmission and supply sides o f the system. The distribution operator is, therefore, the channel that irrigates financially the whole power sector. However, high losses in distribution combined with low collections o f billed electricity, have resulted in KESH being paid, over a number o f years, for only about 50 percent, or less, o fthe electricity supplied through its network (see also Annex 1). 6. The electricity distribution system's poor performance has left KESH with insufficient money to invest in proper maintenance, operation, and expansion o f its system, and, more seriously, prevented it from being able to pay for all o f the imported electricity needed to make up for shortfalls in domestic hydropower production. The company required considerable direct transfers from the state's central budget in 2000-2004, 2007 and 2008, but even with such subsidies load shedding has continued. Moreover, KESH resorted to commercial lending to cover its operational losses. As o f February 2008, KESH had commercial short-term debt o f 112 million. In addition to its commercial debt, KESH is exposed to short-term debt issued through various agreements with the Ministryo f Finance o f about 45 million implyinga total o f 157 million (or 1.8 percent o f GDP). 7. The Government, recognizing the importance o f improving the performance o f power distribution and the long-standing inability o f a state-owned structure to make significant progress, has decided to privatize it. In early 2007, it contracted the International Finance Corporation's Advisory Services in Southern Europe (IFC-PEPSE) as the transaction advisor for the privatization. It adopted a new market model for the power sector in conformity with its commitments as a member o f the Energy Community', and separated the distribution system operator from KESH, making it a new joint stock company (OSSH), 100 percent owned by KESH on June 19, 2007. In June 2008, in preparation for privatization, ownership o f the company was transferred to the Ministry o f Economy Trade and Energy (also the owner o f KESH). Inparallel, the Electricity Regulatory Entity (ERE) prepared new regulations, licenses and tariff methodologies, for the various participants inthe reformed power sector. 1The Energy Community internationaltreaty is an importantelementof a strategydevelopedby the member states of South East Europeandthe EUto ensure access to a stable and continuous energy supply. The creation of an area without internal frontiers for energy contributes to economic and socialprogressand ahigher level of employment as well as balancedand sustainable development. All of the Energy Community member countries havethe prospectof EUmembership, and the Energy Community Treaty requires membersto implement the EC Directive 2003/54/EC (electricity). 3 2 The Governmentof Albania hasdeveloped a strongrecordof sector reformsand successfulprivatizations, despite government changes and notwithstandingdelays. After concluding the privatization o f most state- owned small and medium enterprises in 1999, the Government concentrated on larger enterprises and utilities. The privatization o f five non-strategic state owned companies (a brewery, winery, dairy factory, pharmaceutical factory and cement factory) was successfully concluded inthe first half o f 2001 through tender sales, mostly to foreign investors. The privatization o f strategic sectors however, proved more challenging for Albania. A summary ofkey privatizations include: rn The sale o f the Savings Bank - the country's largest bank - to the Raiffeisen Group in the first half o f 2003. Subsequently, the entire banking sector came under private management. rn In June 2005, the Government approved the sale of the state-owned fixed-line telecommunications operator Albtelecom. Calik Energy Telecommunication won the right to acquire a 76 per cent stake in the company for about 120 million, with the state retaining 24 per cent. Although the privatization contract had been signed inJune 2005, the new parliament elected in July that year did not immediately ratify it. InAugust 2006 a review instigated by the Government led to limited re-negotiation and the contract was ratified a year later with few amendments. rn As part o f the privatization process, the state oil company Albpetrol was split into three companies in 2003: Albanian Petroleum Company (oil and natural gas extraction), Albanian Refining and Marketing Oil (ARMO,refining) and Servcom (petroleum distribution). The private sector has been involved successfully in upstream oil exploration and development. However, the privatization o f the country's outdated refinery has been rescheduled several times due to lack o f interest by investors, but in 2008 the government succeeded in selling 85% o f its stake in the oil refining and marketing company ARMO to a foreign investor (Refinery Associates o fTexas, Anica Enterprises & Mercuria Energy Group) for about 125 million. 8. Based on discussions with potential investors that expressed concerns on regulatory risks associated with the OSSH privatization, IFC-PEPSE recommended to the Government that they should request the World Bank's Partial Risk Guarantee (PRG) instrument to help facilitate the transaction. Main concerns o f investors were the lack o f experience o f the Albania's Energy Regulatory Entity with private sector operators and the projected requirements for tariff adjustments, as well as the upcoming elections inJune 2009. 9. Four companies were pre-qualified in the bidding process for the sale o f a controlling stake o f 76 percent o f the shares o f OSSH: ENEL o f Italy, EVN and Energie-Steiermark o f Austria, and CEZ o f the Czech Republic. Only ENEL and CEZ subsequently submitted a final bid. During the bid evaluation, ENEL's proposal was found not to comply with the technical requirements and was disqualified, while CEZ was declared the preferred bidder in November 2008. The Government and CEZ have since successfully concluded negotiations and signed the Share Purchase Agreement (SPA) on March 11 2009, whereby CEZ will pay 102 million for 76 percent o f OSSH shares. The PRG is a condition precedent to the closing o fthe SPA. B. Rationalefor Bankinvolvement 10. The Bank has been engaged inthe Albanian power sector since 1992 through investment projects, donors' coordination, and policy dialogue including on regulatory matters. The Bank's Power Transmission and Distribution Project contributed to the creation o f ERE in 1995, whereas the Power Sector Rehabilitation and Restructuring Project contributed to strengthening ERE through the Law on Regulation o f the Electricity Sector enacted in 2003, especially by removing the right o f the Government to fix a price cap. Because o f the Bank's continuing involvement inthe sector, CEZ requested the PRG inits bid to help mitigate the perceived risks o f a new regulatory framework andthe limited track record o f ERE. 11. The proposed PRGwould guarantee the obligation o f the Government o f Albania (GOA) to compensate the privatized OSSH, should ERE or GOA fail to implement the regulatory framework agreed as part o f the SPA, which will be ratified by the Albanian Parliament. The Bankhas had a successful experience with a similar PRG operationinRomania, where the PRG to date has been instrumental in ensuring that the pre-agreed regulatory framework remained on track in spite o f changes in Governments and Governmental policies inthe Energy Sector. CEZ was prompted to request the PRG also because o f this positive experience inRomania, where the company owns a distributionutility. 12. The Bank i s well placed to provide the proposed PRG because of its sector involvement through sector loans, its ongoing policy dialogue with the Government, and its experience with a similar PRG inRomania as noted above. CEZ may, upon completion o f the privatization, request debt or equity financing from IFC. At this stage, MIGA support i s not anticipated as CEZ does not intendto seek equity insurance. 13. This PRG operation, while not included in the Country Assistance Strategy, is fully aligned with the CAS objectives o f economic growth through support to private sector development and improvement in public services. The PRG would contribute to the CAS outcome o f achieving more reliable power supply, and reduced vulnerability and fiscal risks imposed by the electricity sector. Inthe absenceof the proposed PRG the privatizationwould not conclude. As a result, electricity distribution in Albania would remain state-owned, with its unsatisfactory performance continuing to undermine not only the power sector's financial condition, but potentially also the country's fiscal stability. C. Higher level objectives to which the project contributes 14. The privatization o f OSSH is expected to reduce the fiscal burden imposed by the power sector. During the recent years o f adverse hydrology, the operational weaknesses o f OSSH increased the need for expensive power imports, brought about increased load shedding, and obliged the Government to reintroduce subsidies to KESH. Subsidies had been provided from 2000 through 2003 in response to an earlier period o f adverse hydrology, but were not granted from early 2004 until mid-2007. The drought together with a doubling o f the price o f imported electricity and inadequate tariff increases after 2005 (see Annex 1) caused considerable financial losses that required budget transfers to KESH and increased public sector indebtedness through KESH (see also paragraph 6 above). In contrast, OSSH's performance after privatization will need to comply with: (i) concrete schedule for operational improvements (progressive loss a reductions and revenue collection increases); and (ii) a gradual adjustment o f tariffs to cost- recovery levels. These measures should in the medium-tern reduce the need for government subsidies and increase tax revenue. Achievement o f a satisfactory financial performance o f the privatized OSSH may not on its own eliminate the potential need for subsidies to KESH during future periods o f adverse hydrology, but the loss reduction and collection improvement targets would improve the overall sector's revenues and thereby provide the funds needed to allow KESH to get through future dry periods without further significant government assistance. 15. The privatization o f OSSH would also improve the overall electricity supply situation over time. Since 1997 electricity shortages have been affecting adversely the life and work o f the Albanian people; rural and poor areas suffer disproportionately from supply disruptions. In Albania's most recent Investment Climate Assessment survey o f 2008, electricity problems were highlighted as one o f the two top concerns by businesses o f all sizes and types2. Widespread electricity supply disruptions over a number o f years have prompted businesses and households to invest in power generators that are expensive to operate and maintain, while their extensive use during blackouts contributes heavily to local air pollution and noise. To address the supply Building Competitiveness in Albania World Bank Report No. 47866-AL, forthcoming 4 issue, Albania has been trying for a number o f years to attract FDI in electricity generation. Albania is a member o f the Energy Community and enacted inlate 2006 a new concession law to take advantage of its undevelopedpotential for hydropower. The country's legal and regulatory framework i s conducive to encouraging investments in power generation, while regional price trends could make such projects attractive. However, significant investments in new power generation have not materialized because o f investor concerns about the credit-worthiness o f the public electricity entities. The privatization o f OSSH, on the other hand, should attract investments inelectricity supply because it will: (i) bringa new credit-worthy entity inthe sector that will procure considerable quantities ofpower at market prices, and (ii) establish, over time, a financially sustainable sector. 16. This PRG operation would also contribute to the success o f the Albanian power market and its further integration into the Energy Community market. Albania is a member o f the Energy Community in South East Europe, a market supported by the EU and other countries outside the region. Establishment and maintenance o f an independent electricity regulatory authority is a requirement for membership in the Energy Community. The presence o f the PRG would help to buttress ERE'Sindependence and ensure that the regulatory authority performs in accordance with the pre-agreed Regulatory Framework. PROJECTDESCRIPTION D. Privatizationof OSSH 17. OSSH owns 69,000 km o f network and serves about 1 million customers. Collected annual revenue o f OSSH for 2008 (including arrears) was Lek 32.5 billion, whereas the billed consumption for 2008 reached Lek 39 billion3. In 2008, KESH reported net domestic power generation of 3,833 GWh, all hydroelectric and all o f which was produced by KESH except for 62 GWh supplied by small privately operated hydropower plants. Net imports and exchanges were 2,465 GWh and total available electricity was 6,298 GWh; load shedding i s estimated at 561 GWh(Annex 1contains a detailed electricity balance). 18. The Government decided to sell 76 percent o f the share capital o f OSSH to a strategic investor. Part o f the remaining state-owned shares (24 percent) are to be offered to: (i) the employees o f OSSH in exchange for privatization bonuses and/or vouchers held by these employees, including their parents, spouses and children; and (ii) the former owners o f land that was nationalized during the communist period. The strategic investor will have the right to acquire any shares not taken upbythese two groups. 19. The privatized OSSHwill operate under two licenses: (a) a Distribution System Operator (DSO) License for 30 years with exclusive right to serve all o f Albania; and (b) a Retail Public Supply (RPS) License for 30 years with exclusive right to supply electricity to tariff customers. The DSO license applies to network operation (covering all voltage levels within Albania from 0.4 kV up to and including 110 kV) and to connections o f consumers, including eligible customers who will not be buying their electricity from the Retail Public Supplier (RPS), ,independent generators, and installation and servicing o f meters and meter readings. The Albanian Market Model (AMM) requires market purchases o f electricity to cover all distribution losses; this mechanism provides a strong incentive to reduce distribution losses quickly. 20. The Retail Public Supplier (RPS) License provides for the purchase o f electricity destined for final tariff customers from the Wholesale Public Supplier (WPS), which will remain state- These figures includeValue Added Tax (VAT) at 20 percent 5 owned, at a regulatedtariff and sale to final tariff customers also at a regulated tariff. Billing and collections come under the RPS license as well. The WPS will buy at a regulated price all o f the electricity produced by KESH Generation (KESH Gen) to the extent needed to serve tariff customers except for what i s needed by the TSO for ancillary services. WPS will buy any additional electricity, as needed, to meet the demands o f final tariff customers on the market. The WPS as the "supplier o f last resort" is responsible for overall security o f supply within Albania. Over the next few years, purchases on the market will consist mostly o f purchases o f imported electricity, and the bulk o f the purchased imports will be for distribution losses. 21. Based on the agreed Regulatory Framework, the privatized OSSH will be required to: (i) reduce total losses from 32 percent in 2009 to 15 percent by 2014; (ii) increase the collection rate from 86 percent in2009 to 91 percent by 2014; (iii) improve operational effi~iency;~ (iv) and improve the quality o f electricity supply. Further improvements will be agreed in 2014 for subsequent regulatory periods (not guaranteed by the PRG). In order to effect these improvements, CEZ expects that OSSH will invest around 240 million inthe first five years o f operation after privatization. While OSSH will operate during 2009 with a tariff that i s below cost recovery, the new Regulatory Framework contains specific provisions for reimbursing OSSH for the resulting financial losses in subsequent years. ERE has committed to gradually raise the weighted average end-user tariff by 15% in real terms from January 1, 2010 until the tariffreaches cost recovery levels. OSSHwillbereimbursedfor any financial lossesuntilthe end o f 2012 while tariffs remain below cost recovery. Tariffs in subsequent years are projected to decline as the company meets its progressively ambitious distribution loss and revenue collection targets set out inthe Regulatory Framework. E. Project development objective and key indicators 22. The objective o f the proposed PRG operation is to facilitate the privatization o f OSSH in the context o f a new Regulatory Framework. The project would be considered successful if (i) the transaction is closed and the strategic investor takes over OSSH; and (ii)if the new Regulatory Framework is implemented as agreed for the period o f the PRG coverage. A steady improvement in OSSH's performance is a key requirement of the Regulatory Framework (see paragraph 21). Once these improvements are accomplished, the sector should become viable and further investments intransmission and generation will likely follow. 23. The key performance indicators that would be used to assess the fulfillment o f the project's development objectives in terms of outcomes and outputs are: (i) transaction closed by the target date o f May 2009; and (ii) tariff adjustments approved for the DSO and RPS in timely conformity with the agreed Regulatory Framework. 24. The project's intermediate outcome indicators are: (i) the initial equity investments are made by the investor for the purchase of shares from GOA; (ii) the operation o f OSSH in accordance with its license obligations and the implementation o f the investment programs approved by ERE. Key outcome indicators are: (i) reduction inelectricity distribution losses; and (ii)improvement in collections in accordance with targets set out inthe Regulatory Framework. While the regulatory provisions supported by the PRG will provide incentives for OSSH to achieve these important goals, the degree o f success will also depend on the actual performance o f OSSH under its new ownership. Losses and collections indicators will be included among the For instance, the number of customers per employeeinAlbania is only about 150, comparedto more than 400 insome Central Europe utilities. Efficiency improvements are to be encouragedthrough the use ofprice cap regulationofthe DSOtariff. 6 high level outcome indicators that will be used to evaluate the project, because the PRG i s only one contributing factor among several inmeeting these objectives. F. The PartialRiskGuarantee 25. The proposed PRG would backstop the Government's debt obligation to a commercial bank (the L/C Issuing Bank) that has, on behalf o f the Government, paid under a Letter o f Credit (WC) that may be drawn by the privatized OSSH in specified circumstances. This would be the second PRG to be provided in support o f a power distribution privatization transaction and this use o f the PRG was developed specifically to enhance and facilitate the privatization and concessioning o finfrastructure and public service utilities. 26. The PRG would guarantee debt arising from a drawing o f the L/C which would be issued by a commercial bank in favor o f the OSSH as beneficiary. OSSH would be entitled to draw on the L/C upon the occurrence of a Guaranteed Event to compensate for a resulting loss o f revenues. The Guaranteed Events would be a change or a repeal by the Government or ERE of, or a non-compliance by ERE with, the provisions o f the pre-agreed regulatory framework relating to: (i)the DSO tariff formula and its related inputs, and the RPS tariff formula and its related inputs, including the compensation mechanism, and (ii) timely approval o f tariffs, the which result in a loss o f revenue to OSSH (Annex 5 contains a detailed description). These Guaranteed Events will cover a transitory period in year 2009 and then the first three Regulatory periods up to the end o f year 2014 and will be set forth in the Government Support Agreement (GSA) to be concluded between OSSH, the Ministry o f Finance (MOF), and the Ministry o f Economy Trade and Energy (METE). Following a drawing, the GOAwould be obligated to repay the L/C Issuing Bank for the amount drawn with interest, within 12 months. GOA'Sobligation to repay the L/C IssuingBank for the amount drawn and not repaid at the end o f the 12 month period, would be guaranteed by the Bank under the PRG together with accrued interest. The WC would be for a maximum amount o f 60 million, and would be valid for a term o f a maximum o f six years from the transfer date o f OSSH. The LK amount o f 60 million was the minimumlevel o f risk mitigation negotiated by GOAwith CEZ (estimates o f OSSH revenue requirements andpotential exposure o f OSSH to non-adjustment o f tariffs are provided inAnnex 7). Thus the PRG would backstop well-defined risks relating to the Regulatory Framework, which would be under GOAand ERE'Scontrol, while OSSH will assume all the commercial risks associated with operating a regulated distribution company (operational, collections, and investments). The PRG term sheet and contractual structure are attached as Annex 4. 27. Upon the occurrence o f a Guaranteed Event, OSSH would notify GOAand the Bank o f a claimed Event o f Default. Ifthe Event o f Default is not remediedwithin the review/cure periods provided for in the GSA and provided the claim i s undisputed, OSSH would be entitled to draw under the WC upon the presentation o f the relevant documentation to the LK Issuing Bank, and the WC amount would be reduced by the amount o f the drawing. Inthe event that a claim under the GSA is disputed by the Government, the claim would be referred to international arbitration. Pending adjudication o f the claim, OSSH would be entitled to draw provisional payments under the L/C by posting appropriate security issued in favor o f the Government. Following the resolution o f the dispute, if an award i s made against OSSH, the Government would be entitled to claw back the advance payment made to OSSHby calling its security. 28. Following a drawing, GOAwill be obligated to reimburse the L/C Issuing Bank, under the terms o f an agreement to be entered into between the L/C Issuing Bank and the GOA,for the amounts drawn (plus accrued interest) within a repayment period o f 12 months. Ifthe GOAfails to make the required repayment by the end o f that period, the L/C Issuing Bank would have the 7 rightto call on the PRG for the overdue principal amounts plus accrued interest and the amount o f the PRG would be reduced by the amount o f such payments. Although the validity period o f the L/C would be approximately six years from the effectiveness o f the privatizationtransaction, the PRG term would be up to a maximum term o f eight years to accommodate the pre-agreed periods for making claims (cure periods) under the GSA, the one-year repayment period following a drawing in the last year o f the L/C availability period, and the 60-day payment period within which the Bank would be obligated to pay the L/C Issuing Bank following a call on the PRG. As with all guarantee operations, the Republic o f Albania will undertake to indemnify the Bank, on demand or as the Bank may otherwise determine, for any payments made by the Bank under the PRG, pursuant to the Indemnity Agreement to be entered into betweenthe Bank and GOA. 29. Under the PRG, the Bank will have the right to limit its liability to outstanding draws under the L/C in the circumstances set forth inthe Guarantee Agreement, including if there is a material breach by OSSH o f its obligations under the Project Agreement to be entered into betweenthe Bank and the OSSH. 30. The PRG would be priced at 30 basis points per annum on the guaranteed amount payable every six months in advance. In addition, there would be a Front-end Fee o f 25 basis points, an Initiation Fee o f 15 basis points and a Processing Fee o f up to 50 basis points (for reimbursable expenses) on the guaranteed amount. All PRG-related charges would be payable by OSSH. The above is consistent with the pricing policy for IBRDGuarantees. 31. The issuance o f the PRG will be conditional upon the receipt by the Bank o f the relevant Government to the provision o f the guarantee o f a loan provided by a private bank as required under Section 1(b) o fArticle IV o fthe Bank's Articles ofAgreement. 32. Value Added of the PRG. GOAhad formally requested the Bank to provide a PRG following requests from the pre-qualified bidders. The agreement o f GOAto condition the effectiveness o f the privatization upon the issuance by the Bank o f the PRG facilitated the signing o f the SPA andhelpedto secure the interest o f CEZ, a major regional player inthe power sector, inthe acquisition o f OSSH. The PRG is also believed to have enhanced the price offered by CEZ. Furthermore, the PRG will help to catalyze around 240 million of expected investments inthe distribution network by OSSH over a period o f five years. With the proposed investments and improvements in management and operations in the form o f reductions in technical and non-technical losses stipulated in the pre-agreed Regulatory Framework, the distribution sector should be put on a sustainable path to cost recovery tariffs, with the PRG affording protection to CEZ during the transitional period. In the absence o f the PRG, there could well have been a bid failure which would have meant that OSSH would have continued to be a major budgetary drain on the GOAwith consumers facing deteriorating electricity services. G. Lessonslearned and reflectedinthe project design 33. Access to reliable electricity is a key driver o f economic growth and a direct means o f reducing poverty because it improves the productivity o f households and enhances the delivery o f social services. The successful privatization o f electricity utilities, a key component o f reforming energy markets, is therefore a priority for the governments o f many developing countries and transition economies, as they seek to improve efficiency and reliability, and attract private investment in the sector. Inthe Bank's experience, a satisfactory privatization o f power distribution utilities should precede efforts to attract private investment to other parts o f the sector; as cash flows arise mostly from distribution. 8 34. Because o f the mixed post-privatization experiencz o f investors in distribution utilities, primarily due to tariffs not being adjusted towards cost-recovery in a timely manner, there has been heightened investor sensitivity to the regulation o f the sector, which i s perceived as a critical risk. In response to these global lessons, the Bank adapted the PRG to specifically support distribution privatization by backstopping regulatory risk. The conceptual design work o f this PRG structure was completed in late 20025 and since then the Romania transaction has been successfully completed and is currently operational.6 35. Utilityprivatizations elsewhere have also shown that tariff adjustments should be gradual and accompanied with improvements in service. The agreed regulatory framework for this privatization establishes a clear and sustainable pathway for operational improvements. It also includes a compensation mechanism that allows some flexibility to the regulatory authority to partially defer tariff increases over time, so that adjustments can take place gradually as sector performance recovers. As OSSH's performance improves, its tariffs are expected to come down while still provide adequate returns (see paragraph 21 and Annex 7). 36. Tariff adjustments should also be accompanied by better provision o f social assistance. Currently, electricity tariffs inAlbania establish a first block o f consumption for households (up to 300 k W m o n t h ) at a low rate o f Lek 7/kWh, while for higher consumption the tariff i s Lek 12/kWh. The tariff-blocks system i s a second-best way to deliver subsidies to needy households because of its poor targeting (all households receive it regardless o f their economic situation). EREhas begun a study to evaluate minimumconsumption requirements, and the results o f this study will be used to change the width o f the first block in the tariffs o f January 1, 2010. In addition, the Bank has ongoing technical assistance programs to assist the Government with its overall social assistance provision7(see also paragraphs 63 below). H. Alternatives considered and reasons for rejection 37. The Government decided in 2006 to privatize power distribution because o f persistent failure by KESH to achieve success in reducing power distribution losses and improving collections. Its decision also took account o f the considerable progress made up to that time in restructuring the power sector and strengthening the regulatory authority. The Government initially was expecting to achieve the privatization without the PRG. However, following strong feedback from potential investors for the need o f risk mitigation, GOArequested the Bank for the PRG in support o f the privatization. As noted above, the Bank's involvement to date has helped to advance the process to a stage where the SPA was signed on March 11,2009. 38. With respect to the manner o f privatization, one alternative would have been not to have a PRG, given its associated costs and the resulting contingent liability for GOA.However given the fact that CEZ made its bid conditional to the PRG, this has proved not to be an option for GOAandbothCEZ and GOAagreethat the value o fthe PRGwill significantly exceed its costs. IMPLEMENTATION I. Partnershiparrangements 39. IFC's Private Enterprise PartnershipSoutheast Europe Infrastructure has acted as the Privatization Advisor for OSSH's privatization. USAID has been providing technical assistance See Mitigating RegulatoryRisk for Distribution Privatization-The World BankPartialRisk Guarantee, EnergyandMining Sector BoardDiscussionPaperNo. 5, November2002. This transactionreceiveda `best practice' rating from QAG. 7Forinstance the "Regional SafetyNets", ESW/TA, P113286and"Albania SocialProtection" TA, P111798. 9 to ERE for preparation o f regulations and licenses. Albania i s an active member o f the Energy Community. Many donors and financiers have sustained a coordinated support to Albania's energy sector with the Bank for more than a decade (see Annex 2). J. Institutionalandimplementationarrangements 40. GOAwill transfer a controlling stake o f 76 percent o f OSSH's shares to CEZ a.s. (CEZ), an integrated electricity conglomerate based in the Czech Republic' and majority owned by the Government. CEZ's principal businesses encompass electricity generation and distribution, sales o f electricity and heat, as well as coal mining. In2007, CEZ owned about 14.3 GW o f electricity generation capacity, sold 73,793 GWh o f electricity and had more than 70,000 employees in its operations in the Czech Republic, Poland, Hungary, Romania, Bulgaria and other countries. In November 2008, CEZ was among the top ten European power utilities with about 6.8 million customers and a market capitalization o f about 16.3 billion. The company serves about 3.5 million electricity customers in the Czech Republic and owns controlling stakes at electricity distribution companies in South East Europe (1.67 million customers in Romania and about 2 million customers in Bulgaria). CEZ reported net income o f CZK 42.8 billion in 2007 and estimates a net income o f CZK 48.6 billion (about US$ 2 billion) in 2008, while it maintained the lowest debt leverage ratio among European power utilities and a rating o f A-/A29. CEZ i s a key member o f the CEZ Group with its primary focus on pursuing investment opportunities in ' Central and South Eastern Europe. Entry into the Albanian electricity distribution will provide CEZ with a unique opportunity to firther expand its operations in the Balkans following its acquisitions o f distribution inRomania and Bulgaria, and generation inPoland and Bulgaria. 41. Initially the RPS will be part o f OSSH, but it will be organized under a separate management structure (with separate accounts) and later as a separate legal entity in order to conform to the EC's Electricity Directive. Whether combined or separate, the RPS and OSSH will need to coordinate their activities to reduce distribution losses andimprove collections. The RPS is responsible for billing and collection, with the bills o f final customers including a charge for use o f the DSO's network as well as purchase o f energy. The DSO is responsible for meter reading and maintenance and for consumer connections. Therefore the RPS will have to request the DSO to disconnect consumers who have connected illegally or are indefault, but operational control for both entities can be effectively coordinated as they are both owned by OSSH. 42. The DSO will operate under a tariff designed to cover the costs o f operating the distribution system, including the costs o f purchasing electricity on the market to cover distribution losses plus an allowed rate of return on the approved rate base. The tariff will be based on specified distribution loss reduction levels to be achieved (see paragraph 21 above, subject to qualifications set out in Annex 5). The DSO can make additional profits by over achieving the targets, but must absorb any financial losses from failing to meet the targets; powerfilincentives to improve performance are therefore inplace. 43. The RPS will operate under a retail tariff that passesthrough the cost o fbuyingelectricity at a regulated price from the WPS plus the transmission tariff plus the distribution tariff plus a margin to cover operating costs, and a designated fee o f 2.2 percent o f purchases from the WPS for performing the retail supply activity. The tariff is based on the assumption o f a bad debt * CEZ group is owned by CEZ as. ajoint-stock company incorporatedinMay 1992 and listed inthe stock markets of Pragueand Warsaw; the Czech Republic continuesto bethe company's largest shareholderwith a almost 70% stake as of 31 December 2007. Sources:CEZ Annual Report 2007; CEZ Quarterly Presentation to Investors, November 2008. 10 allowance that will be reduced from 14 percent o f billed revenue in 2009, by one percentage point each year (subject to qualifications set out inAnnex 5). 44. The PRG will guarantee adherence by ERE to the detailed tariff methodologies for the DSOand RPS tariffs. Further details are given inAnnex 5. K. Monitoring and evaluation of outcomes/results 45. The proposal to provide the PRG has already achieved one o f its key objectives. The Government and CEZ have concluded their negotiations and signed the Share Purchase Agreement (SPA). CEZ will take ownership o f OSSH, once the SPA i s ratified by parliament and the PRG has been issued, which i s expected to take place in M a y 2009. The first key outcome therefore will be effectiveness o f the privatization transaction. 46. Duringthe PRG validity period, the key events that will be closely monitored are ERE's regulatory decisions. The Bank i s closely involved in the power sector through its previous and three ongoing projects and its continuous review o f sector performance with respect to the Power Sector Action Plan. It is therefore, well positioned to monitor the guarantee operation until2014 through periodic supervisions. The Bank will also review and comment on the regulatory framework to be agreed in2014. Key indicators to be monitored and to be used inthe evaluation of outcomes andresults are discussed inSection I1(B). L. Sustainability 47. The Albanian power sector i s sensitive to hydrology. In 2007 a severe drought cut domestic production (all from hydropower plants) from a normal level o f well over 4,000 GWh to 2,900 GWh, while electricity import prices more than doubled between 2005 and 2008. Although hydrological conditions improved in late 2008, it has not been possible to raise tariffs enough to cover the incurred costs o f imports, forcing KESH to make large short-term borrowings and to request assistance from the Government. Future hydrological variations will affect the state-owned WPS rather than OSSH, while OSSH may pass through to their tariffs future variations inthe import price and the regulated price o f the WPS. 48. Financial sustainability o f the sector will be strongly dependent on OSSH's performance. OSSH's pre-privatization performance has moderately improved (losses decreased from 39.4 percent in2006 to 32.7 percent in2008, and collection rate increased from 81.9 percent in2006 to 83.3 percent in2008). However, ERE's decision to maintain tariffs at the level that came into effect on March 1, 2008 until January 1, 2010 (transition period for privatization) made it necessary to reach agreement with CEZ on the handling o f the losses o f OSSH incurred during 2008 and those expected to be incurred during 2009. Financial losses o f 2009, as well as losses incurred in subsequent years as a result o f phased tariff increases, are to be handled by means o f an agreed compensation mechanism. Under this mechanism, increases in end-user tariffs are to be at least 15 percent per year inreal terms as long as there are amounts to be compensated. The Government, ERE and CEZ have agreed to these arrangements. The above arrangements provide for a balanced and reasonable path forward to reach financial sustainability inthe medium-term. 49. Overall sector performance will depend on the realism o f the agreed targets for loss reduction and collection improvement. Such risks will be borne by the privatized OSSH. The prospects o f sustainability are supported by CEZ's technical and financial credentials and its demonstrated ability to improve distribution performance in other South East Europe countries. Sustainability will be self-reinforcing to the extent that the targets are achieved. The current levels o f the critical loss and collection rate variables, despite recent improvements, are so far 11 below potential that the opportunities for improvement are large, and large improvements would increase overall sector revenues and reduce the required level o f future tariffincreases. 50. Sustainability will also depend on ERE honoring the agreed provisions o f the regulatory framework both during and after project implementation. It will be particularly important to ensure that the RPS and DSO tariffs cover their costs, and that overall tariffs for the power sector rise reasonably quickly to cost-covering levels. While the current regulatory framework i s new, the prospects for satisfactory performance by ERE are helped by the enactment o f a sound legislative foundation designed to protect ERE's independence and by the adoption of comprehensive secondary legislations and regulations that lay out a clear path to sustainability. The current framework for the electricity sector in Albania conforms with EU Directives and is more advanced compared to other countries inthe region and i s considered satisfactory. 51. Sustainability o f the privatization will also require Government support to: (i) that ensure electricity bills o f budgetary and state-owned entities are paid fully and promptly; (ii) enforce through courts OSSH's efforts to reduce illegal use o f electricity and payment delinquencies; (iii) maintain adequate social safety net coverage for vulnerable electricity consumers; and (iv) avoid inappropriate interferenceinthe regulatory process. M. Critical risks and possible controversial aspects 52. Given KESH's past underperformance and ERE's mixed record in sufficiently adjusting tariffs to cover cost increases, this is considered a substantial risk operation. The project has an overall substantial risk rating as its outcome is contingent on considerable risks external to the Project as well Project-specific risks. The main risks are summarized inthe table below: 12 IRiskRating Risks RiskMitigation Measures BeforeI M e r Mitigation Political Risks (i) GovernmentofAlbania The A Regulatory Statement has been negotiated between ERE, METE, and may interferewith the tariff CEZ, outlining key parameters of performance and required revenues for setting process. EREhas a OSSH for the first three Regulatory periods until 2014 covered by the H S mixedrecord of adjusting PRG. In addition, there is an undertaking by ERE that similar parameters tariffs to cover costs and has would be developed for the fourth Regulatory period. The Regulatory limitedexperienceof Statement i s annexed to the Share Purchase Agreement and will be ratified regulatingprivate sector by the Albanian Parliament. The GSA providesfor an independentpanel of entities. experts during an appeal process, if a dispute between OSSH and ERE arises on tariff matters. The Bank's counter-guarantee should prove a strong disincentive for both the Government and ERE to deviate from the pre-agreed regulatory framework and from breaching the GSA. Furthermore, the Bank will closely monitor the situation through supervision andwould have a 12 month period from the time o f a claim on the L/C to work with the Government and resolve issues before the PRG can be triggered. USAID is planning continued technical assistance to improve ERE'Sdecision making capabilities. (ii)Future governments may Albania has a track record of honoring privatization transactions, even challenge the privatization of when governments change. The process followed for the privatization of OSSH. OSSH was conducted, with IFC-PEPSE's involvement, in a transparent and competitive manner. IFC and the Bank have been engaged in consultations with the current opposition parties to explain the process and S M benefits of this privatization for the country. As noted above, the counter- guarantee relating to the PRG would also be a strong disincentive for any new Government to interferewith the agreedregulatoryprocess. (iii) Governmentmaynot The OSSH's performance has been unsatisfactory in the past, mainly because provide sufficient support to under state-ownership the quality of electricity provision --and its OSSH (enforcement of law associated costs-- have been politicized, resulting in inadequate investment regarding illegal connections and management practices, as well as inadequate enforcement of and non-payment of bills). provisions regarding illegal use of electricity and non-payments. The Lack of such support may privatizedOSSH should serve as a means to de-politicize the sector, while cause difficulties in meeting the private investor's incentives to improve performance are strong. CEZ the privatization objectives of has presented preliminary business plans' to centralize the billing and H S reducing overall losses and monitoring of electricity invoices, which combined with advanced increasing collection rates. metering, network controls and personnel training, should enhance the company's performance in the short- to medium-term. However, without sufficient support from governmental institutions to address the issues o f electricity theft and non-payment of electricity (for instance: the courts and bailiffs acting on illegal connections and non-payment; the Ministry o f Finance aiding non-budgetary state owned companies when lacking funds for electricity), OSSH's performance may still suffer, placing at risk the performance of the sector. Macro-economic Risks Evenwith the OSSH IThe government has begun to address this problem through the issue in privatization, the state-owned December2008 of a guarantee of E50millionfor KESH's commercialdebt KESHmay continue to carry and an additional loan from the Ministry of Finance of 25 million. In lossesduring 2009. Hence, addition, it is enforcing the payment of electricity bills from government H M thereis arisk that unless there agencies (also a prior action for the January 2009 IMF review). Finally, it is a swift restructuring of i s including in the budget a contingency o f 0.3 percent of GDP for KESH, KESH's debt, andadequate, with a commitment that any additional support to KESHwill be within its explicit and transparent fiscal deficit target of 4.2 percent. The government recognizes that these contingent provisionsmade for are ad-hoc and short-term measures, and success of the privatization is budget transfers to KESH necessary (while not sufficient) for the integrity and predictability of the during 2009, there could either budget. Furthermore, to immediately improve the financial situation of beafiscal shockoranimpact KESH and its ability to supply electricity at the wholesale level, the on electricity supplies. Government has agreed that part of the privatization proceeds will be used to reduceKESH's commercial short-term debt. 13 IRiskRating Risks RiskMitigation Measures Before After Mitigation I Depending on hydrology and Inpast years, extensivesupply disruptions affected rural and poor areas of I I regionalelectricity prices, the Albania disproportionately, but as OSSH's performance improves the tariff increase, necessary in the overall supply situation should improve. The country's social assistance short-term, to bring financial program (Ndihma Ekonomike) i s well targeted but reaches only one third S M viability to the sector (before ofthe poor. Inthis context, the Governmenthas resortedto the sub-optimal OSSH'sperformanceimproves approach o f pricing electricity in consumption blocks with the lowest- undernew ownership after the pricedblock set at 300 k W m o n t h(see also paragraph63). More than half first threeyears) may affect of electricity household consumers use less than this amount, which is vulnerable partsofthe therefore set too generously to protect only the poor. By July 2009 ERE populationinAlbania. will redefine the pricing structure to improve targeting. While some consumers will be affected by this re-structuring, the poor are expected to fall within the re-defined first consumption block. More generally, the ability of the government to administer social assistance needs to improve, but also efforts to educate electricity consumers on energy efficiency and electricity use have to take place. The Bank has on-going technical assistance projects to improve the overall social assistance capacity of the Government, while the project team aims to continue working with donors on improving awareness regarding energy efficiency measures during implementation. Regulatory Framework Risks OSSH'sunbundlingand Secondary legislation and regulatory decisions have been developed in I independentoperationhave earnest by the Government and ERE over 2007 and 2008 with technical only recently been assistance from the USAID and extended commenting and involvement by S M implemented and the current the Bank and IFC. The overall electricity market model design and regulatory framework has only accompanying secondary regulations have been reviewed by the Bank and been usedand tested in found to be modern and adapted to the Albanian realities. The electricity practice for abrief period. market is in line with European Union guidelines and directives on Future implementation might electricity, including proper allocation of risks and incentives to bring still presentunforeseen sector sustainability in the medium-term. The Regulatory Framework challenges. contains an overall balanced approach, where the new OSSH operator undertakes significant commitments to improve performance, while the Government and the Regulatory Entity agree to provide reasonablereturns ifthatperformanceisreached. The region remainsunder By mid-2009 the 100 M W Vlora thermal power plant is expected to come supplyconstraints, which online adding 15-20percent to internal electricity generation. Transmission couldresult ineither high constraints should be alleviated by mid-2010, as donor-financed projects electricityprices or persistent will be completed. Recent rainfalls in 2009 have improved hydroelectric s M disruptions inthe first couple reserves in the region, while the global financial crisis has constrained o f years ofthe privatization, electricity demand growth, resulting in temporary reductions in regional putting at risk the performance prices. This should help in keeping costs under control in 2009 and o f OSSH. potentially 2010. Overall riskrating H S Risk rating: H (High risk), S (Substantial risk),M (Moderate risk), N (Negligible, or low, risk) 14 53. PRG Risk Coverage. As indicated above, there are a number o f potential risks related to the OSSH privatization, but the PRG will cover only limited and pre-defined risks. The main reason for regulatory uncertainty from CEZ's perspective are that: (a) the regulatory framework is new and largely untested, and (b) ERE has limited track record o f regulating private companies. The Bank, with its extensive involvement and ongoing electricity sector support to the Government, i s well positioned to bridge the regulatory credibility gap for the investor through the PRG. The Bank has been working closely with ERE and its technical advisers USAID, and the Government, in the development o f the Regulatory Framework, which will be ratified by Parliament as part o f the Share Purchase Agreement. Because ERE has been intensively involved in the negotiations o f the Regulatory Statement, which would become law once ratified by Parliament, the probability o f a change or repeal by ERE o f the framework should not be a major risk. Similarly, the Government has led the negotiations with CEZ and will be concluding a GSA in which it will undertake to compensate CEZ for any non-compliance o f the regulatory framework, which will be backed by the PRG and counter-guaranteed by Albania inthe form of an Indemnity Agreement to be concluded with the Bank.This is likelyto prove a strong disincentive for either the existing Government, or any new Government, to breach the Agreements or the law by interfering with the regulatory process, as a call on the PRG could jeopardize not only this operation but the country's entire lending program with the Bank. This aspect o f the Bank's leverage through its counter-guarantee has been tested in Romania where the regulatory framework backstopped by the PRG remained on track even when a new Government radically changed the energy privatizationpolicy. 54. Furthermore, the proposed PRG structure i s designed to provide the right incentives for the Government to comply with its privatization Agreements. Inthe event o f a breach, the GOA would be at risk first and the Bank's Guarantee would not be exposed for a subsequent period o f 12 months, given the 12 month repayment period afforded to GOAunder the WC structure. This would allow the Bank sufficient time to work with GOAand EREto help remedy any default and prevent a call on the Bank's PRG. Thus the PRGposes manageable risks for the Bank. N. Loadcreditconditions andcovenants 55. The PRG would be subject to the Conditions Precedent inthe Term Sheet inAnnex 4. APPRAISAL S U M M A R Y 0. Economicandfinancialanalyses 56. The main benefits o f the privatization o f OSSH include: (i)reduced technical and non- technical distribution losses; (ii) improved bill collection; (iii) improved quality o f electricity supply inthe form o f avoided distribution outages and reduced voltage levels and fluctuations; (iv) improved operational efficiency through better management; (v) reduction in uneconomic consumption o f electricity through obliging consumers to pay for all o f the electricity they consume; and (vi) revenue to the Government from its shares o f OSSH. 57. The strictly economic benefits include reduced technical distribution losses, improved 'quality of supply, improved efficiency and reduction inuneconomic consumption. The financial benefits include all o f the items inparagraph 56 except reduction inuneconomic consumption o f electricity. The main economic and financial costs consist only o f the additional rate o f return needed to cover the private buyer's risks relative to the rate o f return needed if the OSSH remained under government ownership. The PRG provided a benefit in terms o f a higher bid 15 price for OSSH shares submitted by CEZ, as a result o f its role inreducingthe regulatory risks to which the OSSH would be exposed. The costs o f the PRG would be borne initially by the OSSH, but will be reflected in the tariffs. From the point o f view o f the Government, the benefits o f the PRG would consist o f lower electricity tariffs due to the reduced required rate o f return. The PRG amount, however, would take the form o f a contingent liability for the Government duringthe guarantee period. 58. Given the narrow focus o f the proposed PRG operation it would be inappropriate to do full economic and financial benefit-cost analysis o fthe privatization. P. Technical 59. The detailed arrangements for the operation o fthe PRG are described inSection II(C). Q. Fiduciary 60. There are no fiduciary issues as there will be no procurement, or procurement-related, disbursements under the project. Should the Bank guarantee be called, the Bank would disburse to the L/C bank and Albania would then be obligated to repay the Bank in accordance with the terms o f the Indemnity Agreement betweenAlbania andthe Bank. 61. It should be noted that IFC's involvement as a transaction advisor throughout the bidding process has created broad confidence in Albania that a fair, transparent, and competitive procedure was followed for the sale o fthis strategic asset o f the Albanian state. R. Social 62. No land acquisition or resettlement is required due to privatization. The new DSO owner may reduce the number o f employees andwill provide the legal compensation ifit does so. 63. In past years, extensive supply disruptions affected rural and poor areas of Albania disproportionately, but as OSSH's performance improves the overall supply situation should improve. The country's social assistance program (Ndihma Ekonomike) i s well targeted but reaches only one third o f the poor. In this context, the Government has resorted to pricing electricity inconsumption blocks. Currently, low-income consumers benefit from two protection mechanisms: (i)a social subsidy scheme for electricity and (ii) a tariff block system. The electricity social subsidy scheme was established in 2006 to compensate targeted socially vulnerable groups for the increase inthe price o f electricity for monthly consumption below 210 kWh". But, the system is not functioning well since the procedures are burdensome and the payments are small. The block-tariff system provides a subsidized price for consumption below 300 k w m o n t h . This level is considerably larger than the estimated minimum required consumption for an acceptable standard o f living o f about 200 kWh per month. It could, therefore, be reduced over time to improve targeting so that vulnerable consumers with low consumption would remain protected, while other consumers would receive slightly larger bills (see also Annex 8). 64. In accordance with ERE requirements, the DSO will be obliged to connect new customers and furnish all customers with meters. This would lead to faster regularization o f connections than has occurred in the past, resulting inmuch improved quality o f supply to those consumers. This regularization would be accompanied by reductions in distribution losses and improvement in collections from formalized customers, but would o f course impose additional lo uniformtariffforallconsumerscameinforcein2007until2008,whichincreasedthefirstblockoftariffsfromLek A 4.5ikWh to Lek 7kWh. The first block of consumption was set at 210k W m o n t h in2006. 16 expenses on users that have intentionally avoided regularization and hence payments up to now. With respect to consumer protection, the DSO will handle consumer complaints in accordance with satisfactory proceduresenforcedby ERE. S. Environment 65. The potential environmental impacts concerning electricity distribution systems activities are relatively low, rather reversible, and of low significance. A general environmental concern in distribution systems are PCBs". The Bank financed a study to investigate PCBs were present in power sector in the 1990s under the Power Transmission and Distribution Project. The consultants that reviewed it didnot find any indicationthat PCBs were present. 66. IFC's consultants have reviewed OSSH's standards and found satisfactory health and safety standardsperformed inmost OSSH substations. 67. OSSH is requiredto comply with the environmental laws andregulations o fAlbania. 68. No physical works would be supported by the PRG. The Environmental Assessment category i s C. T. Safeguardpolicies Safeguard Policies Triggered by the Project Yes No Environmental Assessment (OP/BP 4.01) [ I [XI Natural Habitats (OP/BP 4.04) [ I [XI PestManagement COP 4.09) [ I [XI Physical Cultural Resources(OP/BP 4.1 1) [ I [XI Involuntary Resettlement (OP/BP 4.12) [ I [XI Indigenous Peoples [OP/BP 4.10) [ I [XI Forests (OP/BP 4.36) [I [XI Safety o f Dams (OP/BP 4.37) [ I [XI Projects inDisputedAreas (OPBP 7.60) [ I [XI Projects on International Waterways (OP/BP 7.50) 11 [XI G. Policy Exceptions and Readiness 69. No exceptions to Bank policies are sought. 70. The project i s expected to be ready for Board presentation on May 5, 2009. It should be noted however, that, while the structure o f the guarantee i s well-defined, the Guarantee Agreement, the IndemnityAgreement and the Project Agreement betweenthe Bank and OSSH are beingnegotiated. These agreements are expectedto be substantially negotiated by the date of Board presentation. If they are not, and should the negotiated agreements result in any substantial changes in the terms o f the guarantee form those approved by the Board, the guarantee would be resubmitted to the Board for approval. Such approach is consistent with the procedure set forth inBP 14.25 on Guarantees. Polychlorinatedbiphenyls (PCBs) andpolychlorinatedterphenyls (PCTs) are halogenatedaromatic hydrocarbons,which belong to the group ofpersistentorganic pollutants (POPS),which are virtually not soluble inwater. Becauseof their physical properties andhigh ignitiontemperatures, PCBs are usedinelectrical transformers, capacitorsand condensers. They were manufactureduntilthe mid-l980s, after which they were banneddue to their toxicity andpersistence. 17 ALBANIA Privatization of the Power Distribution System Operator Annex 1: Country and Sector Background Country Background 1. Albania has successfully maintained macroeconomic stability over the last 10 years with steady growth and low inflation. Growth has been above five percent annually in all but one o f the last ten years, and inflation below five percent in all years. Despite the global financial challenges, 2008 growth remained strong at around 6 percent. Such sustained growth resulted in an estimated GNI per capita o f US$3,290 in 2007, upgrading Albania to the group o f middle income countries. However, sustaining high growth rates and maintaining macroeconomic stability will prove more challenging in the future amid the global economic crisis and deterioration in the productive capacity and financial position o f the electricity sector. The first signs o f adverse trends come from declining remittances (16 percent estimated reduction in 2008) and a 9 percent decrease inbank deposits between September and January 2008. Given the strong links between remittances, consumption and imports, the latter are also showing signs o f slowing down. This slowdown will almost inevitably be accompanied by a reduction in growth which i s likely to fall below 2 percent in2009. 2. Inrecent years there hasbeena gradual improvementinthe fiscal deficit from.6.6 percent o f GDP in 2002 to 3.2 percent in2006, although itjumped to 5.6 percent in 2008. The gradual fiscal consolidation has resulted from a combination o f improving revenue administration and reduced interest payments and has contributed to a sustained decline in public debt from 62 percent at end 2003 to 55 percent in 2007. The increases in the deficit in 2007 (to 3.8 percent, from 3.2 percent in 2006) and 2008 are largely due to increased public investment, and can therefore potentially be reduced in later years. Given adverse international developments, the availability o f financing could become a constraint, at least during 2009. The government has proposed a 2009 budget deficit o f 4.2 percent o f GDP, based on an optimistic GDP growth . scenario o f 6 percent, and aiming to complete most o f the Durres-Kukes-Morine road works while pursuing another round o f wage and pension increases. However, more conservative calculations and factoring in likely slower growth, show that the spending commitments in the draft budget are likely to imply a deficit o f closer to 5 percent o f GDP.' Potential difficulties in financing such a deficit, and given the government's stated commitment to contain the deficit at around 4 percent o f GDP, might imply the need for significant budget adjustments during the year. 3. High and rising current account deficits in 2007 and 2008 arose mainly from the acceleration o f public investment as well as higher electricity imports, and food and commodity prices. These trends, combined with a slowdown in remittances, lead to an estimated 2008 current account deficit o f 13 percent o f GDP. In2009, this trend is expected to reverse, following the drop o f food and oil prices, and the decline in imports as aggregate demand (particularly consumption and public investment) falls, which should more than offset the impact on exports o f a less favorable external environment. Part o f the increase in the current account deficit in 'TheIMFforecast for the 2009 deficit is 3.8 percent, slightly lower than the government budget, and assumesthat as inpast years actual spending will be lower than budgeted due to limits inprocurement capacity. 18 2008 has been financed by a rise inForeign Direct Investment (FDI), and ongoing privatizations may help to maintain a reasonable flow o f FDIeven in2009. However, medium-term FDIflows will depend on a strong reform agenda. Inthis respect, the privatization o f Albania's electricity Distribution System Operator (OSSH) is a key development for the country. 4. The most significant risks to growth andmacroeconomic stability arise from the ongoing recession in large parts o f the world economy and the financial position and electricity supply capacity o f the state owned electricity producer (KESH). Albania's internal electricity generation capacity is today about 95 percent dependent on hydropower. During years with low rainfalls, the combination o f dry weather; below-cost retail tariffs; high network losses (technical and commercial); poor collection rates; and increasing demand for electricity, means that KESH can accumulate debt and maintain electricity supply2, or practice extensive load-shedding. An extraordinary dry period in2007 resulted inboth supply shortages and financial losses. In2008, when relatively dry weather continueduntilDecember, KESH improved the supply situation, but continued to accumulate losses and debt. At the same time, in preparation for privatization reform, KESH was unbundled and a new distribution company (OSSH) was established to handle the network operations o f electricity distribution andthe retail public supply service. 5. Albania still faces key challenges to sustain the positive developments seen in the past. Weak public institutions, corruption, inadequacies in contract enforcement and property rights, infrastructure and electricity deficiencies remain critical constraints for business environment and investment in Albania. Complementing the IMF dialogue on macro-economic stability and its technical and advisory assistance to strengthening tax administration, the Bank is using a combination o f instruments, namely the Business Environment Reform and Institutional Strengthening Project and the Land Management and UrbanDevelopment project inconjunction with the DPO to support improvements in the business climate, through (i) adoption and the implementationo f regulatory governance tools aimed at improving the quality o f business-sector related regulations, (ii)establishment and operations o f a Secretariat for Regulatory Reforms for the removal o f administrative barriers to investment; and, (iii) adoption and implementation o f a transparent landregistration system. 6. After concluding the privatization or liquidation o f most state-owned small and medium enterprises in 1999, the Government concentrated on larger enterprises and utilities. The privatization o f five non-strategic state owned companies (a brewery, winery, dairy factory, pharmaceutical factory and cement factory) was successfully concluded in the first half o f 2001 through tender sales, mostly to foreign investors. The privatization o f strategic sectors however . proved more challenging for Albania. In 2001, the government granted two 30-year concessions for chromium mining to the . Italian company DARFO, as well as providing concessions to the Turkish copper mining company Ber Oner. Following the sale o f the Savings Bank - the country's largest bank - to the Raiffeisen Group inthe first half o f 2003, the entire banking sector came under private management. The privatization could have taken place much earlier, had the pyramidscheme events not complicated the overall financial sector situation inthe mid 1990s. 9 As part o f the privatization process, the state oil company Albpetrol was split into three companies in 2003: Albanian Petroleum Company (oil and natural gas extraction), Albanian Refining and Marketing Oil (ARMO, refining) and Servcom (petroleum Because ofthe hydro dependence, shortfalls insupply can only be covered with imports of expensive electricity. 19 distribution). Since the privatization has been rescheduled several times due to lack o f interest by investors. Only this year the government succeededin selling 85 percent of its stake in the oil refining and marketing company ARMO to a strategic foreign investor (Refinery Associates o f Texas, Anica Enterprises & Mercuria Energy Group) for 128.75 million. ARMO is the country's only refinery and holds a 20 per cent share in the retail market. In June 2005 the government approved the sale of the state-owned fixed-line telecommunications operator Albtelecom. However, by September 2005 the privatization had yet to be approved by the new parliament. Calik EnergyTelecommunication won the right to acquire a 76 per cent stake in the company for 120 million, with the state retaining 24 per cent. In August 2006 a review instigated by the Government ruled that the sale had a number of important shortcomings. Although the privatizationcontract had been signed inJune 2005, the new parliament elected inJuly that year did not immediately ratify it. The contract was ratified a year later with few amendments. Power Sector Background 7. Power Sector Infrastructure. The three hydropower plants on the Drin River Cascade (Fierza, Koman and Vau iDejes) and the two hydropower plants on the Mat River Cascade (Ulza, Shkopeti) account for over 90 percent o f electricity production in Albania. Fierza, constructed from 1971to 1978 at the top of the DrinCascade, has active storageof 2,300 million m3, four units with total plant power of 500 MW and annual productionof about 1,800 GWh. Koman, constructed from 1980 to 1985 inthe middle o f the Drin Cascade, has active storage o f 200 million m3,four units with total plant power o f 600 MW and annual production of about 2,000 GWh. Vau iDejes, constructed from 1967 to 1971 at the lower end o f the Drin Cascade, has active storage of about 250 million m3, five units with total plant power of 250 MW and annual productionof about 1,000 GWh. Ulza, constructed from 1952 to 1958 at the highend of the Mat Cascade, has active storage of about 240 million m3,four units with total plant power o f 25 MW and annual production of about 120 GWh. Shkopeti, constructed at the lower end o f the Mat Cascade from 1958 to 1963, has active storage o f 40 million m3,two units with total plant power of25 MW and annual production o f about 94 GWh. 8. The only thermal power plant still operating occasionally inAlbania is at Fier. The plant operates on heavy fuel oil produced by the Ballsh oil refinery and available capacity i s only about 20 MW. The plant was not used in 2008. The GOAadvanced a concession for its rehabilitation and selected a preferred bidder in February 2008, but no agreement has been concluded to date. 9. The transmission system consists o f 120 km o f 400 kV, 1,100 kmo f 220 kV, and 50 km o f 150 kV. There i s a 400 kV interconnection to Greece (Elbasan - Kardia), a 220 kV interconnection to Montenegro (Vau iDejes - Podgorica) and a 220 kV interconnection to Kosovo (Fierze - Prizren). There i s also a 150 kV interconnection with Greece (Bistrice 1 - Igumenice). The 220 kV transmission network serves to interconnect the three large hydropower plants on the Drin River Cascade that normally account for over 90 percent of total electricity generation inAlbania (Vau IDejes - 5x50 MW, Koman - 4x150 MW,andFierza-4x125 MW) and the thermal power plant o f Fier with the major load centers of Tirana-Durres, Elbasan, Burreliand Fier. There are 11existing transmission substationswith atotal installed capacity of 2,400 MVA. Two new substations (Durres Rrashbull and Zemblak) have been financed with loans from co-financiers o f IDA under the Power Transmission and Distribution Project. 20 10. The distribution systemconsistsof 325 110/35 and 50 110/20kV substations, ofwhich 40 have been recently rehabilitated with donor assistance, including by the Bank, 1,200 km of 110 kV lines, about 25,OOOkm of 35 kV distribution network, 5,000 km of 20 kV distribution network, which is being introduced in large cities to replace the 35 kV, 10 kV and 6 kV networks, 20,000 km o f 10 kV network, 10,000 km of 6 kV network and 9,000 kV of 0.4 network. The 35 kV, 10kV, 6 kV and 0.4 kV network i s mostly old and inneed of replacement. KESH has had difficulty in providing meters to cover the needs o f all consumers, and, in mid- 2007, about 70,000 consumers were without meters. The number o f consumers increased by about 200,000 from 2003 to 2006 to a total of more than 900,000, largely as a result of large migration to Tirana and other cities and the desire of subunits of extended families living in the same dwellings to have their own meters. Since the mid-l990s, KESH, in an attempt to reduce meter tamperingand illegal use of electricity, has been purchasing mechanical meters to be kept together in groups of about 16 in locked heavy metal cabinets and installed at the entrance of apartment buildings, and sealed meters with connections to the grid using tamper resistant co- axial cable for detacheddwellingunits. 11. Power Sector History At the beginning of Albania's economic transition in the early 1990s, the country was virtually 100 percent electrified and was a net electricity exporter. However, while the three hydropower plants on the Drin River Cascade, and smaller plants on other rivers, which produced over 90 percent of total electricity supply, were inreasonably good condition, the Fier thermal power plant and the transmission and distributionsystems were badly run down because of previous neglect of maintenance, and there were frequent power outages due to overloading of facilities. Electricity demand within Albania fell initially to 79 percent of the 1989 level by 1992 because of declines in industrial production. Thereafter it rose by 10.4 percent per year to 6,160 GWh in 2000. This increase was due mainly to a sustained surge in consumption, much of which was not paid for, by households and small commercial establishments. The quality of electricity supply was improved temporarily by 'emergency repairs financed by donors, includingthe International Development Association (IDA). In 1995 KESHwas incorporatedas a separatecompany. 12. By 1998, Albania had become a net electricity importer. From the second half of 2000, the need for imports increased greatly as a result of a fall in hydropower production caused by reduced rainfall. The country was unable to get all the imported electricity it neededbecause of transmission and financial constraints. The result was large load shedding, which had serious adversemacroeconomic effects. The fall inhydropower production between 2000 and 2002 had an unavoidable direct and significant adverse impact on national economic output, and the load shedding (which could have been avoided in the absence of financial and transmission constraints) caused cuts in production by industry and obliged other businessesto purchase and use costly back-up diesel generators. Households unable to afford back-up generators had to suffer without electricity for manyhours o f each day. 13. The Albanian Power Corporation (KESH) was unable to pay for more than a small proportiono f the imports neededout o f its own resources becauseo f financial difficulties caused bywidespread illegaluseof electricity, poor payment ofbills and retailprices which were below the cost of imported electricity. Faced with these difficulties, the Government started providing a subsidy, but its large level (US$3 1.5 million) in 2001 diverted funds from other critical needs includingpoverty reductionmeasures. KESHalso beganimplementation at the start of 2001of a rolling multi-year Power Sector Action Plan to tackle the critical issues o f the sector, with detailed quarterly and annual targets for key variables such as network losses and bill collection. It managed to reduce total transmission and distribution losses from 44.8 percent of net 21 transmitted energy (equal to net generation, except from distribution hydropower plants, plus net imports and exchanges) in 2001 to 39.7 percent in 2004, and improved collections from 76.3 percent in 2001 to 83.8 percent in 2004, largely through reductions in receivables from Government budgetary and non-budgetary entities (See the table below). Non-collection from other consumers (about 90 percent due to households) remained almost constant over this period at just under 20 percent o f the total amount billed. Inaddition, the Electricity Regulatory Entity (ERE) raised the average tariff from Lek 4.41kWh (excluding VAT) in 2001 to Lek 6.7OkWh in2004. As a result of these measures, collected revenue increased from Lek 12.50 billion in 2001 to Lek 23.84 billion in 2004. These improvements and greatly improved hydrology after 2002 enabled KESH to achieve satisfactory financial performance and allowed the import subsidy to be phased out by the end o f 2004. However, load shedding continued throughout this period. 14. Power sector improvements were partly reversed in2005 and 2006 because o f disruption caused by Parliamentary elections, the coming into power o f a new Government and the replacement o f KESH's management and manydistribution employees. Total losses rose to 41.9 percent in 2006, and the collection rate fell to 81.9 percent, but the tariff was raised to Lek 7.26kWh. Collected revenue reached only Lek 24.86 billion in 2006. A turnaround began in March 2007 with the appointment o f a new manager in KESH. The new management has been giving high and widely publicized priority to reducing non-technical losses and improving collections. As a result, total losses fell to 37.1 percent in2007, the collection rate increased to 89.5 percent, and KESH's collected revenue for 2007 reached Lek 27.25 billion. Nevertheless, the return o f below average hydrology in late 2006 and a simultaneous large increase in electricity import prices created severe cash-flow difficulties for KESH in 2007. The Government provided some relief by paying o f f outstanding arrears on bills to government budgetary and non-budgetary entities and. by providing loans. .KESH also obtained large overdraft facilities from Albanian commercial banks to help pay for imported electricity. Despite these contributions from the Government and banks, KESH was obliged to increase load shedding to a record-high 927 GWh. ERE approved a tariff increase to a level o f Lek 8.15ikWh (US$O.OSkWh)in February 2008 (Lek 7.92kWh average for 2008), but KESH continued to have cash-flow difficulties in2008 despite a reduction indistribution losses to 32.7 percent and a collection level o f 83.3 percent. Load shedding was 561 GWhin2008. 15. As o f September 2008, KESH had a total short-term debt o f Lek 22 billion (180 million). In addition, after OSSH was fully separated from KESH and took over the function o f importing power inJuly 2008 it incurred a short-term debt o f 10 million. This debt is expected to be transferred to KESH after OSSH is privatized. Inorder to help alleviate KESH's financial difficulties, the Government provided in 2008 a guarantee o f 50 million for loans made by Albanian banks to KESH. The Government also provided a soft loan o f 25 million to KESH, with a provision for it to be renewed in2009. Inaddition it provided a subsidy o f 6 million to the water companies to be used to pay their unpaid bills to KESH. The Government has agreed with IMFon further measures to help KESH. These include: (i) extending the validity period o f the 50 million guarantee to five years; (ii)providing direct loans or other measures to restructure KESH's existing short-term debt; and (iii) increasing the contingencies in the 2009 budget to 2 percent o f GDP, out o f which 0.03 percent (about Lek 3 billion, equivalent to 30 million) are reserved for providing a direct subsidy to KESH. In addition, the Government is planningto use part o f the proceeds from the sale o f OSSH shares to CEZ to pay off part o f KESH's outstanding short-term debt. 22 16. The table below shows that demand rose by about 1.3 percent per year from 2001 to 2008 compared to 10.4 percent per year from 1992 to 2000. The reduction in rate o f growth is probably partly due to the increase in electricity prices, reductions in network losses and improvements in collections. Poor quality supply (voltage variations large enough to damage appliances as well as load shedding) may also have led some consumers to switch permanently to alternative sources o f energy. However, total current demand, which includes estimated load shedding, may have been underestimated because o f the difficulty o f measuring the load shedding. If so, the load shedding may be even larger than the amounts shown for the years 2000 to 2008. 17. The expected commissioning o f the Vlore Thermal Power Plant, financed by EBRD, EIB and the Bank, in2009 will add about 760 GWyear o f domestic production. The completion at about the same time o f a 400 kV transmissioninterconnectionto Podgorica (financed by KfW, to be connected with a new Tirana-Elbasan section financed by COOPI) and a subsequent 400 kV transmission interconnection to Kosovo will relieve the transmission constraint on importing electricity. In 2008, the Government entered into a public-private partnership with EVN (Austria) for development o f the Ashta Hydropower Plant below Vau iDejes on the DrinRiver. This plant will produce about 260 GWh o f electricity on average per year after it comes into operation in2012. A concession was granted in 1997 for a hydropower plant on the Vjosa River, but up to now no significant constructionhad taken place. A concession is being plannedfor the Fier Thermal Power Station. However, it will be several`years before these last two options will start producing power. As a result, Albania will remain a large net electricity importer for some years. Since hydropower production ranges from below 2,900 GWhinvery dry years to as much as 5,800 GWh in abnormally wet years import requirements will continue to be subject to large variations. Because o f a worsening electricity shortage in South East Europe import prices rose unusually high levels in 2007 and 2008, and KESH has occasionally been unable to contract imports even when it has secured the h d s to pay for them. The main actions that KESHshould implement until new power stations are built are to strengthen its financial performance so as to improve its ability to pay for enough imported electricity to cover the supply deficit and to finance needed reinforcement and expansion o f the transmission system to improve quality o f electricity supply (see table). 18. Power Sector Reform. The power sector i s undergoing reform. The Law on Regulation o f the Electricity Sector, enacted in August 2003, provided for strengthening o f ERE, and removed the authority o f the Government to fix a price cap. The Transmission System Operator (OST), created from the separation o f transmission from KESH, was registered as a joint-stock company on July 14,2004 with KESH as the holding company. The Transitional Market Model was approved in August 2004. All non-household customers have been granted the right to become eligible consumers and choose their own suppliers inconformity with the Energy Treaty 2008 deadline. However, all but one customer had chosen to remain as tariff customers as o f 2008. The strengthening o f ERE'Sindependence and the creation o f OST enabled Albania to meet the initial conditions o f membership in the Energy Community. A second phase o f the reform process leading to privatization and further implementation o f the market model commenced with the Government's decision in 2006 to privatize power distribution. IFC has been providing assistance to the Government for this purpose. A revised market model, the Albanian Market Model (AMM) was approved by the Government in 2008. The AMM distinguishes between a Wholesale Public Supplier (WPS), which is for now a part o f KESH, and a Retail Public Supplier (RPS), which is being privatized with the Distribution System Operator (DSO). The WPS is responsible for security o f supply to all tariff customers. It sells 23 its electricity to the Retail Public Supplier at a price regulated by ERE. The DSO is responsible for owning and operating the distribution system, and buys electricity to cover its technical and non-technical distribution losses from the market. Since distribution losses were 1,927 GWh in 2008 the DSO i s currently the main buyer in the unregulated market, The distribution margin o f the DSO and the allowed supply fee o f the RPS as well as the retail prices for tariff customers are fixed by regulationby ERE. 19. The AMM also stipulates that a power generation company, KESH Gen, i s to be separated from KESH and incorporated. Its shares will be held initially by KESH, but the company may be privatized subsequently. KESH Gen will be responsible for the three hydropower plants on the Drin River and the two hydropower plants on the Mat River. The AMM stipulates that KESH Gen will provide ancillary services to the TSO and offer its remaining electricity to the WPS at a regulated tariff. Any electricity not taken by the WPS may be sold on the market. Any profits are to be provided to tariff consumers through later adjustments inKESHGen's regulatedtariff. 20. OSSH owns 69,000 km o f network and serves over 900,000 customers. The relationships among the various market participants may be clarified by making use o f KESH's electricity production and consumption figures for 2008.. KESHreported net domestic power generation o f 3,833 GWh, all hydroelectric and all o f which was produced by KESH except for 62 GWh supplied by small and medium privately operated hydropower plants. Net imports and exchanges were 2,465 GWh, o f which 49 GWh were for an "eligible" customer served o f f the distribution network3. Total available electricity was 6,298 GWh, which was less thantotal demand o f 6,859 GWh by an amount equal to load shedding o f 561 GWh. Electricity entering the distribution network was 5,886 GWh, o f which 5,817 came through the transmission system and 69 GWh were injected directly into distribution by small hydropower plants owned by KESH. The difference between the estimate o f electricity entering the distribution network and the figure for total available electricity is equal to transmission own consumption and losses o f 214 GWhplus sales by OSSH to a high-voltage consumer o f 197 GWh. Sales to tariff customers served by the distribution network were 3,912 GWh. Under the current market model, the Wholesale Public Supplier (WPS) i s responsible for purchasing this amount o f power plus the electricity to be sold at high-voltage level and selling it to the Retail Public Supplier (RPS). WPS bought all the domestic hydroelectric power production o f 3,833 GWh less 214 GWh needed by the TSO to cover transmission losses. It would have had to purchase 489 GWh o f imported electricity to cover the gap betweenits sales to the RPS and its purchases o f hydroelectric power. The eligible consumer imported 49 GWh and received 47 GWh from the distribution network. Distribution losses were 1,927 GWh (32.7 percent o f electricity entering distribution). OSSH was responsible from June 2008 for purchasing electricity to cover such losses in the market (mainly through imports). Thus, until distribution losses are significantly reduced, the OSSH will be purchasing much more electricity on the market than the WPS. The RPS would have billed final consumers for sales o f 4,109 GWh. The DSO was entitled to charge a distribution fee for 3,959 GWh o f electricity exiting the distribution system, which included 47 GWh for the eligible customer, but excluded the 197 GWhsold by the RPS at the high-voltage level. 21. Electricity Tariff. The tariff structure in 2008 for final consumers is shown in the following table. This structure is expected to remain inplace until January 1, 2010, when ERE ~ ~ ~~ Eligible customers, according to the AlbanianMarket Model, are electricity consumers that canpurchase their electricity freely inthe market. Such purchases are not subject to regulatedtariffs for electricity supply. 24 plans to introduce the first regulatory period with the privatized OSSH. A new tariff structure and level are expectedto beintroduced at the same time. 22. Hydropower Issues. The Albanian power sector faces a key issue: (i) because of a large variability in annual hydropower production from below 3,000 GWh to nearly 6,000 GWh as a result of hydrological variations; and (ii)because the electricity tariffs have been based on the weighted average cost of domestic hydropower production(less than Lek l/kWh) andthe import price (more than Lek lO/kWh in2008). The most damaging consequenceo f these two factors i s an enormous variation from year to year in the costs of meeting electricity demand, with the costs being particularly high in poor hydrological years when additional imports need to be purchased to offset reductions in domestic hydropower production. As mentioned above, KESH's inability to pay the increased costs during the two dry periods that the power sector has experienced since Albania became a net electricity importer, 2000-2002 and late 2006-2007 resulted in massive load shedding with major adverse consequences on the economy and consumerwell-being. 23. The new regulatory system contains the following features for addressing this issue. (i) EREhas agreed inthe Regulatory Statement to set the notional level of hydropower production for sale to the TSO and the WPS at the regulated hydropower price at 4,200 GWh per year, which is below the average level o f 4,400 GWh over the ten years 1999 -2008. KESH Gen. is expected to sell any surplus production at the international price. Since the probability o f producing 4,200 GWh or more per year exceeds 50 percent this provision reduces the amount o f variation in costs o f supply to the WPS compared to the case in which the notional level o f production i s set at 4,400 GWh. (ii) ERE is to adjust the WPS tariff to cover interest costs for maintaining a line o f credit to pay for the additional imports needed in poor hydro years. (iii) EREcandecideto adjust the WPS tariffannually for differences inexpensesdue to any previous year over or under productiono f hydropower. (iv) The Council o f Ministers decided on October 3, 2007 to assume responsibility for hydrological risk mitigation inorder to provide electricity to all consumers at unchangedprices. Ifthis decision i s filly implemented the aboveprovisions (ii) and(iii) not needto beputinto effect. would 24. The AMM's stipulation that the "hydro benefit" will all be reserved for the tariff customers creates a krther set of problems that will impede the operation o f the competitive power market unless offsetting remedies are found. First, it implies that any profits KESH Gen 25 will make from selling surplus power above 4,200 GWh will have to be returned to tariff customers. This is expected to occur through lower approved tariffs for KESHGen sales to the WPS and for the WPS's sales to the RPS. Second, it prevents KESH Gen from acting as a competitor inthe Albanian or regional market except when it has surplus power. It also removes the possibility o f introducing competition between individual power plants. It even removes KESH Gen's incentive to profit from the opportunity o f making power exchanges with neighboring countries by sending out power during peak periods in return for receiving larger quantities in off-peak periods. As a publicly owned company KESH Gen could try to optimize exchanges anyway, realizing that the benefits would go to Albanian tariff customers through a lower KESH Gen tariff. However, these considerations would reduce the attractiveness o f KESHGento apossible futureprivatebuyer. 25. A second adverse result is to increase the likelihood o f load shedding by the WPS, which i s responsible for security o f power supply to tariff customers. This i s due to the per unit cost o f electricity imported by the WPS being greater than the sales price, which i s based on the weighted average o f low-cost domestic hydropower and high cost imports. As a publicly owned entity, the WPS may try to meet total demand, but ifit runs into financial difficulties (because its tariff is too low or for any other reason) it may be unable to buy all the imports it needs not just because it would have to wait to receive payment from the RPS, but mainly because that payment would cover only a portion o f the import cost. However, if the above-mentioned provisions for dealing with hydrological variations are fully implemented, this load shedding i s less likely to occur. 26. A third result o f giving the hydro benefit to tariff customers is to reduce the likelihood that more than a few eligible consumers will opt out of being tariff customers, since they would lose their share o f the hydro benefit. The DSO would not be affected by whether eligible customers cease being tariff customers or not since it will continue to receive distribution fees from these consumers whether or not they cease being tariff customers, as long as they are served off the distribution network. The RPS would only be affected to the extent that the revenue base against which its 2.2 percent profit margin i s calculated would be reduced if some eligible customers cease being tariff customers. 27. The design o f the DSO tariff avoids another possible adverse result by providing for the DSO to buy the electricity needed to cover distribution losses on the market (i.e,, through imports) rather than from the WPS at the WPS regulatedtariff. This provision gives the DSOthe incentive to reduce distribution losses as long as the cost o f doing so i s less than the marginal cost o f electricity supply. Moreover, this provision means that the DSO will buy most o f the imported electricity needed by Albania for as long as distribution losses remain high, thereby reducing both the risk and the magnitude o f load shedding by the WPS. The risk o f the private DSO not buying enough electricity to cover its losses is considered low since this would mean defaulting on its responsibilities under its license, which could lead to the license being cancelled. 26 Awrage Tariffs(Realw. NominalLeWkWh) TransnissionandDistributionLosses (in% of .+. 10 electricityenteringtransmission) NominalAv. Ez$zNon-technicaldistributionlosses Tariff p 6o1 =Technical distributionlosses fl Transmissionlosses R dAv. tariff 4 2 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009~ 2000 2001 2002 2003 2004 2005 2006 2007 2008 CollectionRatioandCollectedRewnues CollectionbyTypeofConsumers (YOofbilled) CollectedRevenue(BillionLek) JncludngArrears 200 100.0 -Collections (incl. for arrears)(%) 35.0 - 30.0 80.0 150 25.0 60.0 20.0 100 40.0 15.0 50 10.0 20.0 5.0 0 2ooo 2001 2002 2003 2004 2005 2006 2007 2008 0.0 0.0 !OOO2001 2002 2003 2004 2005 2006 2007 2008 households Otherprivate Budgetary BNon-Budgetary &man@ Praction, NetImports andbadSheddng ElectricitySubsidy 6 0.8% a =Net Generation Net unports 0Loadshedding -DRnand 5 0.7% 7 0.6% 4 0.5% 3 0.4% U v) $ 4 2 0.3% 11111111 E03 0.2% 1 2 0.1% 1 0 0.0% 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2ooo 2001 2002 2003 2004 2005 2006 2007 2008 rzzmSubsidy(bln ofleks)e% of GDP Summaryof figures of the Albanian Power Sector Sources: KEsH, Bank staff estimates 27 Albania Power Sector Energy Balance and Selected FinancialData Selected Data on the Power Sector 2001 2002 2003 2004 2005 2006 2007 2008 Energy (GWh) Demand 6,258 6,200 6,200 6,429 6,640 6,465 6,656 6,859 Hydro Generation 4,737 5,325 5,274 5,331 2,875 3,788 Fier Thermal PowerStation 81 76 77 93 72 0 Vlore Thermal Power Plant 0 0 0 0 0 0 Plant Consumption and Losses 91 97 95 99 46 17 Net Generation 3,690 3,123 4,811 5,395 5,256 5,325 2,901 3,703 KESHlOSSH Net Importsand Exchanges 1,750 2,269 916 478 504 545 2,828 2,418 Importsof Eligible Suppliers 0 -43 0 0 20 60 0 49 Transmltted Energy 5,440 5,349 5,727 5,873 5,780 5,930 5,729 6,170 Load Sheddlng 818 851 473 556 760 409 927 558 Net Generation in Distribution 85 90 101 126 0 131 Sales to HV Customers 14 14 68 146 90 219 200 Distrlbutlon to Dlstributlon Zone Customers 4,839 4,751 5,195 5,557 5,471 5,743 5,297 5,886 Losses (GWh) Transmission 601 584 603 338 264 223 213 214 Technical Distribution 849 816 792 1,067 1,147 1,277 1,062 1,167 Non-Technical Distribution 985 830 974 925 994 983 812 760 Total Distribution 1,834 1,646 1,766 1,992 2,141 2,260 1,874 1,927 Percent Losses Transmission(% of Transmitted Energy) 11.0 10.9 10.5 5.8 4.6 3.8 3.7 3.5 Technical Distribution(% of Distribution) 17.5 17.2 15.2 19.2 21.o 22.2 20.0 19.6 Non-Technical Distribution(% of Distribution) 20.4 17.5 18.7 16.6 18.2 17.1 15.3 12.9 Total Distribution(% of Distribution) 37.9 34.6 34.0 35.8 39.1 39.4 35.4 32.7 Total Losses (% of Transmitted Energy) 44.8 41.7 41.4 39.7 41.6 41.9 36.4 34.7 Sales (GWh) EligibleCustomers 0 0 0 0 18 58 1 47 HV 14 14 68 146 90 219 197 MV and Non-DomesticLV 1,111 1,066 892 1,188 1,243 1,242 1,343 1,619 Domestic 1,894 2,039 2,451 2,286 2,067 2,132 2,076 2,293 Total 3,005 3,119 3,357 3,542 3,474 3,522 3,641 4,156 Bllled (lncl. VAT) (Lek Million) 15,910 19,817 23,974 28,456 29,919 30,127 30,464 39,032 Collection 12,496 17,496 21,318 23,843 24,060 24,600 27,253 32,500 Percent Collection 76.3 88.3 88.9 83.8 80.4 81.7 89.5 83.3 Billed (excl. VAT) 13,258 16,389 19,978 23,713 24,933 25.106 25.387 32,527 Average Tariff (excl. VAT)(LeWkWh) 4.41 5.25 5.95 6.69 7.21 7.25 6.97 7.92 Source: KESH 28 ALBANIA Privatization of the Power Distribution SystemOperator Annex 2: Major RelatedProjects Financed by the Bank and/or other Agencies 1. Support for the Albania Electricity Sector. Donor assistance to the power sector began with IDA and Swiss financing o f emergency repairs to the power system under the Critical Imports Project in 1992. At that time the power system was badly rundown as a result o f lack o f maintenance and was partly damaged by vandalism. Although the country had a surplus o f hydroelectricity there were frequent power cuts due to unscheduled outages in the transmission and distribution systems. Shortly thereafter, non-technical power losses began increasing rapidly. Since then, donor assistance has focused mainly on four areas: supply o f meters and technical assistance aimed at reducing non-technical power losses and improving bill collection; rehabilitation o f the hydropower stations on the Drin River; rehabilitation and strengthening o f the power transmission and distribution systems; and the beginning o f sector reforms aimed at improving efficiency, establishing competition and creating conditions conducive to eventual private sector participation inthe power sector. 2. With respect to the IDA-financed projects, the Critical Imports Project was rated satisfactory by OED. The Power Loss Reduction Project was rated satisfactory with respect to implementation, but unsatisfactory with respect to achievement o f the Development Objective since the numerical power loss reduction targets were not achieved. The same ratings were given for the Power Transmission and Distribution Project. While the original development objectives in terms o f loss reduction, bill collection and sector reform were not achieved, the revised targets fixed as a condition for lifting the project's suspension were achieved (see Annex 1). The Implementation Completion Report for the Power Sector Rehabilitation and Restructuring Project (for sector reform and rehabilitation o f transmission and distribution) rated the outcome as Moderately Satisfactory. The Power Sector Generation and Restructuring Project (for sector reform and the construction o f a new combined-cycle power station at Vlore) is under implementation. The ECSEE APL2-Albania Project for transmission system strengthening is also under implementation and rated Moderately Satisfactory. The ECSEE APL5 Project for Albania Dam Safety was approved by the Bank's Executive Directors inJune 2008, and became effective inDecember 2008. 3. EIB, Italy, Norway and Switzerland have supported efforts to reduce non-technicalpower losses and improve revenue collection through the financing o f meters and technical assistance. EBRD and later Italy have provided management support to KESHthat has focused largely on the same goals. EBRD, Austria, Italy, Japan and Switzerland financed rehabilitation o f the hydropower stations on the Drin River through the Drin River Cascade Rehabilitation Project. EBRD, EIB, Italy, Japan and Switzerland co-financed (with IDA) power transmission and distribution system rehabilitation through the Power Transmission and Distribution Project. EBRD and EIB are co-financing the PSGRP with IDA. Germany, Italy and Norway have been providing separate assistance for power sector rehabilitation. South Korea i s providing financing for the Babica 220/110 kV substation and the 220 kV Fier-Babica transmission line. Spain has been providing finance for power distribution. Italy has provided financing for imports o f electricity. The United States (USAID and USTDA) and Canada (CIDA) have been providing technical assistance for power sector reforms and investment evaluation. A transmission line 29 from Elbasan through Tirana to Podgorica i s being implemented with financing by Italy and KfW.The ECSEE APLS Project for Albania Dam Safety was approvedbythe Bank's Executive Directors inJune 2008, and became effective inDecember 2008. 30 ALBANIA Privatizationof the Power DistributionSystemOperator Annex 3: ResultsFramework and Monitoring 5 PDO OutcomeIndicators Use of Outcome Information Facilitatethe privatizationof OSSH (i) transactionisclosed The (i) experiencefromthis The inthe context ofanewregulatory byMay2009. privatization will provide guidance framework. for possible future privatizationof power generation. (ii) adjustmentsare Tariff (ii) particulartariffsapproved The made inconformity with the will provideanindicationof likely regulatory framework future performance of EREunder the new regulatory framework Higher Level Objective: A (i) DistributionLosses See also (i) above. Losses, financially viable andwell collections, andinvestments performing sector i s established (ii) Collectionso f Billed indicators are high level outcome Electricity indicators --the PRG i s only one factor among several to meet these (iii) Investments Sector objectives. IntermediateResults ResultsIndicatorsfor Each Use of ResultsMonitoring Sub-Component (i)qualifiedstrategicinvestor A (i) Initialpurchase of shares (i) magnitudeofthe The assumes ownership o f the DSO. o f OSSH. investments will indicatethe attractiveness of the Albanian power sector to investors and thereby provide guidance for preparationof privatizationo f other parts o f the sector. It also enables the Government to decide on how to use the revenue from sale o f OSSH. (ii) The new regulatory framework i s (ii) operatesin OSSH (ii) extentofsuccesswill The implemented for the period o f the accordancewith its license reveal how well the new guaranteecoverage. obligations andimplements regulatory framework is the investment programs working andprovide approved by ERE. indications onwhether and how to improve it. 31 ~ W Es 2 Y Es 2% 3 4 v o ALBANIA Privatization of the Power Distribution System Operator Annex 4: The PRGTerm Sheet and Contractual Structure Summary of Terms and Conditions of the World Bank (IBRD) PartialRisk Guarantee (PRG) for the Privatization of OSSHinAlbania L/C Applicant The Ministryo f Finance (MoF) ___ ~____ ~ ~~ ~ IBRDGuaranteed L/C: A revolving Standby Letter o f Credit (WC) Facility issued in favor o f the WC Beneficiary by the WC Issuer. The MOF's obligations to repay the L/C Issuer for the amounts drawn under L/C will be guaranteed by IBRD. Upon repayment by the MOF to the WC Issuer o f amounts drawn by the L/C Beneficiary, the WC shall be re-instatable for such amounts. If the MOF fails to reimburse the L/C Issuer for such amounts drawn by the WC Beneficiary within twelve (12) months plus accrued interest, the WC Issuer will have the right to request IBRDthe repayment o f such amounts under the IBRDguarantee. The WC shallnotbereinstated for any L/C amounts drawn by the WC Beneficiary and paid by the IBRD to the WC Issuer under the IBRD guarantee following the failure of the MOF to reimburse such amounts. The Letter o f Credit issued by the L/C Issuer would be drawn by the L/C Beneficiary following a `Guaranteed Event' (see below). Ifthere is a dispute between MOF and the privatized company OSSH as to whether a Loss andor a Guaranteed Event has occurred, the WC can also be called for provisional payments pending the settlement o f the dispute, provided that the WC Beneficiary shall provide the WC Issuer with appropriate security (acceptable to both the L/C Beneficiary and the MOF and to be reflected in the GSA (as defined below), in favor o f the MOF guaranteeing such provisional payments inthe event the final decision determines that the MOF had no liability or its liability was for less than the amount o f the provisional payments. LIC Beneficiary: The privatized company OSSH, in its capacity as energy distribution system operator (DSO) and energy retailpublic supplier (RPS). ___ ~ ~ ~ ~ L/C Term: Up to 6 years to cover the Transitory Period in 2009 and the First, Second, and Third Regulatory Periods, as such terms are defined in the Regulatory Framework (see below) and the additional period allowed for the filing o f a claim under the GSA. L/C Issuer: A commercial bank acceptable to MOF, the IBRD and the WC Beneficiary and that will be selected by the MOF in accordance with its applicable procedures. L/C Form: The WC will be issued in a form satisfactory to the investor, MOF and IBRD. PRGPurpose: To provide a guarantee for the repayment to the WC Issuer o f the amounts drawn by the L/C Beneficiary under the WC following the occurrence o f a Guaranteed Event (as defined below) that results in a loss o f annual 33 regulated revenues (a Loss) to OSSH during the transitory period and the three regulatory periods identified inSection 1.2 o fthe Regulatory Statement (RS) approved by Decision No. 12 o f the Board o f Commissioners o f the Albanian Electricity Regulatory Entity (ERE) on March 3,2009. GuaranteedEvents: The GuaranteedEventswill consist of: A change, repeal or non-compliance by the ERE or the GOA of certain provisions o f the Regulatory Framework (as defined below) governing: (i) timelyapprovalofthedistributionsystemoperator(DSO) andretail the public supplier (RPS) tariffs applications as submittedby OSSH, pursuant to Clause 1.3 o f the RS; and (ii) DSOtariffformulaandtheRPStariffformulaandtheirrelatedinputs the including the compensation mechanism as reflected in Sections 5 and 6 o f the RS but excluding any references to regulatory periods beyond December 31,2014. The inputsto the DSO and RPS formulae include: For the DSO Formula The determination o f the regulatory asset base (RAB) for 2009 and subsequent years through 2014 as described in Section 6 o f ERE's Board o f Commissioners Decision No. 79, dated June 26, 2008 and in Section4.1 o f the RS. The weighted average cost o f capital (WACC) calculation methodology including the treatment o f the pre-tax allowed return on equity (ARoE) until December 31, 2014, as described in Section 4.2 of the RS and ERE's Boardo fCommissioners DecisionNo. 79, dated June 26,2008. Recognition o f the cost o f equity o f 16.44% pre-tax until2014 as set out inSection4.2 ofthe RS. Full pass-through into the applicable tariff by way of the WACC calculation o f the cost o f new debt (including shareholder financing) acquired following the specified procedures set out in Section 4.2 o f the RS. Application o f the 60% gearing ratio for the DSO as set out in Section 4.3. of the RS. Determination o f the costs o f operation (OPEX) o f the DSO in2009 and subsequent years through 2014, as set out in Section 5 o f ERE's Board o f Commissioners Decision No. 79, dated June 26, 2008 and Section4.4 o f the RS. Working Capital Requirement for the DSO as described in Section 4.4 o f the RS. The starting level and future targets for DSO distribution loss reduction and changes to these that may result fi-om the Loss and Audit Studies as described inSection4.5 o f the RS. Fullpass through of the cost of power to cover distribution losses for power procured on the open -market in accordance with tender 34 procedures approved by ERE as set out inSection4.5 o f the RS. Setting the X-factor equal to zero for the first three regulatory periods and recognition by ERE o f any profit stemming from the reduction o f operational costs (excluding losses), as set out inSection 4.6 o f the RS. For theRPS Formula Recognition o f the bad debt allowance targets as may be revised as a result o f the BadDebt Study, as set out inSection 5.2 o f the RS. Recognition o f RPS profit margin o f 2.2% on annual electricity purchases from the wholesale public supplier (WPS) until 2014 as set out inSection 5.3 o f the RS. Fullpass-through for the power procurement costs ofthe WPS as set out inSection 5.3 oftheRS. Adjustment to the tariffto final consumers to compensate for differences between forecast and actual revenue resulting from the circumstances specified inSection 5.3 ofthe RS. Non claiming o f any increased earnings, before interest and taxes o f OSSH, relating to the period starting on 1st January 2009 and ending on the date o f closing o f the transaction relating to the privatization o f OSSH according to the comfort letter issued by METE on March 9, 2009. The Guaranteed Events relate to the following documents (which are subject to further due diligence by the Bank) (the Regulatory Framework) to be attached to the Government Support Agreement (GSA): ERE'sBoardof Commissioners Decision Nr.18 concerning "Electricity Generation Tariff for KESH for the period from March 1, 2008 to February 29,2009", dated February 14,2008,; ERE's Boardo f Commissioners Decision Nr. 19 concerning "Electricity Transmission Service Tariff for the period from March 1, 2008 to February 29,2009", dated February 14,2008,; ERE's Board o f Commissioners DecisionNr.20 concerning "Electricity Distribution Service Tariff for the Users o f the Distribution System, for the period March 1, 2008 to February 28, 2009", dated February 14, 2008, ; ERE's Board of Commissioners Decision Nr. 21 concerning "Retail Electricity Prices for Tariff Customers for the period March 1, 2008- February 28,2009", dated February 14,2008; ERE'SBoardof Commissioners DecisionNr.75 concerning "Electricity Wholesale Tariff',dated June 26,2008; ERE's Boardo fCommissioners DecisionNo. 79 concerning "Electricity Distribution System Operator Tariff Calculation Methodology", dated June 26,2008; ERE's Board o f Commissioners Decision No. 80 concerning "Retail Sales to Regulated Tariff Customers Tariff Calculation Methodology", dated June 26,2008; OSSH's tender procedures regarding selection o f banks providing new debt to be approved by ERE by the closing date o f privatization o f 35 - OSSH's tender procedures regarding selection o f supplier o f electricity covering the losses to be approved by ERE by the closing date o f privatization of OSSH; - Council o fMinisters Decision from February, 2009 - Regulatory Statement (RS) approved by EREon March 3,2009 - Comfort letter issued by METE concerning government compensation to OSSH for financial losses in 2009 resulting from specified possible EREdecisions and dated March 9,2009. In the event of any conflict between the RS and any other of the ERE decisions or regulations indicated above, the RS shall prevail. L/C Amount: An amount of up to Euro 60 million. The L/C shall be available for drawings by the L/C Beneficiary upon filing o f a claim on the basis o f drawdown mechanisms and the presentation of supporting documentation to be agreed between the parties in the GSA and the Standby L/C, and satisfactory to the IBRD. Upon the MOF repayment to the L/C Issuer o f the amounts drawn by the WC Beneficiary under the L/C, the drawn amounts shall be reinstated by the WC Issuer. IBRDMaximumGuaranteed An aggregate amount equivalent to the L/C amount plusaccrued interest Amount: GuaranteeValidityPeriod: L/C term plus 14 months L/C ReimbursementPeriod: Following any L/C drawings, the MOF will be obligated to repay the drawings to the WC Issuer within a period o f twelve (12) months from the date o f each drawing together with interest thereon to be reflected in a Reimbursement and Credit Agreement to be concluded between the MOF and the LK Issuer. In the event of a non-payment by the MOF of the amounts drawn under the L/C at the expiration o f the twelve (12) month period, the WC Issuer would have the right to call on the IBRDguarantee for the amounts due plus accrued interest following which the L/C would not be reinstateable for the amounts repaid by the IBRD. Interest Rate on Drawings An appropriate spread acceptable to MOF and IBRD, and payable by the during the Reimbursement MOF. Period charged by the L/C Issuer: IBRDGuaranteeFees: 30 bpger annum on IBRD guaranteed amounts outstanding, payable semi- annually inadvance by the WC Beneficiary. IBRDFront-endFees: a) A Front-end Fee o f25 bponthe guaranteed amount. b) An Initiation Fee o f 15 bp o fthe guaranteed amount (but not less than USD100,000) for internalProjectpreparation. c) Processing Fee o f a maximum o f 50 bp of the guaranteed amount to cover IBRDdesignated reimbursable expenses. 36 All IBRDrelatedfees to bepayable bythe L/C Beneficiary. L/C Fees: To be negotiated between MOF, the LK Issuer, andthe WC Beneficiary, and payable by the WC Beneficiary Conditions Precedent to the Usual and customary conditions for financing o f this type, including the effectiveness of the IBRD following: Guarantee: a) Execution, delivery and effectiveness o f all privatization and related agreements (including the GSA), each in form and substance satisfactory to IBRD; b) Provisiono f relevant satisfactory legal opinions from: (i) Ministry the o f Justice of the Republic o f Albania relating to the Share Purchase Agreement, the Indemnity Agreement, the Government Support Agreement, and the Reimbursement and Credit Agreement, (ii) counsel to OSSH relating to the Project Agreement; (iii) totheWC counsel Issuing Bank relating to the L/C; and (iv) counsel to CEZ regarding the Share Purchase Agreement. c) Payment in full o f the Initiation Fee and Processing Fee, and the first installment ofthe Guarantee Fee; and d) Conclusion o f a Guarantee Agreement between the L/C Issuer and IBRD, a Project Agreement between the L/C Beneficiary and IBRD, and an IndemnityAgreement between IBRDand MOF. GovernmentSupport The MOF will enter into a GSA with the L/C Beneficiary under which the Agreement: Ministrywould undertake to indemnify the WC Beneficiary for the loss of revenues resulting from the occurrence o f a Guaranteed Event on the basis o f drawdown and dispute resolution mechanisms and supporting documentation to be agreed betweenthe parties andsatisfactory to IBRD. Reimbursement& Credit The MOF will enter into a Reimbursement & Credit Agreement with the L/C Agreement: issuer in which it will undertake to repay the L/C issuer the amounts drawn under the L/C within a period o f twelve (12) months from the date o f each drawing plus accrued interest. GuaranteeAgreement: The terms and conditions o f the IBRD Guarantee would be embodied in a Guarantee Agreement betweenthe L/C Issuer and IBRD. Indemnity Agreement: Albania would enter into an Indemnity Agreement with IBRD. Under the Agreement, Albania would undertake to indemnify IBRD on demand, or as IBRDmay otherwise determine, for any payment made by IBRDunder the terms o f the Guarantee. The Indemnity Agreement will follow the legal regime, and include dispute settlement provisions, which are customary in agreements betweenmember countries and IBRD. ~ ProjectAgreement: The L/C Beneficiary would enter into a Project Agreement with IBRD in respect o f its Guarantee. Under such Agreement, the L/C Beneficiary will provide reports (including audit reports) and other Project information, and make warranties, representations and covenanted undertakings, including in respect o f compliance with applicable environmental laws and applicable 37 I 1 World Bank requirements relating to `corrupt practices'. I Other Provisions: As part o f its appraisal process, IBRD would carry out a review o f the financing and commercial structure o f the Project and any related financing agreements, and the proposed risk coverage, as deemed relevant by IBRD. The Project Company would be expected to comply with all applicable Bank policies and requirements, relating to disclosure of mformation, and applicable fiduciary and anti-corruption safeguards. 38 ALBANIA Privatization of the Power Distribution System Operator Annex 5: Electricity Regulation and Regulatory Framework Backstopped by the PRG Privatization of the Power Distribution System Operator 1. TheElectricity Regulatory Entity (ERE). The ERE was established in 1995 but remained weak until its authority was strengthened by the Power Sector Law enacted in 2003, which, among other provisions, removed the right o f the Government to fix a cap on electricity prices. The Law provides for the appointment o f the Chairman and the Commissioners by Parliament and these officials may not be removed except for particular reasons that would rarely be applicable. The ERE i s financed by annual fees paid by the licensees and has a staff o f 45. USAID has been providing technical assistance for training and preparation o f the necessary regulations provided for under the Power Sector Law. Under the ERE, the average tariff level has risen from Lek 4.41kWh in2001 to Lek 8.15kWh (O.O63kWh) in2008 after February, but is still not at cost recovery level. 2. The EREis, inter alia, competent to: set the rules and requirements for granting, modifjmg, transferring and revoking o f licenses to generation, transmission, distribution and supply companies; set, regulate and review tariffs contracts and the terms and conditions o f service o f electric energy proposed by a licensee or reviews them according to circumstances; resolve disputes between licensees and consumers, andbetween or among licensees; monitor and control the operation o f services by licensees, with powers o f inspection, access, acquisition o f documentation, andrelevant information; - control whether the licensee providing power services to customers i s respecting the terms o f the contract or is providing services consistently with standards established by the terms o f the license or any regulation approvedbythe ERE; and publicize and make known the conditions under which the electric energy services are provided inorder to ensure maximum transparency and the competitiveness o f the supply (Article 8 o f the Power Sector Law) Regulatory and Competition Frameworkfor Electricity Distribution and Retail Supply 3. The regulatory and competition framework i s governed by the Power Sector Law, and by the Albanian Market Model (AMM) that was adopted by the Council o f Ministers in January 2007 and amended inJanuary 2008 to accommodate the Government's decision to have separate wholesale and retail public suppliers. The AMM i s designed to meet Albania's commitments under the Energy Community Treaty, which requires conformity with the EC Directive 2003/54 (electricity), which requires liberalization o f the power systems o f the EuropeanUnion countries. 4. The power sector has been restructured by creating separate generation, transmission, distribution and supply entities. Each has a license from ERE, and those intended to operate under regulated tariffs have such tariffs. However, all o f these entities are currently publicly owned (apart from private Qualified Suppliers), with the DSO being the first to be offered for sale to a private investor. 39 5. A competitive market has yet to be established and it will be some years before it will be possible to have much competition. Since all domestic power production, except for a small amount from small hydropower plants, comes from one entity, KESH Gen, and is sold at regulated prices either to the TSO or the WPS, there is no possibility o f competition between generation companies within Albania at the present time. The only new power station that will come into operation inthe next few years is the Vlore Thermal Power Plant. It will be operated by a separate company, initially fully owned by KESH and will have a Power Purchase Agreement (PPA) with the WPS. Therefore it will be some years before competition between domestic generators within Albania i s likely to take place. Inthe meantime, the main way that competition can occur in Albania i s through the possibility for Eligible Consumers to choose between alternative Qualified Suppliers who would purchase on the import market. Although the ERE has authorized all non-household electricity consumers to be Eligible Consumers, only one large consumer has so far opted to cease being tariff customers. Others may be reluctant to do so inthe near future since they would lose the hydrobenefit. Regulationofthe DSOandthe R P s 6. OSSH will operate under two licenses: (a) a Distribution System Operator License for 30 years with exclusive right to serve all o f Albania; and (b) a Retail Public Supply License for 30 years with exclusive right to supply electricity to final tariff customers. The Distribution System Operator License applies to network operation (covering all voltage levels within Albania from 0.4 kV up to and including 110 kV) and to connections o f consumers (including Eligible Consumers, who will not be buying their electricity from the RPS) and independent generators, installation and servicing o f meters and meter readings. The Retail Public Supply License provides for the purchase o f the electricity destined for final tariff customers from the WPS at a regulated tariff and sale to final tariff customers at a regulated tariff. The RPS will also pay the Transmission Systems Operator (TSO) a regulated fee for transmission services. Billing and collections come under the RPS license as well. There will be a detailed contract between the RPS and the WPS, and this contract will require the approval o f ERE. 7. The DSO and RPS tariffs will be regulated in accordance with the "Electricity Distribution System Operator Tariff Calculation Methodology" and the "Retail Sales to Regulated Tariff Customers Tariff Calculation Methodology", both approved by ERE on June 26,2008. Certain provisions o f these Methodologies have since been amended and supplemented by a Regulatory Statement that was negotiated with CEZ and approved by ERE on March 3, 2009. Consequently, the Regulatory Framework will consist o f the two methodologies mentioned above as well as the Regulatory Statement, which will prevail in the case o f any inconsistencies with the two Methodologies. Distribution SystemOperator (DS0)TariffMethodology 8. This document, together with the Regulatory Statement, establishes the methodology for the calculation o f the distribution access and use-of-network tariffs for the distribution system users o f Albania that is consistent with the Energy Community Treaty. The year 2009 i s to be a transitory regulatory period during which the existing regulatory parameters will be preserved and the tariff approved in February 2008 will apply to year 2009. By September 30, 2009 the DSO is to apply for a new distribution tariff, which is to become effective on January 1, 2010. The year 2010 will be considered as the first regulatory period for the DSO, with the year 2011 40 as the second regulatory period and years 2012, 2013 and 2014 as the third regulatory period. The subsequentregulatoryperiodwill be o f3-5 year term. 9. Tariff submissions are required to be submitted by OSSH before each regulatory period for the DSO from Year 2010. Tariff submissions are required to be made no later than September 1 and to be approved by ERE by December 7 o f the same year. The tariffs for 2010 and the subsequent regulatory periods are intendedto cover the revenue requirements as follows: RR=C + (RAB* WACC), where: RR =the annual revenue requirements; C = the allowed annual cost o foperation for the licensedactivity (OPEX); RAB=the RegulatoryAsset Base; WACC =pre- tax Weighted Average Cost o f Capital 10. Allowed Annual Operating Costs (OPEX) will include the operations and management costs o f OSSH for distribution servicesplus the cost o f imports o f power required to cover target levels o f technical and non-technical distribution losses plus the cost o f transmission o f the imported electricity plus depreciation. For purposes o f determining allowed import costs to cover distribution losses, ERE will assume that total distribution losses as a percentage o f electricity entering the distribution network are reduced from an assumed level o f 32 percent in 2009 by four percentage points in 2010, 4 percentage points in 2011 and 9 percentage points in 2012- 2014 (three percentage points per year) to reach 15 percent in 2014. The imported electricity will be purchased on the basis o f fair, transparent and lawful tender procedures proposedby the DSO and approved by EREno later than the closing o f the privatization o f OSSH. The weighted average price determined from these approved procedures for the year ahead multiplied by the quantity o f electricity needed to cover the approved distribution losses will determine the import costs to be recognized by ERE for determination o f the DSO's tariff for the year ahead. Any differences between the forecast and actual cost o f power purchased to cover the target losses in each year will be filly passed through inthe tariff for the next year in such a way that the DSO will bear no risk arising out o f power procurement on the open market. The differences allowed for pass-through could arise from the actual weighted average price being different from the forecast average or from the quantity o f imports being different because the demand by final consumers is different from the forecast demand. The DSO will be allowed to keep any profits earned as a result o f reducing distribution losses to a percentage below that approved by ERE. Conversely it will have to absorb any possible loss resulting from the distribution loss percentage being higher thanthe target rate. 11. No later than July 31, 2009, the DSO shall have a Loss Audit carried out by an independent technical expert to determine the methodology o f calculation o f total losses and verify the actual 2008 distribution losses. No later than July 31,2010 the DSO shall have a Loss Study carried out by the technical expert to determine the distribution losses incurred in 2009. The Loss Study will be approved by ERE within two months o f submission and the Loss Audit within one month. After they are approved by ERE the results o f these studies will be used to amend the loss reduction schedule (by 4 percent each year for 2010 and 2011 and by an additional 9 percent by the end o f 2014). The costs o f the Loss Audit, Loss Study, Bad Debt Study, as well as the PRG-related costs will be a pass-through inthe OPEX. 41 12. Annual Adjustments o f OPEX: The methodology provides for the annual adjustment o f operating costs excluding import costs and depreciation in accordance with a price cap formula based on rate o f price increase less efficiency improvement (RPI -X). RPI is set equal to the increase in the Albanian Consumer Price Index. X i s set equal to zero for the first three regulatoryperiods, allowing OSSH to keep any profit resulting from a reduction of OPE, but will be subject o f review for the subsequent regulatory period. The DSO will be allowed to request adjustments in its allowed operating costs at the beginning o f regulatory periods for justifiable expenses. 13. Remlatory Asset Base (RAB) will be determined according to the following formula: RAB=A-CG-D+WC+INV where : A =the recognizedvalues o fusedanduseful fixed assets: C G = the value o f assets acquired through gratuitous transfer or constructed with financial resources o f electricity consumers; D=The accumulated depreciationfor the past period o f assetsusedto perform the licensed activity; W C = the working capital requirement, which shall be equal to 1/12 o f OPEX excluding depreciationand financial expenses.; INV = the forecast average cumulative nominal amount o f investments approved by the ERE and invested duringthe regulatory period.( OSSH is required to submit an investment planfor 2009 and2010 no later than 2 months after the closing o fthe Privatization). 14. The starting value o f the Regulatory Asset Base for the DSO for 2009 will be equal to the book value o f fixed assets o f the audited IFRS balance sheet o f the DSO as o f December 31, 2007, plus the value o f investment o f the company for 2008, plus projected investment by the company for 2009 approved by the ERE, less accumulated depreciation for 2008 and 2009. The ERE will exclude from the RAB those fixed tangible and intangible assets financed through grants. These assets were valued at Lek 770 million for 2008. 42 15. WACC will be determined inaccordance with the following formula: WACC = 40%*ARoE + 60%*(Y 1% +Y2%) where: ARoE = allowed return on equity before tax pre-agreed to be 16.44% for the first three regulatory periods. Y1% = the interest rate on old long-term debt multiplied by the share o f old long-term debt intotal long-term debt. Y2% = the interest rate on new long-term debt multiplied by the share o f new long-term debt intotal long-term debt. The interest rate on old debt is the actual rate fixed in the sub-loan agreement between OSSH and KESH under which all o f KESH's pre-privatization long-term borrowings from IDA and other lenders for power distribution are transferred to KESH in exchange for a single bundled long-term debt on which OSSHpays interest at the agreed rate. The interest rate on new debt will be determined at the time the debt i s incurred on the basis o f fair, transparent and lawful tender procedures proposedby OSSH to EREby the end o f February 2009 and approved.by ERE by no later than the closing of privatization o f OSSH. OSSH will also have the right to raise debt from multinational lenders inwhich case such tender procedures would not apply and the actual cost o f debt would be fully pass-through into the applicable tariff byway o fthe WACC. 16. DSO Services: The DSO is licensed to provide five types of service: use o f network, metering and meter-reading, meter disconnection and reconnection, reactive power compensation and connections. The DSO Methodology specifies the different types o f prices and charges that it will approve for the DSO. 17. The DSO will disconnect customers for non-payment or other violation at the request o f the RPS, or qualified supplier or at its own will. It will charge all customers above 50 kVA for reactive power compensation. This charge does not exist now and will require the installation o f new meters. The consumers will be required to pay for their connections, and each new connection will be priced inaccordance with rules set out inthe Methodology. 18. Each customer is to pay a defined capacity charge for use o f network as well as an energy charge. There i s no capacity charge inthe existing tariff. The DSO may also apply to ERE for peak and off-peak charges. These do not exist now and would require new meters. 19. Retail Public Supplier (RPS) Tariff Methodology: RPS tariffs for regulated sales to electricity end-customers will be determined on the basis o f this methodology and the Regulatory Statement. Tariff submission will be required to be made by September 1 and approved by ERE on December 7 before the beginning o f each year. Tariff applications for years 2009 and 2010 are required to be submitted by 30th September and reviewed by ERE by 15th December at the latest with a view to the issuance o f a Tariff Order bythe 1st o f January 2010. 20. The RPS will buy the electricity needed by final consumers from the WPS at a regulated tariff which will be adjusted annually by ERE (WPSt) It will also pay to the TSO the charges approved annually by ERE for transmission use for final consumers (TSOt) The RPS will also pay the TSO for imbalances according to the Market Rules if applicable and there is to be an annual adjustment for the previous year including energy and capacity adjustments from the 43 WPS compared to forecasted levels. The simultaneous annual adjustment o f the WPS, TSO and RPS tariffs will ensure precise pass-through of the RPS's electricity supply costs to the end-use tariffs. 21. The Revenue Requirement associated with end-user tariffs will be calculated on the basis o f the following formula: RRactn= (WPStarifh +TSOtarifh)xVn +DSOtarifhxVdn +PSOcostsn +RPScosts -ACOMPBn where RRactn = actual applied revenue requirements in million Leks from final users recognizedby ERE inyear n. WPStarifh =the WPS tariffrecognizedby EREinyear n. TSOtarifh = the TSO tariffrecognizedby EREinyear n. Vn = total sales volume o f electricity in GWh to tariff customers agreed by OSSH and EREinyear n. DSOtarifh =the DSO tariff recognizedby EREinyear n. Vdn = total sales volume o f electricity to tariff customers connected to the distribution system agreed by OSSH and EREinyear n. PSOcostsn = public service obligation costs (such as energy efficiency programs) recognizedby EREinyear n. RPScostsn = retail public supply costs plus RPS profit margin equal to 2.2% o f the purchases from the WPS, excluding VAT, recognizedby EREinyear n ACOMPBn = reduction in the compensation account in year n recognized by ERE in compliance with the agreed compensation mechanism 22. The tariff to final consumers will include an adjustment to compensate the RPS for differences between forecast and actual revenue as o f result o f deviations in forecasting demand inindividual consumer categories when they are newly created or when there are tariff changes that are not inthe same proportion for all customer categories. 23. The tariff to final consumers will also be adjusted to reflect the allowed bad debt level. 24. BadDebt Level: The allowed bad debt level ( equal to uncollected revenue inthe given year divided by total billed revenue o f RPS excluding VAT for the same year) is assumed to be at 14% base level in 2009. The level for 2010 and subsequent years will be equal to the 2009 base level reduced by one percentage point each year up to Year 2014 The Regulatory Statement provides for OSSH to carry out by 2010 a Bad Debt Study to be undertaken by an independent financial expert to be agreed by CEZ and ERE. This study will determine the methodology to be used to calculate the bad debt level and the actual 2008, 2009 and 2010 level o f bad debts. The actual bad debt level for 2010 determined by the Study will then be used as the base for the subsequent bad debt reduction schedule provided for in the Regulatory Statement. In case the actual 2009 and 2010 bad debts are higher in 2009 and 2010 than 14% and 13%, respectively assumed prior to the Study then the resulting loss to the RPS from the difference between the assumed and actual levels can be recovered through the Compensation Mechanism described below. Ifthe actual bad debt in any year after 2009 i s less than the base level to be allowed by ERE, the RPS willbe allowed to keep the extrarevenue. 44 25. The RPS tariffmethodology specifies the prices and charges that are to beput into effect for the RPS. The bills for household customers and non-household customers suppliedin0.4 kV ...... may includethe following charges: Generation services (LekkWh) 1st Block ( x k W m o n t hfor households) 2"d Block (residual kWh Transmission services (LekikWh) Distributionservices (LekkWh) Customer charge (LeWmonth) Public Service Obligations (LekikWh) 26. The bills for each group of non-household customers, according to the supply level o f voltage may include the following separatedcharge: . Generation services (LekkWh) . . Capacity charge (LekkWh) Energy charge (LekikWh) Transmission services (LekikWh) Capacity charge (LemWh) Energycharge (LekkWh) Distributionservices .. ..... Capacity charge (LemWh) Energycharge (Lek/kWh) Reactivepower charge (LekkWh) Customer charge (LeWmonth) Public Service Obligations (LekkWh) 27. For HV and MV customers, the monthly invoice i s to include a capacity charge. It will be set at zero until the customer installs electronic meters to record and store hourly customer demand. 28. Compensation Mechanism: The Compensation Mechanism provides for OSSH to be compensated in subsequent years for any financial losses incurred in any previous year as a result of ERE approving the DSO and RPS tariffs below the required levels provided for in the Regulatory Framework. In the event that the calculated Revenue Requirement of OSSH for a given year, in its function of RPS, result in an increase o f the weighted average end-user tariff (the total required revenues of OSSH in its function o f RPS in given year divided by total estimated volume o f electricity sales in a given year) higher than 15% plus CPI, then EREmay allow a tariff increase o f only 15% plus CPI and carry forward any unrecovered revenues to be reflected in future year tariff increases. These unrecovered revenues will form the compensation account from the year when the entitlement arises and ending inthe year (inclusive 00inwhich the amount is fully compensated. Should the expected increase of the weighted average end-user tariff for the following year be lower than 15% plus CPI, then ERE i s expected to take into account any unrecovered compensation amount in the tariff increases for that year, up to 15% plus CPI. OSSH will be compensated for such compensation amounts at the DSO WACC 45 prevailing in the year preceding its application. The precise mathematical formula for the CompensationMechanism is set out inthe Regulatory Statement. 29. Inaddition to the portion ofRPS' Revenue Requirements which arenotreflected inERE approved tariff increases up to the 15% minimum tariff plus CPI, the following components would also be subject to the Compensation Mechanism: 0) Financial Losses for the Transitory Year o f 2009 when no tariff increases are to take place. ERE will provide compensation to OSSH for any financial loss incurred by the DSO and the RPS in 2009 resulting from actual tariffs prevailing on March 1, 2009 being lower than the tariffs that would come into effect from 1st January 2010based on the Regulatory Framework. (ii) FinancialLossestotheRPSrelatingtobaddebtlevelsresultingfrombaselevel o fbad debt allowance assumed in2009 and 2010 being lower than actual bad debt levels determined by the Bad Debt Study as described in the Regulatory Statement. (iii) FinancialLossestotheDSOintheeventactualdistributionlossesarehigherthan the base level assumptions o f 32% for Years 2008 and 2009 as determined by a Loss Audit andLoss Study described inthe Regulatory Statement. 46 ALBANIA Privatizationof the PowerDistributionSystemOperator Annex 6: ImplementationArrangements 30. The Government will transfer a controlling stake o f 76 percent o f OSSH's shares to the CEZ Group (CEZ), an integrated electricity conglomerate based inthe Czech Republic". CEZ's principal businesses encompass electricity generation and distribution, sales o f electricity and heat, as well as coal mining. In 2007, CEZ owned about 14.3 GW o f electricity generation capacity, sold 73,793 GWh o f electricity and had more than 70,000 employees in its operations inthe Czech Republic, Poland, Hungary,Romania, Bulgaria and other countries. InNovember 2008, CEZ was among the top ten Europeanpower utilities with about 6.8 million customers and a market capitalization o f about 16.3 billion. The company serves about 3.5 million electricity customers in the Czech Republic and owns controlling stakes at electricity distribution companies in South East Europe (1.67 million customers in Romania and about 2 million customers in Bulgaria). CEZ reported net income o f CZK 42.8 billion in 2007 and estimates a net income o f CZK 48.6 billion (about US$ 2 billion) in 2008, while it maintained the lowest debt leverage ratio among European power utilities and a rating o f A-/A216. 31. Initially the RPS will be part o f OSSH, but it will be organized under a separate management structure (with separate accounts) and later as a separate legal entity in order to conform to the EC's Electricity Directive. Whether combined or separate, the RPS and OSSH will need to coordinate their activities to reduce distribution losses and improve collections. The RPS is responsible for billing and collection, with the bills o f final customers including a charge for use of the DSO's network as well as purchase o f energy. The DSO is responsible for meter reading and maintenance and for consumer connections. Therefore the RPS will have to request the DSO to disconnect consumers who have connected illegally or are indefault, but operational control for both entities can be effectively coordinated as they are both owned by OSSH. 32. At the end o f 2007, KESH's receivables from customers totaledjust under Lek 50 billion (US$500 million), o f which Lek 44.2 billion were from households. However, the opening balance sheet for OSSH includes only receivables o f households relating to bills after January 2007. At the time o f privatization, all household debt for unpaid electricity bills prior to 2007, amounting to Lek 45 billion, will be transferred to KESH.Collection o f long-dated bills i s likely to be challenging, but OSSH is authorized to collect all receivables before 2007 on behalf o f KESHand receive a fee equal to 10percent o f the value o f the receivables collected, including VAT, for doing so. 33. A number o f long-term loans received by KESH for the distribution system have been consolidated into a single long-term liability in the opening balance sheet o f the OSSH. OSSH will pay debt service on this liability to KESH. The long-term loans are mainly those provided to KESHby international donors. The result o f this treatment is that OSSH will deal with KESH rather than the donors, and KESH will continue to be responsible for the debt service on the individual loans, as well as for honoring the other commitments under the loan agreements. l5CEZgroupisownedbyCEZa.s. ajoint-stock company incorporatedinMay1992andlistedinthestockmarkets ofPrague andWarsaw; the CzechRepublic continues to be the company's largest shareholder with a 69% stake as ofMarch 2009. l6Sources:CEZ Annual Report 2007; CEZ Quarterly Presentation to Investors, November 2008. 47 KESH's short-term liabilities incurred mostly for importing electricity up to June 30, 2008 remain with KESHrather than OSSH. 34. The DSO will operate under a tariff designed to cover the costs o f operating the distribution system, including the costs o f purchasing electricity on the market to cover distribution losses plus an allowed rate o f return on the approved rate base. The tariff will be based on specified distribution loss reduction levels and collection rates to be achieved (see paragraph 21 above, subject to qualifications set out inAnnex 5). The DSO can make additional profits by over achieving the targets, but must absorb any financial losses from failing to meet the targets. Powerful incentives to improve performance are therefore inplace. 35. The RPS will operate under a retail tariffthat passesthrough the cost o fbuyingelectricity at a regulated price from the WPS plus the transmission tariff plus the distribution tariff plus a margin to cover operating costs, and a designated fee o f 2.2 percent o f purchases from the WPS for performing the retail supply activity. The tariff is based on the assumption o f a bad debt allowance that will be reduced from 14 percent o f billed revenue in 2009, by one percentage point each year (subject to qualifications set out inAnnex 5). 36. CEZ's plans to improve the performance o f OSSH include: 0 Organizational restructuring from the current geographic based approach to a combination o f finctionalities andregional focus 0 Strengthening and upgrading o f existing 10kV lines and 110/10 substations 0 Installation o f metering to all customers and advanced technology metering to selected private customers 0 Replacement o f old transformers with new ones that have low losses. 0 Metering o f reactive power and metering o f customers o f above 50 kVA with electronic meters 0 Investment in 0.4 kV networks introducing Aerial Bundled Cable lines that minimize unauthorized access to the network 0 Improvement o f the billing and collection systems by introducing a new information technology system that will maintain clean, centralized, client information. 0 Training o fpersonnel 0 Introductiono fperformance-based remuneration system 0 Strengthening o f OSSH's environmental performance. 48 ALBANIA Privatization of the Power Distribution System Operator Annex 7: Economic and FinancialAnalysis 1. Projections of Required Electricity Tarijjfs, Amounts in the CompensationAccount and Possible PRG Exposure. The following table presents projections o f revenue requirements for the DSO and RPS together with estimates o f required tariffs up to 2014, the last year o f the third regulatory period. It also presents estimates o f tariff growth assuming the maximum increase in any year is limited to 18 percent and tariffs in subsequent years are determined in accordance with the operation o f the agreed compensation mechanism. In addition it includes estimates o f amounts in the compensation account by year for each tariff scenario and possible payments to OSSHrequiredunder the PRGmechanisminthe event that tariffincreases are less thanthe floor rate o f 18 percent and there is still money inthe compensation account. The main results are the following. Iftariff increases are limited to 18% per year, the tariff would need to grow from Lek 8.15kwh ($USO.OSkwh) in 2008 to Lek 9 . 6 k w h (US$O.O94kwh) in 2009 and Lek 11.3 kwh(US$O.11lkwh)in2010 inorder to cover current year costs as well as pay off financial losses from previous years, but would thereafter fall gradually to Lek 9 . l k W h (US$ 0.089kWh )in2014 as a result o f reductions indistribution losses and improvement in collections in accordance with the agreed schedules for these two variables. The amounts in the compensation account would increase from Lek 5.8 billion (US$57 million) in 2009 to Lek 10 billion (US$98 million) in 2010, diminish to Lek 5.8 billion (US$57 million) in2011 andto zero by 2012. PRG payments would be triggered ifthe tariff trajectory is below the 18 percent per year path. Ifthe tariff increases were limitedto 5 percent per year plus inflation adjustment o f 3 percent, payments would be required o f Lek 3.4 billion (US$ 34 million) in2010,, Lek 8.3 billion (US$81 million) in2011, and Lek 4 billion (US$39 million) in2012. The table i s based on the following assumptions: The provisions o f the agreed regulatory framework, including the Regulatory Statement dated March 3,2009. Projections o f electricity production, production prices and demand prepared by KESH for the draft NinthPower Sector Action Plan (December 2008) and o f estimates o f costs o f purchase o f materials and product and supply and services for the DSO presented by KESHinthe EighthPower Sector Action Plan Bank staff estimates o f inflation, import prices, personnel costs, new debt amounts and interest rate, depreciation, andinvestments after 2008. 49 Electricity BalanceAssumptions 2009 2010 2011 2012 2013 2014 Net KESHhydro(GWh) 4,200 4,200 4,200 4,200 4,200 4,200 NetMorethermal (GWh) 400 742 742 742 742 742 Privategenerators(GWh) 80 85 90 99 109 120 Total netgeneration(GWh) 4,680 5,027 5,032 5,041 5,051 5,062 ImportsbyWPS (GWh) 381 139 393 626 888 1,162 Average importprice(LekkWh) 7.5 8.5 9.5 9.5 9.5 9.5 KESHhydro price(LekkWh) 0.78 0.78 0.78 0.78 0.78 Morethermalpower price(LekkWh) 8.5 9.5 9.5 9.5 9.5 Privategenerators price(LeklkWh) 8.3 10.4 9.0 9.2 9.5 WPS price(LekkWh) 1.6 2.70 3.26 3.52 3.81 4.10 Total transmissionlosses (GWh) 319 314 330 318 322 326 Transmissioncharge(LekkWh) 0.51 0.53 0.54 0.56 0.57 0.59 ElectricitysoldbyWPS to RPS(GWh) 4,742 4,852 5,095 5,349 5,617 5,898 Small hydrosoldto distribution(GWh) 64 62 62 62 62 62 Electricitysoldto HVconsumers (GWh) 200 200 200 200 200 200 Useof dist. by eligibleconsumer (GWh) 100 100 100 100 100 100 Electricitysubjectto dist charge(GWh) 4,642 4,752 4,995 5,249 5,517 5,798 Importsto cover dist. losses(GWh) 2,184 1,848 1577 1395 1224 1023 Projectedtariffs, CompensationAccount and PRGExposure (Lek million) 2009 2010 2011 2012 2013 2014 DSO Importsto cover losses 16,384 15,708 14,984 13,256 11,632 9,720 Transmissioncosts 1,114 971 853 778 703 605 Personnel costs 4,173 4,272 3,804 3,307 2,633 2,847 Purchaseof materialsand product 1,457 1,603 1,603 1,603 1,603 1,603 Supplyand sewices 1,705 1,876 1,876 1,876 1,876 1,876 Total O P Mwlo deprec. 24,833 24,430 23,120 20,820 18,447 16,650 Deprec 2,097 2,034 1,789 1,864 2,031 2,031 Total O P Mw deprec. 26,930 26,464 24,910 22,683 20,478 18,681 Workingcapital 2,069 2,036 1,927 1,735 1,537 1,388 Investment 1,900 2,440 2,684 2,952 3,248 3,572 Debt repayment 1,560 1,560 1,560 1,560 1,560 1,560 Recognizedfixedassets 15,354 15,697 16,347 17,815 17,815 17,815 RAB 17,226 17,733 18,274 24,272 24,272 24,272 Olddebt, interestrateof 3.1% 21,146 21,146 21,146 21,146 21,146 21,146 Newdebt,interestrateof 8.5% 1,363 1,966 2,455 2,649 2,777 3,101 Weightedaverage interestrate 0.034 0.036 0.037 0.037 0.037 0.03 WACC, ROEof 16.44%vith40%weight 0.086 0.087 0.088 0.088 0.088 0.089 Requiredrevenue 28,417 28,009 26,513 24,819 22,617 20,830 Requireddistributioncharge(Lekkwh) 6.1 5.9 5.3 4.7 4.1 3.6 RPS PurchasesfromWPS 7,587 13,091 16,629 18,814 21,424 24,178 Transmissioncosts 2,418 2,549 2,756 2,981 3,224 3,487 Billeddistributioncharge 28,417 28,009 26,513 24,819 22,617 20,830 Profit(at2.2%of purchasesfromWPS) 167 288 366 414 471 532 Required revenuew/o baddebt provision 38,589 43,936 46,265 47,028 47,737 49,026 Required revenueof RPSw baddebt prov. 44,871 50,502 52,573 52,840 53,041 53,875 Requiredaverageretailtariff (Lek/kWh) 9.5 10.4 10.3 9.9 9.4 9.1 Actual 2009tariffrate 8.15 Estimatedcollectedrevenue in2009 33,237 Financiallossof DSOandRPSin2009 5,352 e Ind interestfor oneyear atWACC 5,815 50 Assume tariff increase limited to 18%/yr 9.6 11.3 11.1 9.4 9.1 Total uncompensatedloss with interest 9,953 5,810 0 0 0 Assume tariff increase limited to 13%/yr 9.2 10.4 11.1 9.4 9.1 Total uncompensatedloss with interest 11,823 10,400 0 0 PRG payment 1,720 4,220 Loss net of PRG payment 9,953 5,810 0 Assume tarlff increase limited to 8Ydyr 8.8 9.5 10.3 9.4 9.1 Total uncompensatedloss with interest 13,693 14,792 4,352 0 0 PRG payment 3,440 8,258 4,000 0 Loss net of PRG payment 9,953 5,810 0 0 Loss if 18% increase in 2010,O in 2011 9.953 14,251 PRG payment 7,761 Sources: Energybalanceprojectionsfor 2009-2011from draft 9th PSAP. Projectionsfor 2012-2014are Bank mission estimates. DSOcost estimatesfor 2009 are from 8th PSAP. Personnelcost projectionsfor 2010-2014 are by IFC and make provisionfor downsizingplus compensationto redundantemployees. 1. For 2009, the price paidto WPS is the approvedtariff rate of Lek 1.6/kWh. For later years the prices are calculated from the projectedcosts of KESH hydroelectricity,imports, Vlore thermal power, and private generators. 2. New debt in any year is assumed to be equal to the sum of investmentand repaymentof old debt less depreciation. 3. No explicit account is taken of the 10%corporatetax rate since this tax would not have any effect on required revenue. itwill be paid out of the equity return. 4. The short term debt of KESH is currently Euros 180 million. It is assumed that Euros30 millionwill be eliminated bya governmentsubsidy It is also assumed that the rest will be handledin such a way that there will be an interest expense at the rate for new borrowingof 8.5% The interestexpenseequal to Lek 1,556 million is includedin the requiredrevenuefor the WPS and raises its tariff after 2009 correspondingly 5. The loss in year n is equalto the loss plus interest in year n-I plus the loss in year n plus interest at WACC for the total in year n. 51 ALBANIA Privatization of the Power Distribution System Operator Annex 8: Safeguard Policy Issues 1. N o land acquisition or resettlement i s required due to privatization. The new DSO owner may reduce the number o f employees andprovide legal compensation. 2. Low-income consumers benefit from the social subsidy scheme established in 2006 to compensate targeted socially vulnerable groups for the increase in the price o f electricity for monthly consumption below 210 kWh from Lek 4.5ikWh to Lek 7ikWh. Only those consumers inthe targeted groups that are confirmed byKESHto bepayingtheir electricity bills are allowed to receive the subsidy. In 2007 Albania switched from an increasing block tariff pricing to a single tariff in electricity pricing. Until 2006, households which consumed less than 210 KWh paid 4.5 LEK per KWh, while those which consumed more paid 9.0 LEK per KWh. In2007, all households were charged a flat 7 LEK per KWh. However, the block-tariff system was re- established in2008 with a first block o f consumption for households (up to 300 kWWmonth) at a low rate o f Lek 7/kWh, while for higher consumption the tariff was raised to Lek 12kWh. More than half o f electricity consumers use less thanthis amount, which is therefore set too generously to protect only the poor. 3. The 300 kWhlevel is considerably larger than the estimate o f about 200 kwhper month made by the National Agency o f Energy in 2003 as the minimumrequired consumption for an acceptable standard o f living. It could, therefore, be reduced over time when there i s need for overall increases in tariffs. By July 2009 the pricing structure is expected to be reviewed to improve targeting. While some consumers will be affected by this re-structuring, the poor are expected to fall within the re-defined first consumption block. While vulnerable consumers with very low consumption would be little affected, all other consumers would receive larger electricity bills. However, these arejustified since electricity costs far exceed the current price of Lek 7ikWh for the first block. 4. A 2006 Bank study on the Poverty and Social Impact Assessment o f electricity tariff reforms for all the countries in the Western Balkans shows that, the share o f electricity expenditures intotal household expenditures was around 5 percent for the poorest quartile o f the population o f Albania. The same study also indicates that current electricity prices in Albania are below cost recovery prices, and should pricing move towards cost recovery, the share o f electricity expenditures would rise to about 5.4 percent o f total household expenditures for the poorest quartile. Other estimates place the share o f electricity expenditures in total household expenditure for the poorest 10 percent o f the population at 6 per~ent'~. A householdis considered energy poor (unable to afford electricity) whenever its share o f electricity expenditure reaches or exceeds 10 percent o f total expenditures. On this basis, it does not appear that at current prices, many households are electricity poor inAlbania. However, it is also clear that the poor spend a higher share o f their expenditure on electricity than richer households and there might be some social pressure to reduce the burden o f further increases in electricity prices on the poor. The study explores the alternativemechanisms for mitigating the impact o f additional price increases l7 Fankhauser,SladjanaTepic,"CanPoorConsumersPayforEnergyandWater?"EBRDWorkingPaperNo.92, Samuel August 2005 52 on the poor and reaches the conclusion that, as currently designed, a tariff based subsidy i s preferableto support the poor than through the Ndihma Ekonomikeprogram. 5. Inaccordance with ERErequirements, the DSO will be obliged to carry out connections o f new customers and furnish all customers with meters. This is likely to lead to more rapid regularization o f connections with customers in recently built-up areas on the outskirts o f large cities than has occurred in the past, resulting in much improved quality o f supply to those consumers. This regularization would be accompanied by significant reductions in distribution losses and improvement in collections from formalized customers, but could impose considerable expenses on users that have intentionally managed to avoid it up to now. With respect to consumer protection, the DSO will be obliged to handle consumer complaints in accordance with satisfactory procedures enforced by ERE. 6. The potential environmental impacts concerning electricity distribution systems activities are relatively low, rather reversible, and o f low significance. However, the continuous practice o f certain activities over a number o f years (30-40 years) can potentially cause more significant impacts than those normally expected. 7. A general environmental concern in distribution systems are PCBs18 present in the mineral oil used in transformers manufactured before the mid-1980s. If PCBs are present they would likely be inold transformers still inuse inthe distribution, as well as any other dismantled material /equipment contaminated with PCBs. The Bank financed a study to investigate whether PCBs were present inpower sector inthe 1990s under the Power Transmission and Distribution Project. The consultants that reviewed it did not find any indicationthat PCBs were present. 8. Unchecked growth o f tall trees and accumulation o f vegetation may result ina number of impacts, including power outages through contact o f branches and trees with distribution lines; ignition o f forest and brush fires; corrosion o f steel equipment; blocking o f equipment access; andinterference with critical grounding equipment. 9. IFC's consultants have reviewed OSSH's standards and found that the health and safety issues concerning the operation o f the installations are well performed in most OSSH substations. Potential dangers concerning the managing of low, medium and high voltage equipment seem to be well understood by all personnel, safety equipment (gloves, boots, helmets) i s available, and staff are able to handle materials using such equipments. Moreover, there were always preventive signs in evident locations and fire extinguishing equipment was in place bothinside the buildingand outside inthe transformers' area. 10. OSSH is required to comply with the environmental laws and regulations o f Albania. However, because o f Albania's obligations under the Energy Community treaty, the European Union environmental standards (Acquis Communitaire) would be applicable inthe sector. 11. N o physical works would be supported by the PRG. The Environmental Assessment category is C. * Polychlorinatedbiphenyls(PCBs) andpolychlorinatedtqhenyls (PCTs), which arehalogenatedaromatic hydrocarbons, which belongto the group ofpersistentorganicpollutants(POPS).PCBsandPCTsare liquidand solid substances,which are virtually not soluble inwater. Becauseoftheir physicalpropertiesandhigh ignition temperatures,PCBs areusedmainly as heat- transfer or insulationliquids inelectricaltransformers, capacitors andcondensers, andareusedas hydraulic oils inthe mining sector. They were manufactureduntil the mid-l980s, after which they were banneddue to their toxicity andpersistence. 53 ALBANIA Privatization of the Power Distribution SystemOperator Annex 9: Project Preparation and Supervision Planned Actual PCNreview 06/26/2008 06/30/2008 Initial PID to PIC 07/01/2008 03/17/2009 Initial ISDS to PIC 07/10/2008 03/17/2009 Appraisal 04/06/2009 04/07/2009 Negotiations 04/09/2009 Board/RVP approval 05/05/2009 Planneddate o f effectiveness 05/15/2009 Planneddate o fmid-term review 03/03/2012 Plannedclosing date 05/31/2017 Keyinstitutions responsiblefor preparation ofthe project: The Government ofAlbania (inparticular the Ministry ofTrade and Economy and the Ministry o fFinance and their advisers), KESH, OSSH, ERE, CEZ's project team includingtheir advisers. Bank staff and consultantswho worked on the project included: 1 I Name I Title Unit Demetrios Papathanasiou Sr. Energy Economist ECSSD FaridaMazhar Lead Financial Officer FEU I Mohinder Gulati I Country Sector Coordinator I ECSSD 1 I MonicaTeresa Restrepo I Counsel I LEGCF I Kirsten BurghardtPropst Counsel LEGEM ErjonLuci Economist ECCU4 I Yolanda Gedse 1 Program Assistant I ECSSD I Upali Perera I InformationManagement Assistant I FEU ~ ~ ~~ ~ ~ ~ Richard Hamilton Consultant ECSSD 54 ALBANIA Privatization of the Power Distribution System Operator Annex 10: Documents inthe Project File 1. "Regulatory Statement." March4,2009 2. Energy Regulatory Authority. Board o f Commissioners Decision No. 69. 24.06.2008. "License for Distribution of Electric Energy" 3. Energy Regulatory Authority. DecisionNo. 71. 24.06.2008. "License for the Activity o f RetailPublic Supplyof Electric Energy" 4. Energy Regulatory Authority. Decision No. 79. 26.06.2008. "Electricity Distribution System Operator Tariff Calculation Methodology" 5. Energy Regulatory Authority. Decision No. 80. 26.06.2008. "Retail Sales to Regulated Tariff CustomersTariff Calculation Methodology" 6. SharePurchaseAgreement betweenthe Ministry of Economy Trade and Energyand CEZ a.s. March 11, 2009 7. Preliminary Business Plan of OSSH for the years 2009-2014, prepared by CEZ for the World Bank, March2008. 55 ALBANIA Privatization of the Power Distribution System Operator Annex 11: Statement of Loans and Credits Differencebetween expected andactual Original Amount inUS$Millions disbunements ProjectID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev'd P110845 2008 Disaster RiskMitigation 3.00 6.16 0.00 0.00 0.00 9.20 1.23 0.00 P110481 2008 ECSEEAPL 5 DAMSAFETY 0.00 35.30 0.00 0.00 0.00 32.21 0.37 0.00 P107833 2008 SECONDARY AND LOCALROADS 0.00 20.00 0.00 0.00 0.00 14.40 -3.58 0.00 PO96643 2007 BERIS 5.60 3.70 0.00 0.00 0.00 9.48 3.84 0.00 PO96263 2007 LAND ADMIN & MGMT PROJ 19.96 15.00 0.00 0.00 0.00 31.44 4.38 0.00 PO78949 2007 TRANSPORT 20.00 5.00 0.00 0.00 0.00 10.55 2.14 0.00 P100273 2006 AVIAN FLU - AL 0.00 5.00 0.00 0.00 0.00 3.33 2.33 0.89 PO82814 2006 HEALTHSYST MOD 0.00 15.40 0.00 0.00 0.00 13.50 6.84 3.31 PO78933 2006 EDUC EXCEL& EQUITY 0.00 15.00 0.00 0.00 0.00 12.24 5.41 0.00 PO90656 2005 ECSEEAPL2 (ALBANIA) 0.00 27.00 0.00 0.00 0.00 26.68 17.52 0.00 PO86807 2005 COASTAL ZONE MGMT (APL #1) 0.00 17.50 0.00 0.00 0.00 13.26 12.20 0.00 PO82375 2005 NATURAL RES D E W 0.00 7.00 0.00 0.00 0.00 3.94 2.51 0.00 PO82128 2004 WATER RES MGMT 0.00 15.00 0.00 0.00 0.00 2.59 0.48 0.00 PO77526 2004 POWER SECTORGENER & 0.00 25.00 0.00 0.00 0.00 12.73 12.45 12.48 RESTRCT`G PO41442 2003 MUNW A T E W 0.00 15.00 0.00 0.00 0.00 1.40 -1.06 0.00 PO55383 2001 SOC SERV DEVT 0.00 10.00 0.00 0.00 0.00 2.46 0.40 0.40 Total: 48.56 237.06 0.00 0.00 0.00 199.41 67.46 17.08 ALBANIA STATEMENTOF IFC's Heldand Disbursed Portfolio InMillions ofUS Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic. 2005 FusheKruje 30.00 0.00 0.00 0.00 30.00 0.00 0.00 0.00 2002 INSIG 0.00 0.00 6.23 0.00 0.00 0.00 6.22 0.00 2000 NCBank 0.00 2.00 0.00 0.00 0.00 2.00 0.00 0.00 1999 Procredit ALB 0.00 0.98 0.00 0.00 0.00 0.98 0.00 0.00 2003 Vodafone Albania 17.83 0.00 0.00 3.70 17.83 0.00 0.00 3.70 Total portfolio: 47.83 2.98 6.23 3.70 47.83 2.98 6.22 3.70 ApprovalsPendingCommitment FY Approval Company Loan Esuity Quasi Partic. 2002 Savings Bank 0.00 0.02 0.00 0.00 Totalpendingcommitment: 0.00 0.02 0.00 0.00 56 '-- ALBANIA Privatization of the Power Distribution System Operator Annex 12: Country at a Glance Europe8 Lowar- POVERTYand SOCIAL Central mlddle- Albania Asla Income Developmentdlamond' 2007 Population,mid-year (millions) 3.2 445 3,437 GNIper capita (Atlas method, US$) 3,290 6,052 1,887 Life expectancy GNI (Atlasmethod, US$billions) 10.5 2,694 6,485 Average annual growth,200147 Population(%) 0.5 0.0 1.1 Laborforce (%) 1.1 0.5 1.5 Gross primary Most recentestimate(latestyear available,200147) capita enrollment Poverty (% ofpopulation belownationalpoverty line) 25 Urbanpopulation (% of totalpopulation) 46 64 42 Lifeexpectancyat birth (years) 76 69 69 Infant mortality(per 1,000 livebirths) 15 23 41 Childmalnutrition(% of childrenunder 5) 25 Access to improvedwater source Access to an improvedwater source (% ofpopulation) 97 95 86 Literacy(% ofpopulationage 15+) 99 97 89 Gross primaryenrollment (% of schoolage population) 105 97 111 -Albania Male 106 98 112 __Lower-middieincomeorom Female 105 96 109 KEY ECONOMICRATIOSand LONG-TERMTRENDS 1987 1997 2006 2007 Economlcratlo.9 GDP (LIS$6iilionsJ 2.2 2.2 9.1 10.6 Gross capitalformationIGDP 28.4 16.8 25.0 26.6 Exports of goods and servicesIGDP 15.5 10.5 25.1 27.2 Trade Gross domesticsavingsiGDP 28.3 -9.5 1.o 0.2 Gross nationalsavingsiGOP 28.3 4.9 17.4 17.3 T Current account balancdGDP -12.4 -7.2 -9.0 Domestic Capital Interest payments1GDP 0.3 0.3 Total debUGDP 23.4 25.7 savings formation Total debt servicelexports 4.4 3.4 Presentvalue of debvGDP 19.9 I Presentvalue of debvexports 46.9 Indebtedness 1987-97 199747 2006 2007 2007-11 (averageannualgrowth) GDP -1.9 6.3 5.0 6.0 6.1 -Albania GDP per capita -1.7 5.9 4.4 5.7 5.0 -Lower-middle-incomegroup Exportsof goods and services 15.6 19.9 5.2 7.0 6.1 STRUCTURE of the ECONOMY Iga7Igg7 *Oo6 2007 Growth of capital and GDP (%) (% of GDPJ Agriculture 33.2 33.6 Industry 45.8 18.7 Manufacturing .. 13.3 Services 21.0 47.7 Householdfinal consumptionexpenditure 62.0 98.7 90.1 90.3 General gov't final consumptionexpenditure 9.6 10.8 8.9 9.5 Importsof goods and services 15.6 36.7 49.2 53.5 -GCF +GDP (averageannual growthJ 1987-97 199747 2o06 IGrowthof exports and Importa(%) I Agnculture 4.5 2.0 Industry -11.1 8.0 Manufactunng .. 6.7 SeMces -0.2 8.0 3.5 5.8 Householdfinal consumptionexpenditure 2 6 8 5 General gov't final consumptionexpenditure -11 3 0 5 2 Gross capitalformabon 216 125 124 126 -Exports +Imporb Imports of goods andsemces 179 173 7 8 209 Nota 2007 data are preliminaryestimates This tablewas producedfrom the DevelopmentEconomics LOB database. *The diamonds show four keyindicatorsin the country(in bold) comparedwith its incomegroup average if data are missing,the diamondwll be incomplete 57 Albania PRICES and GOVERNMENT FINANCE 1987 1997 2006 2007 Inflation (%) Domestic prices I (%change) Consumer prices 33.2 3.0 3.0 ImplicitGDP deflator 0.0 0.9 2.0 0.7 Government finance (%of GDP,includescurrentgrants) I Current revenue 49.2 18.3 25.3 26.9 02 03 04 05 OB Current budgetbalance 23.7 -8.8 2.4 2.1 -GDPdeftator Overallsurpius/deficit -0.1 -3.2 4.3 --+--CPI TRADE 1987 1997 2006 2007 (US$millions) Export and import levels (US$ mlll.) Totalexports (fob) 311 259 789 1,142 4.000 T Agriculture 34 50 50 Mineral products 8 8 5 8 5 3,000 Manufactures 75 a05 1,144 Total imports (cif) 316 694 2.895 3.570 2,000 Food I77 486 553 1,000 Fuelandenergy 12 266 303 Capitalgoods 272 1 I 977 1,290 0 Exportpriceindex(2000=1)0) 258 253 206 01 02 03 04 05 06 07 Importpriceindex(2000-WO) 164 140 142 miports mknparts Terms of trade (20OO=WO) 96 lr) 145 BALANCE o f PAYM ENTS 1987 1997 2006 2007 (US$mi/lions) Current account balance to GDP (%) Exportsof goods andservices 334 222 2,283 2,805 0 Imports of goods andservices 336 809 4,472 5,527 Resource balance -2 -586 -2,189 -2,723 2 Net income 0 50 253 288 4 Net currenttransfers 265 1,280 1,481 6 Currentaccount balance -272 -656 -954 Financingitems (net) 312 736 1055 -8 Changesinnet reserves -12 -40 -80 -r)l '-10 Memo: Reserves includinggold (US$ millions) 339 1,332 1420 Conversionrate (DEC,/ocal/US$) 8.0 146.7 98.5 90.5 7 EXTERNAL DEBT and RESOURCE FLOWS 1987 1997 2006 2007 (US$ millions) Composition o f 2006 debt (US$ mill.) Total debtoutstanding anddisbursed 515 2,340 IBRD 0 0 6 IDA 148 729 803 Total debtservice 24 0 2 IBRD 0 O 0 IDA 1 r) 11 Composition of net resourceflows Official grants 75 147 F 107 Official creditors 46 121 Private creditors -1 -11 Foreigndirect investment (netinflows) 48 325 Portfolio equity(net inflows) 0 0 WorldBank program Commitments 30 46 70 A - E- Bilaterd Disbursements 29 46 54 B .IBRD IDA D Other mltilatsral - F- Private Principalrepayments 0 5 6 C-IMF G Short-tert - Netflows 19 41 48 Interest payments 1 6 6 Nettransfers 18 35 42 Note:This tablewas producedfrom theDevelopment Economics LDB database. 9/24/08 58 US$ rnillions) nports ofgoods and tesource balance .let income let ciirrent transfen ALBANIA Privatizationof the Power Distribution SystemOperator Annex 13: Maps Y d s e P:MLBANIAENERGnGENERALMLBANIA-PRG-P ~~~~WADMASTERCOPY~-~-~OO~.~OC 11 04/09/20093:35:00PM 59 IBRD 36849 18°30' 19°00' 19°30' 20°00' 20°30' 21°00' CROATIA MONTENEGRO 42°30' To Prizren Valbona BeliDrim 42°30' S E R B I A To Podgorica Bajram Han i Hoti Curri Fierza Drin Koplik Lake Krume Shkodėr Laq i Koman Laq i Ligeni i RENC te Dejes Koman Fierzes Kalimash Shkodėr Pukė Farrez Gjegjan 42°00' V.Dejes 42°00' Buene Bushat SPAĒ Zall-Rec ALBANIA Shėngjin Lezhė Rubik PRIVATIZATION OF THE Rrėshen Kurbnesh DriniZi Shkopet POWER DISTRIBUTION SYSTEM Peshkopi Shutri F.Kuqe Laē Ulza OPERATOR PROJECT Burreli Vojnik Mamurasi Suē Krujė Bulqize 41°30' Fushė Krujė EXISTING TRANSMISSION LINES: 41°30' 400 kV F Y R Vorė 220 kV Shijak U.Trakt. Crni Drim 110 kV or 150 kV Shkozet Selite MACEDONIA Durrės HYDROPOWER DAMS TIRANA EXISTING SUBSTATIONS IBE Kavajė Librazhd SELECTED CITIES Krrabė Fiber NATIONAL CAPITAL Elbasan 1 Shkumbin Elbasan 2 RIVERS Peqin Elbasan Prenjas INTERNATIONAL BOUNDARIES K.Metal. Lake Belsh Cėrrik Ohrid 41°00' 41°00' Lushnje To Oher 0 10 20 30 40 50 Kajan Guri Kuq Lake KILOMETERS Pogradec Prespes Gramsh Kuēovė A d r i a t i c Fier Seman Devoll Marinzė Uznovė Maliq Vjose Patos Berat S e a Kafaraj Zemblak Ballsh Korēė Bilisht Selenice Osum 40°30' 40°30' Vlorė 18°30' Mavrovė To Kardhja 10° SWEDEN 20° 30° Ersekė RUSSIAN Krahes Kelcyrė DENMARK LATVIA Baltic FED. Sea LITHUANIA Memaliaj RUSSIAN Pėrmet FED. BELARUS NETH. POLAND GERMANY Vjose GREECE 50° LUX. Gjirokastėr CZECH UKRAINE REP. FRANCE SLOVAK REP. 40°00' 40°00' MOLDOVA SWITZ. AUSTRIA HUNGARY Delvinė SLOVENIA CROATIA ROMANIA Sarandė Bistrice Kakavija This map was produced by the Adriatic BOSNIA AND HERZEGOVINA Map Design Unit of The World Bank. SERBIA Black The boundaries, colors, denominations ITALY Sea BULGARIA Sea and any other information shown on this MONTENEGRO map do not imply, on the part of The Area of map FYR MACEDONIA World Bank Group, any judgment on the legal status of any territory, or any 40° ALBANIA 40° GREECE Tyrrhenian 30° endorsement or acceptance of such Sea Aegean boundaries. Sea GREECE TURKEY 10° 20° 19°30' 20°00' To Igumenice 20°30' 21°00' MARCH 2009