Documentof The World Bank FOR OFFICIAL USE ONLY ReportNo.: 32686-PE PROJECTAPPRAISAL DOCUMENT ONA PROPOSEDLOAN INTHE AMOUNT OF US$50.0 MILLION AND A PROPOSEDGRANT FROMTHE GLOBAL ENVIRONMENT FACILITY TRUST FUND INTHE AMOUNT OF US$lO.O MILLION TO THE REPUBLICOF PERU FOR A RURAL ELECTRIFICATIONPROJECT FEBRUARY7,2006 Finance,Private Sector and Infrastructure Department Bolivia, Ecuador, Peru and Venezuela Country ManagementUnit Latin America and the CaribbeanRegion This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization CURRENCY EQUIVALENTS (Exchange Rate Effective 02/07/06) CurrencyUnit = Soles 3.31 Soles = US$1 US$ = S D R l FISCAL YEAR January 1 - December31 ABBREVIATIONS AND ACRONYMS ADINELSA Administration Office of Electric Infrastructure CAS Country Assistance Strategy CONAM National Council for the Environment CONATA National Council for Taxation DEP Executive Office for Projects DGE General Office o f Electricity EA EnvironmentalAssessment EMPs EnvironmentalManagement Plans ERR Economic Rate o f Return ESMAP Energy Sector Management Assistance Program FIRR Financial Internal Rate o f Return FONAFE National Fundfor Financing o f the Entrepreneurial Activity o f the State FONCODES National Fundfor Compensation and Development FONER Fundfor Rural Electrification FOSE Fundfor Social Compensation o f Electricity FMRs FinancialManagement Reports GEF Global EnvironmentalFacility GoP Government o f Peru IADB Inter American Development Bank IBRD International Bank for Reconstruction and Development INEI National Institute o f Statistics and Information-Technology IPDF Indigenous Peoples Development Framework ISDS Integrated Safeguards Data Sheet MEF Ministry o f Economy and Finance MEM Ministry o f Energy and Mines NGOs Non-Governmental Organizations N P V Net Present Value OSINERG Supervisory Commission for Energy Investment PDC Project Directory Committee PEU Project Executing Unit PID Project Information Document PPIAF Public-Private Infrastructure Advisory Facility P V Photovoltaic SA Special Account SIL Specific Investment Loan SNIP National System o f Public Investment SOE Statements o f Expenses TA Technical Assistance UNDP United Nations Development Program UNFCCC UnitedNations Framework Convention on Climate Change VAD Value Added for Distribution WB World Bank Vice President: Pamela Cox Country ManagedDirector: Marcel0 Giugale Sector Director: Makhtar Diop Sector Manager: Susan G. Goldmark Task Team Leader: Susan V. Bogach I Demetrios Papathanasiou PERU RuralElectrification CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE ................................................................. 1 1. Country and sector issues.................................................................................................... 1 2. Rationale for Bank involvement ......................................................................................... 2 3. Higher level objectives to which the project contributes .................................................... 2 B. PROJECT DESCRIPTION ................................................................................................. 3 1. Lending instrument ............................................................................................................. 3 2. Project development objective and key indicators.............................................................. 4 3. Project global environmental objective and key indicators ................................................ 4 4. Project components ............................................................................................................. 4 5. Lessons learned and reflected inthe project design............................................................ 8 6. Alternatives considered and reasons for rejection.............................................................. 9 C. implementation .................................................................................................................... 10 1. Partnership arrangements.................................................................................................. 10 2 . Institutional and implementation arrangements., .............................................................. 11 3. Monitoring and evaluation o f outcomes/results ................................................................ 12 4 . Sustainability and replicability ......................................................................................... 12 5. Critical risks and possible controversial aspects............................................................... 13 6. Loan conditions and covenants ......................................................................................... 14 D. APPRAISAL SUMMARY ................................................................................................. 15 1. Economic and financial analyses ...................................................................................... 15 2. Technical........................................................................................................................... 16 3. Fiduciary ........................................................................................................................... 16 4. Social ................................................................................................................................. 17 5. Environment...................................................................................................................... 17 6. Safeguard policies............................................................................................................. 18 7. Policy exceptions and readiness........................................................................................ 19 Annex 1: Country and Sector Background ............................................................................. 20 Annex 2: Major RelatedProjects Financedby the Bank and/or other Agencies ................29 Annex 3: Results Framework and Monitoring ....................................................................... 30 Annex 4: Detailed Project Description ..................................................................................... 34 Annex 5: Project Costs............................................................................................................... 42 Annex 6: Implementation Arrangements ................................................................................. 43 Annex 7: FinancialManagement and DisbursementArrangements ..................................... 51 Annex 8: Procurement Arrangements ...................................................................................... 59 Annex 9: Economic and Financial Analysis ............................................................................. 65 Annex 10: Safeguards Policy Issues .......................................................................................... 90 Annex 11: Project Preparation and Supervision .................................................................... 93 Annex 12: Documents inthe Project File ................................................................................ 95 Annex 13: Statement of Loans and Credits .............................................................................. 96 Annex 14: Country at a Glance ................................................................................................. 98 Annex 15: Incremental Cost Analysis .................................................................................... 100 MAP IBRDNo 33465 . PERU RURALELECTRIFICATION PROJECT PROJECT APPRAISAL DOCUMENT LATINAMERICA AND CARIBBEAN LCSFE Date: February 7,2006 Team Leaders: Susan V. Bogach / Demetrios Country Direcior: Marcel0 Giugale Papathanasiou Sector Managerhlirector: Sectors: Power (85%); Renewable energy (15%) Susan G. GoldmarWMakhtar Diop Themes: Rural services and infrastructure Project ID: PO90116 Environmental screening category: Partial Lending Instrument: Specific Investment Loan Assessment Safeguard screening category: Limited impact Global Supplemental ID: PO90110 Team Leader: Susan V. Bogach / Demetrios Lending Instrument: Specific Investment Loan Papathanasiou Focal Area: C-Climate change Sectors: Renewable energy (100%) Supplement FullyBlended?: Yes Themes: Rural services and infrastructure(P) Source Local Foreign Total BORROWEWRECIPIENT 46.30 5.15 51.45 INTERNATIONALBANKFOR 12.50 37.50 50.00 RECONSTRUCTIONAND DEVELOPMENT GLOBALENVIRONMENTFACILITY 4.00 6.00 10.00 ENTERPRISES 20.10 13.00 33.10 Total: 82.90 61.65 144.55 Responsible Agency: Ministryo f Energy and Mines Av. Las Artes Sur 260, SanBorja, Lima 41 Lima, Peru ?Y 2007 2008 2009 2010 2011 2012 h u a l 3.10 5.60 10.90 13.10 14.10 3.10 kmulative 3.10 8.70 19.60 32.70 46.80 50.00 7Y 2007 2008 2009 2010 2011 2012 2nnual 0.50 2.30 2.00 2.00 2.70 0.50 Jumulative 0.50 2.80 4.80 6.80 9.50 10.00 Project implementationperiod: Start July lst, 2006 End: June 30,201 1 Expectedeffectiveness date: July 1st, 2006 Exnected closing.date: December 31st. 2012 Does the project depart from the CAS incontent or other significant respects? Ref: PAD A.3 [ ]Yes [XINO Does the project require any exceptions from Bank policies? Ref: PAD D.7 [ ]Yes [XINO Have these been approved by Bank management? ]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 C.5 rL vivaerL iX T ~ AJI 1i'lw Does the project meet the Regional criteria for readiness for implementation? Ref: PAD D.7 [XIYes [ 3 N o Project development objective Ref: PAD B.2, TechnicalAnnex 3 The objective o f the proposed Project would be to increase access to efficient and sustainable electricity services inrural areas o f Peru. Global Environment objective Ref: PAD B.2, TechnicalAnnex 3 The project's global environmental objective i s to achieve reduction o f greenhouse gas emissions through use o f renewable energy inrural areas for provision o f electricity. Project description [one-sentence summary of each component] Ref: PAD B.3.a, TechnicalAnnex 4 The proposed Project has five main components: (a) investment inrural electrification sub-projects by private and state-owned enterprises, supported by central government subsidies, to provide new electricity connections for rural households, businesses and public facilities, usingboth conventional grid electricity or renewable energy systems that would serve dispersed or remote populations; (b) technical assistance to catalyze private sector participation and create capacity for a demand driven approach for rural electrification (projects proposed by service providers incoordinationwith local communities and governments), as well as particular promotion o f renewable energy; (c) a pilot program to promote productive uses; (d) a small hydro generation financing facility to provide project financing, duringthe construction and initial operationperiod, for grid-connected plants; and (e) project management. Which safeguard policies are triggered, ifany? Ref: PAD 0.6, TechnicalAnnex 10 The safeguard policies that apply are: Environmental Assessment, Involuntary Resettlement, Indigenous Peoples, and Safety o f Dams. Significant, non-standard conditions, if any, for: Ref: PAD C.7 Boardpresentation: None Loadcredit effectiveness: There will be a single effectiveness condition o f adoption o f the OperationalManualby MEMand dated covenants as follows: 1. appointment o f external financial auditors within three months; ii. aSupremeDecreecreatingtheProjectDirectoryCommitteewithinthreemonths; iii. evidencethatanadequatefinancialmanagementsystemhasbeencreatedwithinthreemonths; and iv. appointment o f procurement auditors within six months. Disbursement conditions will include: i. AdministrativeFinancialAgreementestablishedforruralelectrificationsubsidyfunds and contracts inplace for key staff o fthe PEU(Component 1); and ii. AdministrativeFinancialAgreementestablishedandFundManagerservicescontractedfor Small Hydro GenerationFinancingFacility, Independent Investment Committee established (Component 4) A. STRATEGIC CONTEXT AND RATIONALE 1. Country and sector issues More than six million people inthe predominantly poor rural areas o f Peru do not have access to electricity. At about 30% coverage, this i s one o f the lowest rural electrification rates in Latin America. Together with scarcity of other infrastructure services, lack o f electricity results in highcosts for basic energy services, a lower quality o flife, poor medical care and education, and limited opportunities for economic development. The incidence of poverty in rural areas highlightsthe importance o f investingin provision o f basic infrastructure such as electricity, as part o f the national rural development agenda. Rural electrification in Peru, after the power sector reform o f the early nineties, has been limited to direct investment by the central government. The existing framework has not leveraged potential additional hnds from communities, regional governments, or the service providers. Electricity distribution companies hold concession areas concentrated in small areas around urban centers, with an obligation to meet service requests only within 100 meters o f the existing network. To expand coverage, the Government o f Peru (GoP) has been spending, in the last ten years, on average US$40-50 million per year for electrification investments through the public sector. Investments were carried out through social funds (e.g. FONCODES) and more importantly, by the Executive Office for Projects (DEP), a division o f the Ministry o f Energy and Mines (MEM). DEP plans, designs and constructs projects. Once the construction phase i s completed, rural electricity systems are turned over for operation either to state-owned distribution companies, or to a specially created state-owned asset-holding company that manages the systems under operation contracts with state-owned companies, or municipalities. The current model has a number of acknowledged limitations. Several attempts have been made to change the existing institutional and legal framework for rural electrification. Two laws have been passed by Congress but not implemented in recent years, because o f conflicts with provisions o f other laws (Law for Electrification o f Rural and Isolated or Frontier Areas in 2002, and Law to Regulate the Promotion o f Private Investment inRural Electrification in 2004). Both initiatives, while incomplete, contained a number o f positive elements, including incentives for private investment, decentralized planning, and the proposed creation of a Rural Electrification Fund. Peru recently reiterated its commitment to reduce the electrification gap, aiming to increase rural coverage from 30% to 75% by 2013.2 To help achieve these goals, the GoP aims to develop a new rural electrification framework that would increase economic efficiency in the sector and attract broader participation and financing from communities, regional governments and electricity service providers. Such a framework would need to: (a) encourage planning and implementation of projects in a demand-driven, decentralized manner; (b) introduce specific regulations to ensure the economic and financial viability o f projects in rural areas; (c) create incentive mechanisms for rural electrification investments by existing and new electricity service Ofthe 9.4 million people living in rural areas of Peru in 2002, 78% were poor and 5 1% were extremely poor (compared to 42% and 10% for urban areas). See the Rural Electrification Plan of 2004. This i s estimated by MEM to require about US$860 million (US$86 million annually). 1 providers; and (d) expand the use o f new technologies to serve remote populations, especially renewable energy. The World Bank i s assisting MEM, through the Public Private Infrastructure Advisory Facility (PPIAF), to prepare proposals to reform the Rural Electrification Sector in Peru. Under this assistance, a new general framework for rural electrification was prepared in January 2005, "Propuesta para un Nuevo Marco General para la Electrificacih Rural en el Peru." To provide incentives for investment in rural electrification, it was proposed in the general framework document to create a Fund for National Rural Electrification, which would be an entity specifically created to manage the mobilization, management and disbursement o f funds for rural electrification. The Fundwould also support productive uses promotion campaigns. The general framework i s being used to assist preparationo f a model law for rural electrification. 2. Rationale for Bank involvement There are complex and interwoven issues that need to be addressed in introducing a new decentralized framework for rural electrification. Under this approach, electrification will be driven by communities, local and regional governments, and electricity providers to replace the current centralized provision. The proposed Bank and Global Environment Facility (GEF)- assisted Project would demonstrate key elements o f the proposed approach for rural electrification. The Bank would leverage its ongoing support to decentralization in Peru and exploit its comparative advantage in projects that use public-private service models for infrastructure services, as well as its experience with rural electrification and renewable energy. The proposed Project would function under the existing legal framework, in parallel with the development o f legal and regulatory instruments. GEF participation would support full integration o frenewable energy options, including support for small and mini hydro grids, solar and wind systems into all activities o f the proposed project and the future legal and regulatory framework. Renewable energy options are likely to be cost effective in many jungle and highland areas o f Peru, where populations are remote and/or dispersed. Where electricity demand and capacity to pay are low, minimum service packages would be considered to provide power to schools, health clinics and other public facilities. 3. Higher level objectives to which the project contributes The Bank's participation in the proposed project would support the objectives of employment generation, access to basic services and decentralization as set out in the Country Assistance Strategy (CAS), and discussed by the Board on December 7, 2004. With expansion of electricity service, the proposed project intends to improve the quality o f life in rural areas and, in coordination with the productive uses promotion program, new opportunities for commercial and agro-industrial activities. The Project would aim not only to provide electricity service to rural households and businesses that do not have access to modern energy services, but also to introduce an approach to rural electrification that would result inmore efficient provision o f rural electricity services and higher leveraging o f subsidies o f the central government with funds from electricity service providers, regional governments and local communities. The result would be increased access to electricity service in areas currently without service, and provision o f more 2 efficient and sustainable rural electricity services. The capabilities of regional and local governments to identify, plan and realize rural electrification projects would also be increased. The Project i s consistent with GEF Operational Program Number 6, "Promoting the Adoption o f Renewable Energy by Removing Barriers and Reducing Implementation Costs". Inthe Project, IBRD and GoP funds would provide minimum capital cost subsidies necessary to catalyze investments in rural electrification. Subsidies would be available to projects for grid extension or off-grid systems, including renewable energy. GEF support would be made available to fully integrate renewable energy into the Project. The GEF would provide for: (a) creation o f specific norms and regulations for renewable electricity provision, as well as capacity building o f all participants to develop and propose renewable energy projects (strategic priority CC-3); (b) the creation o f a small hydro generation financing facility that would provide bridge financing to cover the construction period o f small hydropower plants connected to the grid (strategic priority CC-2); and (c) the pilot program for productive uses o f electricity in areas that would increase income generation opportunities to rural communities using renewable energy (strategic priority cc-4). The GoP is taking important actions to tackle some of its environmental problems. TheNational Council for the Environment (CONAM) was established in 1994, as an autonomous body within the Presidency o f the Council o f Ministers. Its mandate i s to propose, coordinate, manage and evaluate national environmental policy. The overall mission o f CONAM is to conserve environment and take advantage o f natural resources in coordination with the public sector and civil society in order to contribute to the sustainable development of the country3. Peru signed the UnitedNations Framework Convention on Climate Change (UNFCCC) inMay of 1992, and the "Acuerdos Marrakech" and "Plan de Acci6n de Buenos Aires" in 2001. Peru has also ratified the Kyoto Protocol Agreement, while a number o f projects have been recently developed with World Bank assistance under the Clean Development Mechanism. CONAM also has biodiversity, climatic change, air quality, solid waste, and environmental education programs. All of the above mentioned initiatives indicate the Peruvian Government's commitment to environmental sustainability. B. PROJECTDESCRIPTION 1. Lendinginstrument This fully blendedProject includes both a GEF grant and an IBRDloan. The lending instrument i s a Specific Investment Loan (SIL) implemented over a five-year period. This approach was decided taking into account the need for a substantial investment component in order to demonstrate a new approach to rural electrification in Peru. A five-year period was considered both necessary and sufficient to demonstrate the new approach, as well as to assist GoP to develop the necessary instruments to incorporate the approach into Peru's overall rural electrification program. CONAM website: http:llwww.conam.gob.pel 3 2. Project development objective and key indicators The objective o f the proposed Project would be to increase access to efficient and sustainable electricity services in rural areas o f Peru. The proposed Project would achieve this by: (a) investment in sub-projects to supply electricity services to about 160,000 currently unserved rural households, businesses and public facilities, such as schools and health clinics (serving about 800,000 people), usingboth conventional grid extension and renewable energy sources; (b) demonstration o f key elements o f a framework for electricity provision inrural areas o f Peru that would attract investment from private and public sector electricity providers, as well as national, regional and local governments; and (c) implementation o f a pilot program to increase productive uses o f electricity that would increase opportunities for income generation in rural areas. The key performance indicators would be the number o f new electricity connections, as well as increased productive use o f electricity intargeted rural areas (see Annex 3 for details). 3. Project global environmental objective and key indicators The project's global environmental objective i s to achieve reduction o f greenhouse gas emissions through use o f renewable energy in rural areas for provision o f electricity. The key global performance indicator i s avoided carbon dioxide emissions. Total estimated emission reductions from facilities installed during the project's life are estimated at 3.61 million metric tons o f COz, over the lifetime o f the systems. The long-term national impact o f this Project i s expected to be much larger than this number, as broad replication i s expected to occur through the establishment o f a national framework for rural electrification and the development o f financing for small hydroelectric projects. 4. Project components The proposed Project has five main components: (a) investment in rural electrification sub- projects by private and state-owned enterprises, supported by central government subsidies, to provide new electricity connections for rural households, businesses and public facilities, using both conventional grid electricity or renewable energy systems that would serve dispersed or remote populations; (b) technical assistance to catalyze private sector participation and create capacity for a demand driven approach for rural electrification (projects proposed by service providers in coordination with local communities and governments), as well as particular promotion o f renewable energy; (c) a pilot program to promote productive uses; (d) a small hydro generation financing facility to provide project financing, during the construction and initial operationperiod, for grid-connected plants; and (e) project management. Each o f these components i s described below (and inmore detail inAnnex 4): Rural Electrification Sub-projects to provide service to about 160,000 newly connected rural households, businesses, and health centers, schools and community centers (serving about 800,000 people). The Project would provide targeted subsidies to public and private electricity 4 service providers investinginrural electrification sub- project^.^ Service providers would include qualified existing and future electricity distributors (public and private), and other qualified enterprises. Rural electrification sub-projects are defined as projects to provide service to new customers inrural areas outside o f existing concession areas. Subsidies would make investments in electrification sub-projects financially viable and would leverage complementary financing from the electricity service providers, regional and local g o v e m e n t ~ . ~Sub-projects would compete for the subsidies in competitions held periodically. Service providers would present proposals for sub-projects, according to guidelines. The sub-projects would need to meet minimumcriteria such as an acceptable rate o f economic returnunder the SNIP system. Ifthere are more eligible sub-projects than funds, sub-projects would be selected for financing using the principal criterion o f minimum subsidy per connection. Possible types o f sub-projects would include: (a) sub-projects to increase connections outside the existing concession areas; and; (b) sub-projects to provide isolated communities with service through mini-grids (diesel, small- hydro or wind systems), or through individual household systems (solar). Itis estimated that about 20,000 ofthe rural connections to be financed under the program would be made to systems using renewable energy (about 12% of total), mainly small hydro micro- grids, solar photovoltaic householdsystems, or solar photovoltaic/dieselhybridgrid systems. In order to have a pipeline o f potential projects, MEM solicited from distribution companies proposals for potential sub-projects to be implemented in the first year o f the Project. The companies responded with 49 proposals for sub-projects. Technical, economic and financial appraisal o f these sub-projects has been conducted and indicates that 9 projects with a total estimated capital cost o f US$20.3 million and an average subsidy requirement o f US$457 per connection could meet the eligibility criteria o f the Project and could be selected for implementation in year one o f the Project (see Annex 9). (Estimated cost US$114.325 million: US$43.375 million IBRD, no GEF.) Technical Assistance for Rural Electrification. Technical assistance would be provided to support the implementation o f the proposed rural electrification approach including: (a) development of the institutional framework and regulations for rural provision o f electricity service, on- and off-grid; (b) capacity building for demand-driven and decentralized identification, planning and development of projects; (c) promotion o f private sector investment inrural electrification; and(d) renewable energy promotion. Activities would include: a. Development of institutional framework and regulations for grid-connected and off-grid rural electricity service, including renewable energy service provision, specifically designed Consumption cross subsidies would also be provided, separately, under the existing Fondo Social de Electrificacih(FOSE) scheme, to customers that use less than 100 kWhper month. The lack o f a legal framework for the direct provision o f investment subsidies, or the transfer o f funds or assets (and some taxation implications), i s the principal outstanding issue for private sector participation. In the case o f public companies, this situation could be solved by considering the subsidy as a capital infusion by the Government, or the transfer and holding o f assets by ADINELSA. In countries such as Chile and El Salvador, specific legal provisions have been adopted to overcome these problems and allow the Governments to provide these subsidies for rural public infrastructure. TA is underway and will be continued within the Project to obtain similar exemptions in Peru. In order to prevent inordinate delays in private sector participation, the fallback option o f proceeding through bidding o f concessions will be adopted within a year o f effectiveness if no private sector proposals have been financed under the Project (see Annex 4). 5 to improve the economic and financial efficiency o f the sector, including procedures for issuing rural concessions; guidelines for electricity systems design and construction appropriate for rural areas; norms for operations; procedures for calculating rural tariffs; and norms for rural quality o f service. b. Capacity building for identijkation and development of sub-projects that are effectively linked to regional development plans. The Project would strengthen the capacity o f electricity service providers to prepare and propose sub-projects. It would also strengthen the capacity o f regional and local governments to coordinate planning and management o f electrification projects with other rural development activities (especially those with substantial revenues from resource development). The Project would assist the selection o f appropriate, least-cost technologies --such as renewable energy-- to electrify remote areas, or regions with dispersed populations, where grid extension would not be economically viable. C. Promotion of private sector investment in sub-projects. This sub-component would catalyze private sector investment in sub-projects. It would include: development o f the legal framework and associated regulations to facilitate provision o f capital cost subsidies to private sector providers; promotion o f the electrification investment opportunities to potential private investors (e.g. mining companies and agribusiness); assistance to private investors to develop sub-project proposals; and, development o f bidding procedures and, bidding out o f specific sub-projects that could be attractive to the private sector. d. Promotion of renewable energy. This sub-component would focus on renewable energy for rural electrification and supply to the grid, especially using small hydropower, including activities such as: development o f appropriate policies and incentives; support for development o f MEM's capacity to promote and manage renewable energy; cost-sharing preparation o fproposals and feasibility studies for renewable energy investment projects; and carrying out technical studies such as resource assessments. (Estimated cost US$3.75 million of which US$O.75 million IBRD and US$2.5million GEF.) Pilot Program for Promotion of Productive Uses of Electricity. Electric power can result in productivity gains and economic growth, thus transforming the underdeveloped rural areas - if complementary elements for development such as market access, human and enterprise capacity, financial services, and resourceshaw materials are available. From a rural community or enterprise viewpoint, access and use o f electricity can contribute to a significant increase in income by reducingproduction costs, increasingefficiency and improving product quality. Currently, the use of electricity in rural areas o f Peru i s overwhelmingly dedicated to evening lighting. The electricity load curve o f rural systems presents a sharp peak for three to four hours (peak to base ratio inmany systems i s five to ten) which indicates significant under-utilization o f system resources and undermines the economic and financial viability o f rural electrification. The use o f electricity for productive activities would make better use o f the underutilized electricity assets and therefore enhance the viability o f electrification sub-projects. This component would support the removal o f key barriers to productive use o f electricity. Enterprises targeted would be those that currently use diesel power or other energy intensive farm and off-farm enterprises that could benefit from use o f electricity. The proposed approach i s one o f capacity building. It i s a marketing approach in the broadest sense - identifying target markets and segments; increasing awareness and skills, assisting potential productive users, user 6 groups and communities to identify opportunities, barriers and solutions; working closely with the electricity service suppliers to ease access; and facilitating access to other necessary services, including financing. Initially, about 4-6 areas would be targeted, with services extended to other regions during the five-year implementation period of this component. They could be either areas newly electrified by the project, or areas that already have had electricity service for some years. The target areas will be selected based on the following criteria: (i) load factor in the grids serving the area low due to underutilized capacity, and not due to supply side constraints; (ii) the electricity service company i s committed to support the promotion o f productive uses; (iii) presence o f significant potential energy intensive productive activities in farm and off-farm enterprises including artisans and rural industries that might benefit from a shift to electricity; (iv) existence o f basic infrastructure (i.e. transport, communications, finance); and (v) for the renewable energy-focused "market" segment, service areas predominantly supplied with renewable energy-based electricity. (Estimated cost US$3.95 million of which US$2.0 million IBRD and US$1.5million GEF.) Small Hydro Financing Facility: Peru i s a country with significant hydroelectric resources due to its geography (Andean mountain range) and climatic conditions. In addition, irrigation and water resources management projects have created civil engineering structures that present competitive hydroelectric generation opportunities for small-scale schemes. Through its carbon financing activities in the country, the World Bank has reviewed a`significant number o f privately sponsored small hydro schemes that would be viable and could provide least-cost provision o f electricity to the grid. Nevertheless, although the financial system inPeru i s quite liquid, local financial institutions are not experienced in project financing o f this type, and in general there i s no debt-financing available on a limited recourse basis. Project sponsors for small-hydro have to finance projects fully on equity, borrowing on balance-sheet, or pledging other assets for collateral. Given the shortage o f equity funds in the country and the inability to leverage equity with debt, financial closure for small hydro projects that present attractive returns at the project level has been difficult. This has been a significant barrier to investments in small hydro schemes. This project component would address the above barriers by usingGEF funds to leverage private equity and commercial debt financing for grid-connected small hydro generating plants that would sell power to the interconnected grid. The purpose o f the Small Hydro Financing Facility would be to assist in the financial closure o f small hydroelectric electricity generation plants (installed capacity less than 10 MW) on a project finance basis. The facility would provide `bridge-financing' for small hydro projects, i.e. loans, at commercial interest rates, assuming the risk and covering the period of construction and initial operation; after that period the loans would be refinanced by commercial banks. Beneficiaries o f the facility would be private companies that would invest in, own, and operate, such small hydro plants. (This small hydro financing facility would not finance connections or distribution systems). (Estimated cost US$l5.0million, of which US$5.0million GEF.) 7 projects; c. Promotion o fprivate sector investment 0.05 0.15 0.10 0.30 d. Promotion of renewable electricity 0.20 1.55 1.75 3. Pilot Program to Increase Productive Uses o f Electricity I 0.45 2.00 1.50 3.95 I1a. Technical assistance for marketing and business 0.35 1.50 1.00 2.85 development services b.DemandDrivenTA 0.10 0.50 0.50 1.10 4. Small Hydro Financing Facility 5.00 10.00 15.00 5. Project Management I 2.65 2.75 1.00 6.40 a. Project management and administration (procurement and 0.50 0.50 0.25 1.25 financial management) b.Technical unit to evaluate investment sub-projects 0.50 0.50 0.25 1.25 c. Monitoring and evaluation unit, including safeguards 0.40 0.50 0.50 1.40 d. Administrative financial agreement fee 1.25 1.25 2.50 Total Baseline Cost (excludinEt front-end fee and unallocated see 51.45 48.875 100 33.10 143.425 5. Lessons learned and reflected inthe project design The Project builds on the Bank's extensive experience in rural electrification. Many o f the lessons documented in the Bank's 1994 study o f rural electrification in Asia6 are still valid and have been built into the Project. Recent rural electrification projects by the World Bank and others were examined, in Argentina, Bolivia, Chile, Ecuador, Laos, Philippines and Vietnam. Experience from other Latin American countries that have successfully established similar approaches to rural electrification, including Chile, Ecuador, and El Salvador, was also used to prepare the project. Lessons learned and incorporated into the project include: (a) preparation should include a detailed estimate o f financial viability o f projects and amounts o f subsidy required, as well as a rigorous analysis o f benefits expected; (b) estimated costs o f supply should reflect generation costs at peak periods when rural demand largely occurs; (c) tariffs should be set high enough to cover the full costs o f generation and transmission at the medium voltage as well as the operation and maintenance costs at low voltage; (d) project design should include productive uses components to increase demand during the off-peak period and increase the economic impact o f projects; (e) selection o f sub-projects to be financed should be based on a simple, clear and transparent methodology; and (f) criteria for allocation o f subsidies should be technology neutral Rural ElectrificationinAsia: a Review o f World Bank Experience, June 30, 1994; Meeting the Challenge of Rural ElectrificationinDeveloping Nations: The Experience o f Successful Programs, ESMAP Report (2005). 8 and should assure that the least-cost technology, including renewable energy, i s used where most viable technically and economically. Other important lessons include the need for active participation o f communities, local and regional governments in both planning and implementation o f projects, especially their contribution o f financial resources. Experience has also shown the benefits o f demand driven identification and design o f projects, with communities proposing projects to the distribution companies, that then package and design sub-projects, based on clear and transparent criteria that are related to economic efficiency. In the absence o f an interested distribution company, the community, local governments, or private enterprises can propose projects to the fund for specific preparation and competitive biddingto interested sponsors. While renewable energy technologies are fully integrated into the Project from the start, GEF support has been included inorder to develop necessary institutional and regulatory requirements and processes, as well as build capacity o f all actors and provide data and technical assistance on resources and technologies. This i s to ensure that renewable energy technologies will take the place that i sjustified by their economic and technical characteristics. 6. Alternatives considered and reasons for rejection Exclusive Focus on Private Sector Participation. The two rural electrification laws passed inthe last four years were limited to promotion o f private investment in rural electrification. The approach proposed under those laws i s for MEM/DEP to identify and prepare potential rural electrification projects which would be bid out to private sector entities and awarded on the basis of least subsidy. The Project approach would instead provide subsidies to sub-projects developed and proposed by service providers, with projects competing for the subsidies. The onus i s on the service providers to identify, prepare and propose sub-projects to the fund, rather than having the sub-projects identified by a central authority and thenbid-out. Since commercially-managed, state-owned distribution companies are the most important actors outside o f Lima, the Project would encourage involvement in rural electrification projects by commercially-managed public enterprises as well as private enterprises. The Project would also promote the participation o f small private sponsors/concessionaires, ensuring long-term financial sustainability and adequate rate o f return on project equity contribution to these new rural electrification projects. Nevertheless, theoretical analysis and empirical evidence show that cost functions in electricity distribution exhibit important economies o f scale, increasing returns to scale and economies o f output and customer density.' Therefore, existing distribution companies, already serving relatively extensive territory with an established customer base, have a natural economic efficiency advantage in expanding their service to new areas. It i s likely that The costs of a distribution system are the costs o f building and operating and maintaining the system o f service lines, mains and transformers. These costs depend upon: (i) the total number o f customers served; (ii) maximum the demand on the system; (iii) the size o f the distribution area; (iv) the capacity of the transformers; (v) the length o f distribution lines; (vi) the total kWh sold; (vii) the price o f labor; and (viii) the price o f capital. Cost functions showing economies o f scale in the electricity distribution industry are well documented theoretically and in empirical research (see references in Annex 1). 9 most o f the new rural electrification project proposals will come from existing distribution companies. Approach of Competition Among Projects Proposed by Distributors. The approach proposed in the Project for provision o f subsidies with competition among projects proposed by electricity distributor companies i s now being used successfully in several countries, including Chile, Ecuador and El Salvador. These countries include those with private sector distribution companies (Chile and El Salvador) as well as public sector companies (Ecuador). Both Chile and El Salvador first tried a process of bidding out concessions, but after limited success they opted for the system o f competition among projects that i s proposed inthis Project. Exclusion of productive uses component. The pilot program for productive uses complicates the project. However, it is considered important to explore ways to maximize the development impact and enhance the economic and financial performance o f the project. GEF assistance i s sought to support promotion o f productive uses, for communities to be supplied with renewable energy. Inclusion of Activities in Other Sectors. The proposed project i s ambitious in that it attempts to introduce a new demand driven mechanism for provision o f subsidies to service providers rather than the centralized approach currently in place, where the MEM itself actually plans, designs, and constructs projects that are then transferred to others to operate. Because o f the challenges expected inimplementing a new framework, and its importance to the future development o f the sector, it was decided not to broaden the Project to include activities in other sectors. However, every effort will bemade to ensure coordination with other projects on the Bank and GOP side. C. IMPLEMENTATION 1. Partnershiparrangements Project implementation includes partnership among MEM, MEF and OSINERG (Supervisory Commission for Energy Investment) in a Project Directory Committee, which would approve the subsidies for sub-projects. Implementation also includes partnerships with banks, private firms and NGOs that will assist in implementing productive uses technical assistance activities, as well as with distribution companies and local and regional governments. Project preparation has been coordinated with: (a) the PPIAF-financed Technical Assistance on Design o f Enabling Framework for Public-Private Participation Models in Rural Electrification, which aims to develop a proposal for a new legal and regulatory framework for rural electrification; (b) an ESMAP assisted Rural Energy Survey conducted by MEM to support a strategy for rural electrification; (c) an earlier World Bank assisted study, Integral Strategy of Rural Electrification (Estrategia Integral de Electrijkacidn Rural) in November 1999; and (d) USAID'spast rural electrification program inPeru. During implementation, efforts would be made to leverage the Bank's other on-going and projects under preparation on rural infrastructure (roads, water) and rural and social development (indigenous peoples, Sierra rural development, health and education). In addition, the project will coordinate with the implementation o f the technical assistance and programmatic loans of 10 the World Bank for decentralization inPeru, as well as with other agencies such as GTZ, which are supporting activities inrural areas. One year overlap i s expected between this Project and the GEF-assisted UNDP Photovoltaic- Based Rural Electrification Project in Peru. The design o f this proposed Project has taken into account the experiences o f the UNDP Project and will coordinate closely and build on the remaining activities of that project. The UNDP Project will have developed experience with management models for implementation o f solar photovoltaic systems, as well as norms for P V systems and a GIS system with information on demand for electricity and the characteristics o f potential beneficiaries. 2. Institutionaland implementationarrangements The Project would be implemented over a five-year period. Project implementation would be guided by a Project Directory Committee, presided over by the Vice-Minister o f Energy and including the Vice Minister o f Economy and the President of the electricity regulatory commission, OSINERG. Final approval o f sub-projects would be by the Directory Committee. The Directory Committee would review the results twice per year, together with Bank supervision team. There would be a Project Executing Unit (PEU) in MEM that would include: (a) an administrative unit responsible for procurement and financial management; (b) a technical unit responsible for evaluation o f rural electrification sub-projects (including supervision o f compliance with safeguards requirements), as well as technical oversight o f the financial facility for small hydropower and the productive uses program; and (c) a monitoring and evaluation unit. An administrative financial agreement with abank would be established for the administrationo f the subsidies awarded to rural electrification sub-projects and the loans awarded under the small hydropower financing facility. Implementation arrangements for each component are described below and inmore detail inAnnex 6. Rural Electrzjkation Sub-projects. Rural electrification sub-projects would compete for subsidies. There would be periodic calls for sub-project submissions. Sub-projects would be proposed to the PEU by existing or future electricity service providers, in coordination with the communities and regional and local governments. The service provider would present a detailed sub-project proposal, and an estimate of the subsidy required, together with a commitment from the company and, if applicable, the regional or local government to provide the remaining financing o f the project. The technical unit o f the PEU would evaluate the sub-project, based on technical, economic and financial soundness and the selection criteria (principally minimum subsidy), and after reporting to the National System o f Public Investment (SNIP) proposes that it be accepted or rejected by the Directory Committee. The evaluation would be made using a methodology and benchmarks previously prepared by the PEU. Ifapproved to receive a subsidy, the service provider would conduct a bidding process acceptable to the Project, mobilize other financing and construct the sub-project. The subsidy would be paid in relation to satisfactory completion o fthe construction contract. Technical Assistancefor Rural Electrij'kation. This would be executed by the technical unit o f the PEU and carried out by national and international consultants. 11 Pilot Program for Productive Uses Component. The technical unit o f the PEU will have overall responsibility for implementing this component. The PEU would recruit a support services contractor to assist the PEU to assist in supervising and coordinating the work o f a number o f regionally-based consultants. Each regional consultant would be responsible to implement the component in its regional area of responsibility under the supervision o f the PEU. The PEU would select 4-6 departments or regions for support. The regional consultants would work collaboratively and build alliances with the critical facilitative services for credit, equipment supply, business development services, market linkages, etc. and development stakeholder organizations that already are available in the communities and, when necessary, mobilize the entry of additional ones. The regional consultants would also work closely with the local electricity service company to ensure that known issues are resolved in advance and that ones that arise duringthe campaign's implementation are resolved. Small Hydro Financing Facility. The facility will include an investment decision making function and a separate administrative financial agreement to handle the disbursement and recuperation o f specific project loans (lending "back-office" functions). A qualified company will be competitively selected to act as Fund Manager with responsibilities that will include: marketing and promotion o f the facility, preliminary screening o f project proposals, detailed evaluation and due diligence on projects, negotiation o f conditions and terms for specific loans and supervision o f investments. A separate three-member Investment Committee will be appointed by the Project Directory Committee o f the project to approve investments proposed by the Fund Manager. For approved investments, the disbursement and repayment o f loan will be handled through an administrative financial agreement with a qualified bank. 3. Monitoring and evaluation of outcomes/results Direct project output indicators will be measured by the PEU and reported semi-annually. Comprehensive monitoring and evaluation arrangements will be implemented, that are consistent with Bank and GEF guidelines and requirements for measurement and evaluation. A comprehensive and detailed national Rural Energy Survey was carried out by MEM supported by the Bank's Energy Management Assistance Program (ESMAP). The survey, carried out through the National Statistics Institute and international consultants, will provide important socio-economic data, which will be complemented by surveys to be carried out prior to the mid- term review and closing date o f the project. Such surveys will be particularly useful in estimating the socio-economic impact of the project. Local and regional governments, together with outreach by the PEU, will be used to monitor consumer satisfaction in sub-project communities. 4. Sustainability and replicability Sustainability. The Project's approach, which relies on electricity service providers to propose sub-projects, together with the use o f capital cost subsidies only, i s intended to ensure the sustainability o f the rural electrification sub-projects. After receiving the capital cost subsidy, the electricity service provider i s solely responsible for operation and maintenance o f the system. The Government's equity objectives would be implemented by incorporating the sub-projects 12 into the GoP's overall FOSE scheme, where small consumers (especially below 30 kWh per month) are cross-subsidized by other consumers. OSINERG has proposed to implement a tariff increase for rural projects, as well as to increase the tariff categories as required, to ensure that operation and maintenance as well as renovatiodreplacement expenses would be covered. Replicability. The Project demonstrates key elements of a new framework for rural electrification. In parallel to project implementation, the GoP i s preparing proposals for a new legal and regulatory fkamework, with assistance fiom the PPIAF. The replicability o f the Project ultimately depends, however, on the establishment o f a Rural Electrification Fund. A key challenge during implementation o f the Project will be to build consensus on a new mechanism to mobilize funds, such as a surcharge on generation, or reduction o f the use o f FOSE to cover only consumers o f less than 30 kWhper month and transfer o f the funds released to subsidies for increasing access to rural electrification. 5. Critical risks and possible controversial aspects RiskMitigation Measures ~ Risks RiskRating ~ Change inpolitical Consensus building activities among main actors in the commitment to Project sector, including MEM, MEF, FONAFE, OSINERG, approach regional governments, electricity service providers. All stakeholders have been keen participants in project preparation, including OSINERG, the distribution companies and FONAFE (the government holding S company for public enterprises). Regional and local governments are increasingly funding Rural Electrification and are expected to welcome the ability to leverage their funds through the Project. PPIAF support assisting consensus buildingon approach. Insufficient demand for sub- Distribution companies already presented 49 conventional projects, especially renewable grid extension projects. Project to provide guidelines and energy sub-projects TA to existing and future companies, including those from the private sector, during preparation and implementation to M increase their awareness and capacity for preparation o f conventional and renewable energy projects. Inadequate legal and The Project is designed to be implemented within the regulatory framework, existing legal framework. However, in order to improve especially for private sector efficiency and effectiveness o f private sector participation, participation TA is provided for development o f appropriate legal framework and regulation. This work builds on ongoing PPIAF assisted TA. M Agreement has been reached with OSINERG to create new tariff categories, if required, to ensure adequate coverage o f operation and maintenance, renovation and replacement costs. Inadequate institutional and GoP has consistently funded rural electrification at a level political support for rural o f US$40-50 million per year for the last 15 years. Interest electrification in the issue o f rural electrification in Congress is broad- M based, reflected by passage o f two laws on Rural Electrification in2002 and 2005. Changes to the distribution Project model would work equally well with privatized sector, e.g. privatization o f companies, as shown in Chile and El Salvador that have L existing distribution privatized distribution but have successfully used a similar 13 Risks RiskMitigationMeasures RiskRating companies or merging o f model to that proposed in the Project for rural several regional companies to electrification. form larger entities Public distribution companies IThe Project would finance about US$20 million in sub- I unable to mobilize their share projects-per year. The requirement for financing from any o f financing given company in any given year would be unlikely to exceed U S $ l million, which could be mobilized from their M own funds. This is within the capacity of distribution companies. FONAFE has confirmed willingness to include investments in the budgets o f distribution companies. Failure to create rural TA and support for consensus building on financing rural electrification fund electrification is included within project S Financial Institutions not re- Minimum requirement o f equity contribution (at 30%) financing small hydro plants would guarantee that asset value o f plant would be at about after construction and 140% o f debt refinancing needs. Interest rates charged for operation period the project would be commercial and higher than regular L corporate financing rates to provide incentives to all parties for refinancing Capacity constraints that may 1. highly qualified professionals in key positions (profiles prevent effective inthe Operations Manual) sFchonization of the ~ - ~ u a l2. highly qualified and experienced Financial Manager operating and Procurement (profile inthe Operations Manual) Plans and budgets, resulting 3. Technical assistance and capacity strengthening S in inadequate disbursements measures will be provided by the financial management and and flow o f funds. disbursement teams 4. Successful implementation o f the FM action plan. Overall Rating M S: Substantial; M:Moderate; L:L o w 6. Loan conditions and covenants Therewould be a single effectiveness condition o f adoption ofthe operationalmanualby MEM and dated covenants for: 0 appointment o f external financial auditors within three months; 0 a Supreme Decree creating the Project Directory Committee within three months; 0 evidence that an adequate financial management systemhas been created within three months; and 0 appointment o fprocurement auditors, within six months. Disbursement conditions would include: 0 Administrative financial agreement established for rural electrification subsidy funds and contracts for key staff inplace (Component 1). 0 Administrative financial agreement established, FundManager services contracted for Small Hydro Generation Financing Facility, and Independent InvestmentCommittee established (Component 4). 14 D. APPRAISAL SUMMARY 1. Economic and financial analyses Although the full results o f a survey conducted in July 2005 have yet to be fully evaluated, most o f the critical assumptions (such as average monthly consumption levels) have been tested against survey results and may be taken as firm. The benefit estimates based on Willingness to Pay (WTP) are derived from end-use data ffom the survey. The technical and cost assumptions for subprojects have been confirmed by a detailed assessment (involving extensive consultation with the distribution companies). A detailed report on economic and financial analysis documents the assumptions, results and methodology that are summarized inAnnex 9. The approach to the economic and financial analysis involved five steps: 1. Preliminary screening: The first step was to assess the 49 proposals submitted by the distribution companies to MEM in May 2005 for general economic and financial feasibility: this resulted inthe selection o f a short-list o f 16 sub-projects for more detailed analysis. 2. Detailed analysis o f the short-list, including comparison o f key assumptions (e.g. for monthly consumption per household) against the results o f the survey, and discussions with the distribution companies to verify technical assumptions. 9 projects passed the short-list analysis for all criteria (ERR>14%, financially sustainable at current tariff levels after the subsidy, maximum subsidy US$800/HH, minimum size o f 1000 HH). The estimated ERR of the accepted subprojects ranges from 21.7% - 59.1%, with an average o f 3 1.7%. 3. Extrapolation o f the initial sub-project results to the entire program (again using survey results, for example to assess the market size o f potential grid-based RE projects). The risk of not finding enough subprojects to consume US$92.4m in subsidy is found to be extremely small. 4. Estimate the ERR for the project as a whole. The aggregate ERR i s estimated at 23.8% (which i s lower than that estimated for the first group o f projects as a result o f more conservative assumptions for projects selected in subsequent years o f the program). 5. Comparison o f the proposed project against the project alternative (i.e. a continuation o f the existing approach to RE). We show that for equivalent funding, the new approach would electrify about 150,000 HH, as opposed to 100,000 HH under the existing MEM approach; with a 20% contribution from distribution companies, 175,000 could be electrified for the same cost. Tariff levels to be paid by customers are affordable when compared to previous expenditures, and would be made even more affordable to rural consumers through the cross-subsidies provided by the FOSE. It should be noted also that OSINERG proposes to raise the tariffs for category 5 (rural areas) in the next tariff revision. OSINERG has also proposed to put inplace additional tariff zones, as needed, in order to cover the full operating and maintenance costs o f rural electrification sub-projects An IncrementalCost Annex was prepared to show the with and without GEF Project case, and to demonstrate how barriers to renewable energy use would be removed by using GEF funds. By hlly integrating renewable energy into all project activities, it is expected that the project would 15 result in 20,000 connections o f households or business customers to electricity provided using renewable energy. Additionally, 30 MW o f grid-connected renewable energy generating capacity would be established. In total, an estimated 6.063 GWh o f electricity would be generated from renewable sources, reducing C02 emissions by an estimated 3.61 million tons over the lifetime o f the equipment installed. The estimated incremental cost per tons o f C02 emission reduction i s US$2.77. 2. Technical Peru already has inplace standards for rural electrification by extension o f the grid, based on the standards o f the National Rural Electricity Cooperative's Association from the USA. The Project i s expected to assist MEM to develop or modify the following: procedures for issuing rural concessions; norms for electricity systems design and construction appropriate for rural areas; norms for operations; procedures for calculating rural tariffs; and norms for rural quality o f service. The aim o f these changes would be to make rural service provision more financially and economically sustainable. Development o f above norms, guidelines and procedures would be done separately for rural electrification sub-projects involving grid-extension, isolated grids using diesel or renewable energy sources, and individual renewable energy systems. It would focus on increasing financial viability by ensuring flexibility for use o f low cost options. The Project would provide training to all stakeholders with respect to the revised norms. Successful development, adaptation and cost-effective implementation o f renewable energy technologies will be one o f the major challenges o f the demonstration subprojects o f this Project. Three main technologies are expected to emerge as cost-effective: hydro-based micro-grids, solar photovoltaic individual home systems; and renewable (hydro, solar)/diesel hybridmini-grids. 3. Fiduciary A financial management assessment has been undertaken in accordance with OP/BP 10.02 and the Guidelines for Assessment o f Financial Management Arrangements inWorld Bank Financed Projects, in order to determine whether the Borrower has or will have in place acceptable financial management arrangements prior to effectiveness, capable o f providing with reasonable assurance, accurate and timely information on the status o f the project in agreed reporting formats. Currently, the overall inherent and control risks have been assessed as moderate. More specifically, at the country and entity level the risks are moderate, while at the project level the risk profile is high. Inorder to mitigate the risks posed by the lack of an established PEU and of recent engagement with the Bank, the following actions will be required: (a) high quality coordination and fluid communication within the Project Executing Unit and between the Unit and the participating entities; (b) high quality annual operating and procurement plans; (c) high quality annual and semi-annual budgets; (d) strong internal controls; (e) clear flow o f funds schema; (f) sound inter-institutional agreements; (g) qualified and skilled professionals in key positions (profiles inthe Operations Manual); (h) a qualified and experienced Financial Manager (profile in the Operations Manual), (i) considerable degree o f technical assistance and capacity strengthening measures (to be provided by the financial management and disbursement Bank teams), and (g) successful implementation o f the FM action plan. 16 Similarly, a procurement capacity assessment was carried out at appraisal, together with detailed design o f the procurement arrangements o f the Project and a Procurement Plan for the first two years o f operation o f the Project. 4. Social A National Rural Energy Survey has been completed, sponsored by MEM and carried out by INEI (National Institute o f Statistics and Information Technology). The survey provides: (i) extensive data on consumption and expenditures o f energy in households with and without electricity; (ii) information to enable more accurate assessment o f potential consumption in sub- projects; (iii)estimates o f the consumer surplus from rural electrification; (iv) socio-economic information on income, social characteristics, attitudes and perceptions o f benefits that will serve as baseline information and be valuable to qualitatively evaluate the socio-economic benefits o f electrification. The Project i s expected to have positive social impacts through increased access to electricity among rural households. It i s expected that increased access to electricity would: (i) significantly improve the quality o f lighting, as well as disposable income o f rural households, since cost o f electricity would be less than alternatives (kerosene, candles, car batteries and dry cell batteries); (ii) increasedopportunitiesforhouseholdstoengageinincomegeneratingactivities;(iii) provide allow household membersto have more flexible working hours and work longer inthe evenings; (iv) improve the access o f the household to news, information and entertainment; and (v) allow children to study and adults to read inthe evening. 5. Environment Environmental impacts o f the Peru Rural Electrification Project are expected to be minimal given the type o f interventions planned under this project, which has the potential to be very positive environmentally due to the reduction o f COz emissions. The project includes provisions to ensure that potential impacts, including induced and cumulative impacts, are assessed and mitigated in accordance with the Bank's safeguard policies. Since the project will be supporting investments through a dedicated subsidy fund, an environmental screening criteridguidelines and management procedures have been prepared as part o f the project's environmental management framework. This framework will be used for screening all subprojects. The project's EA work has also addressed the institutional environmental management responsibilities and capacities, and has set forth enhancement provisions as needed to ensure that participating institutions have the capacity to address any environmental impacts associated with the project. The main stakeholders were consulted as a part o f the process o f the preparation o f EA. Additional consultations (rural communities) are planned during the implementation o f the project, as part o f the preparation o f EMPs. The EA was made available at the offices o f the Project Executing Unit (PEU) and in the World Bank's Infoshop by appraisal. Future EAs and EMPs will similarly be made available to the public. 17 6. Safeguard policies Safeguard Policies Triggered by the Project Yes N o Environmental Assessment (OP/BP/GP 4.01) [ XI [X 1 [I Natural Habitats (OP/BP 4.04) [I Pest Management (OP 4.09) [I [X 1 Cultural Property (OPN 11.03, beingrevised as OP 4.11) [X 1 [I [X 1 Involuntary Resettlement (OP/BP 4.12) [I Indigenous Peoples (OD 4.20, beingrevised as OP 4.10) [X 1 111 Forests (OP/BP 4.36) [I [ XI Safety o f Dams (OP/BP 4.37) [XI [I Projects inDisputed Areas (OP/BP/GP 7.60)* [I [ XI Projects on International Waterways (OP/BP/GP 7.50) [I [X 1 Environmental Assessment and Safety of Dams Policies Project interventions could trigger the environmental and the safety o f dams safeguard policies (OP 4.01 and OP 4.37), depending on the type o f interventions proposed in the specific subprojects designs. Although not likely, specific subproject proposals for small dams (<1Om) could be accepted under the project. To comply with these policies, the borrower has prepared an environmental screening framework and specific environmental guidelines that have been reviewed by the environmental safeguard specialist in the team, who has found them acceptable to the Bank. The environmental screening framework will be used for identifyingthe typology of each subproject proposal, while the environmental guidelines would serve for the preparation o f specific environmental management plans to be considered during construction and operation phases o f each subproject. Both the environmental framework and guidelines include specific provisions mandated by the Safety of Dams policy OP 4.37, i.e. the design and construction o f a new dam has to be supervised by experienced and competent professionals and requires the adoption o f certain dam safety measures for the design, bid tendering, construction, operation, and .maintenance o f the dam and associated works. Social Safeguard Policies The project could trigger the two social safeguard policies (OD 4.20 and OP 4.12), depending on site characteristics and specific subprojects designs. Because the project i s demand driven, the locations where it will be implementedwill not be knownbefore implementation begins. Inorder to comply with these policies and to avoid unnecessary adverse impacts as well as to ensure that the most poor and vulnerable people benefit from project implementation, the borrower has prepared two frameworks that have been reviewed by the social safeguard specialist in the team who has found them acceptable to the Bank: an Indigenous Peoples Development Framework (IPDF, see Annex 10) and a Resettlement Policy Framework (RPF, see Annex 10). * By supporting theproposedproject, the Bank does not intend to prejudice thefinal determination of theparties' claims on the disputed areas 18 The IPDF depicts the process and the principles by which Indigenous Peoples Development Plans would be prepared if the policy i s triggered due to its implementation in lands owned or usedby Indigenous Peoples inthe highlands and the upper selva regions, or whenever IP become beneficiaries o f the project. The IPDF provides an assessment o f the social, economic and cultural traits o f the Indigenous Peoples inthese regions as well as demographic information; and assess the impacts, both adverse and positive ones that the project might have in these communities. The IPDF has been submitted to a preliminary consultation. One consultation was held in the highland city o f Huancavelica, on July 20, 2005 with participants representing peasant communities, producers associations and local authorities. A second consultation was held inthe central upper selva, in the town o f Pichanaki on July 24, 2005 with participants representing indigenous communities, indigenous organizations and members o f the electrification district committee. These consultations have provided useful feedback regarding the kind o f productive activities that these communities would like to develop when having access to electricity (more information is available inAnnex 10). The framework identifies the Project Management Unit as the entity responsible for the preparation of IPDPs. This unit will include a social specialist responsible for all social issues within project management. A Resettlement Policy Framework for Rural Electrification Sub-projects and Small Hydropower Facilities has been prepared by the borrower in case the policy i s triggered due to civil works, rights o f way for transmission lines and use o f water for hydropower facilities. Due to the small sizes o f the required works it i s very unlikely that the policy will be triggered regarding physical displacement o f affected populations. It i s more likely though that the policy will be triggered due to land acquisition, rights o f way or water usage. Nonetheless, the RPF details the process, the criteria and the principles to be followed for the preparation o f site specific Resettlement Plans as required by the policy (more information i s available inAnnex 10). The framework identifies the Project Management Unit as the entity responsible for the preparation o f RAPSand the DGAAE as the unit within MEMresponsible for the supervision o f land acquisition, rights o f way and relationships with local communities. The frameworks were disclosed prior to appraisal in-country inthe Ministryo f Energy and Mines website as well as inthe Infoshop. 7. Policy exceptions and readiness The operation complies with all applicableBank policies. 19 Annex 1: Country and Sector Background PERU: RuralElectrification CountryBackground Peru has had four years o f sustained economic growth with an average growth o f 4%. The economic program o f the present administrationhas focused on maintaining macroeconomic stability, with the goal o f supporting a sustained recovery in economic activity and employment in a context o f low inflation and limited external vulnerability. Peru's economic performance i s likely to continue improving in the coming years, contingent on a favorable external environment. However, increasing economic globalization and the ongoing free trade agreements, continues to demand from Peru more dynamic, equitable, and sustainable growth. The recent economic growth has not yet had a significant effect on reducing poverty, but has stopped the worsening trend inpoverty that began during the recession o f the late 1990s, when the poverty rate increased by 7.5 percentage points between 1998 and 2001, Since then, the poverty rate has held steady at just over halfthe country's population, while the extreme poverty rate fell by almost 3 percentage points between 2001 and the end o f 2003. Poverty remains more severe in rural areas than in urban areas, and is 20 percentage points higher in the sierra (highlands) and the selva (jungle) than on the coast. For example, in2003, 73% o f rural inhabitants lived inconditions ofpoverty8,Likewise, more than six million people inthe predominantly poor rural areas of Peru do not have access to electricity. The incidence of poverty inrural areas highlightsthe importance o f investing inprovision o f basic infrastructure such as electricity, as part o f the national rural development agenda. The government strategy to reduce poverty i s organized around three central objectives, which form the framework for the CAS: (i) competitiveness and employment generation; (ii) and social justice, equity including access to health, education, culture and basic services; and (iii) institutionality, creating an efficient, transparent and decentralized state. Key to these objectives i s the presence of an economic program and institutions ready to buffer the impact o f shocks, and thus ensure that poverty reduction gains are not lost, while addressing structural sources o f poverty. Inlight o f the highdollar indebtedness o f the economy, government i s working to strengthen fiscal balances through controls on expenditures, improved debt management, and increased tax collections, as well as initiating a national competitiveness program for addressing barriers to private sector growth and increasing exports. However, a lack of government resources and the GOP's fiscal austerity measures present challenges in achieving these goals. Energy Sector Background In1992, a new legal and regulatory framework was put inplace for the energy sector (electricity and hydrocarbons), in line with Mr. Fujimori's first administration thorough economic reform. Under the reform, it was planned that the private sector would be the principal actor and the public sector would concentrate its activities inregulation and supervision. An ample privatization program was established to transfer controlling ownership o f public enterprises to the private sector. * Herrera,Javier (2004) "La Pobreza en el Ped, 2003", Institutde Recherche pour le DCveloppement (1RD)-Instituto Nacional de Estadistica e Informatica (INEI), Lima. *Poverty i s defined by Basic Needs Unsatisfied (BNU) who resides inhomes with at least one basic need unsatisfied. 20 Inthe hydrocarbonsub-sector, thebusiness modelchosenwas anopen competitivemarket inproduction and commercialization. Petroperu, the state-owned monopoly company, was partially divested (the integrated business was broken-up in production, refineryhtorage and commercial lines, divested separately.) Inthe electricity sub-sector, the integratedutility modelwas replacedbyanew sector structure basedon the unbundling o f generation, transmission, distribution and commercialization. Competitive markets would operate inthe generation and commercialization segments and transmission and distribution would be regulated, based on free-entry and open-access. The main regulatory body created by the new law was the "Organism0 Supervisor de la Lnversi6n en Energia (OSINERG)" ("Supervisory Commission for Energy Investments"), in charge o f tariff setting, supervision and monitoring o f the legal and technical regulations for the electricity sector. Electrolima and Electroperu, the two publicly-owned and vertically integrated electricity utility companies (serving Lima and the remainder of the country, respectively), were divested. Following the reform process, power shortfall was reduced, distribution losses fell drastically, and electricity tariffs stabilized to economic levels. Although the reform process was successful in general, with the active participation o f the private sector,' the scheme suffered a setback in the distribution segment outside o f the capital city]'. The failure o f privatization o f electricity distribution companies can be mainly attributed to inadequate tariffs and the lack o f a cross-subsidy mechanism among different consumers which i s implicit in companies of a large enough scale. Both of these issues are being gradually addressed (introduction o f FOSE, see below, and contemplation o f additional incremental tariff for rural areas), but the rural sector remains challenging for distribution and around the world requires subsidization. Inthe restructuring ofthe sector, the electricity tariff scheme was predicated on full-cost recovery. An initial transition period o f four years was established during privatization to adjust tariffs to their economical efficient levels. This situation prevailed until the middle o f 2001, with no explicit subsidies to the electricity rates. Under the new Toledo government, Congress passed legislation in August 2001, which established a "social tariff" for electricity consumption (the so called FOSE, "Fondo de Compensacih Social ElCctrica"). The application o f the FOSE subsidy began inNovember 2001, with a temporary duration of three years. However, in July 2004, the Congress extended indefinitely the application o f the subsidy, increasing the levels o f tariff reductions (increasing the amount o f the subsidy). Presently, the private sector owns about 65% o f installed capacity in generation and all o f transmission (with the government owning only small minority stakes that it i s seeking to divest.) Indistribution, two private companies serve Lima, while state-owned companies still serve the remainder o f the country, with about half o f the total nationwide electricity users. Electricity generation in 2004, was 22,613 GWh, o f which 76% came from hydro (considerably less than in 2003, when hydro represented 86% o f generation.) Quality o f electricity service in urban areas i s considered satisfactory and the electricity distribution companies generally operate professionally. However, the existing electricity distribution COPRI (the Peruvian private investment promotion entity, now called ProInversion) indicated initial strategic investments o f over two billion US Dollars, and about US$700 in agreed new investments in the sector, in its 2000 report "Evaluacion del Proceso de Privatizacion del Sector de Electricidad." loDistriluz, an electricity distribution holding corporation composed of four regional companies (Electronorte, Hidrandina, Electronoreste, and Electrocentro), was privatized in 1998 only to be returned to public hands in August 2001, after failing to comply with its contractual obligations with the State. N o w Distriluz is administered by FONAFE, the "Fondo Nacional de Financiamiento de la Actividad Empresarial del Estado, " a management unit under the Ministry o f Economy and Finance. Distriluz companies serve 12 Departments with a total of 1.1 million customers (about 6 million people.) 21 companies hold concession areas concentrated in small areas around urban centers. Their obligation is to meet service requests only within 100meters o f the existing network. Background on Tariffs - Regardingthe sector tariff structure, the L C E established two different hnds o f electricity users, the small retail users under regulated prices (denominated regulated users), and the large users with demands above 1,000 kW (denominated "free" users), which could contract their electricity service directly to generators or distributors, under bilateral contracts at negotiated generation prices. Generation prices are determined by merit order cost-based economic dispatch. Generators trade their energy surplus or deficits at the short-term ("spot") marginal price (see figure below for a schematics o f the system.) Figure 1.1:Schematic of Tariff System "Contestable" Market Contract1 MWh ("Free" Clients) Regulated "Market" (Regulated Clients) I Distributors Distribution Client "Retailing" "Retailing" System I, Services Regulated Competition Generation prices to the regulated users (called "busbar" prices) are calculated periodically (it was twice a year before a recent reform to the LCE that modified this to once a year) based on a three-year (one historical and two future years) economic operation simulation. The transmission network has open access and tariffs are regulated under an economic cost-based procedure. The transmission tariff i s recalculated every year. The distribution system, consisting mainly o f medium voltage (MV) primary distribution linedfeeders and low voltage (LV) distribution circuits, i s regulated under a cost-based efficient model company, for each o f four "typical distribution sectors" (urban high density; urban medium density; urban-rural; and rural), based on users average maximum demand and consumption, load density and geographic dispersion. The distribution tariff i s called the VAD (Value Added for Distribution). The VAD for the different zones and distribution companies are recalculated every four years (a VAD tariff review i s underway and will enter into effect in November 2005; for this review, a new zone was established, by subdividingthe actual zone two.) 22 Table 1.1: DistributionTariffs as of June 2005 (inS/kW- month) Zone 1 Zone 2 Zone 3 Zone 4 VADM 10.437 7.820 12.565 23.933 VAD, 36.094 31.754 42.633 43.305 These per unit capacity costs are converted to more suitable energy units, using typical consumers' demand curves, for establishing consumers' tariffs. The tariff for a typical regulated residential final user consists of: the generation tariff, GT(the busbar price) + the transmission tariff, T T + the distribution tariff, VAD (VADM+ VADL, the distribution added value for MV and LV networks.) For example, the electricity tariff for a residential consumer in Lima, the capital city, with a consumption above 100 kWh per month, i s S/. 0.33081kWh (about USSO.l02/kWh.) The tariff for a similar consumer in a rural area of Peru i s S/. 0.4119/kWh (about US$0.127/kWh), 25% higher than in Lima. These are the fill-cost tariffs. Inthe restructuringof the sector, the electricitytariff scheme was predicated on a full-cost recovery. This situation prevailed until the middle o f 2001, with no explicit subsidies to the electricity rates. When Mr. Toledo took office in July 2001 announced legislation for establishing a "social tariff' for electricity consumption (the so called FOSE, "Fondo de Compensacih Social Electrica"). The subsidy was approved by congress in August 2001, and began to be applied in November 2001, with a temporary duration of three years. The subsidy consisted o f 25% and 50% tariff reduction for monthly consumption up to 30 kWh, for users supplied by the interconnected system (ICs) and by isolated systems (IS), respectively. For consumption between 31 and 100 kWh, the reduction was gradual from a maximum of 25% to a minimum of 7.5%, in the case of I C s users and double this percentage in the case o f IS users. Consumption above 100 kWh per month would pay a surcharge in proportion to energy consumption above 100 kWh/month to finance the subsidy. InJuly 2004, the Congress extended indefinitely the application of the subsidy, increasing the levels of tariff reductions (increasing the amount of the subsidy). The new tariff subsidy for residential consumers withthe FOSEis shown inthe table below. Tariff Reductionfor For consumption Users of Areas consumptionslower or greater than3o equalto 30 kWhImonth kWhImonthup to 100 kWhlmonth Interconnected System Urban 25% o f the energy charge 7.5 kWldmonth A reduction of Interconnected A reduction of System Urban-Rura1and 50% ofthe energy charge Rural 15 kWWmonth Isolated System Urban 50% o f the energy charge A reduction of 15 kWWmonth Isolated System Urban-Rural and 62.5% o f the energy A reduction of Rural charge 18.75 kWWmonth This new level o f subsidy consists o f 25% and 62.5% tariff reductions for monthly consumption upto 30 kWh, for urbanusers supplied by the interconnected system (ICs) and for ruralusers supplied by isolated systems (IS), respectively. For consumption between 31 and 100 kWh, the reduction i s gradual, from a maximum o f 31.25% to a minimumof 7.5%, for rural users supplied by IS, and for urban users supplied 23 by the ICs, respectively. Consumption above 100 kWh per month would pay a cross subsidy in proportion to their energy consumption above 100 k W m o n t hto finance the FOSE discount. The table below shows electricity tariffs, including the FOSE subsidy, for a residential user with monthly consumptionup to 100k w h : Table 1.3: Residential Subsidized Tariffs (S/kWh) Consumption Lima Rural From31to 100kWh 0.322 0.402 Statistics shows that about 33% o f all residential users consume less than 30 kwh per month and about 35% consume between 31 and 100 kWh per month. This means that 68% o f all residential consumers receive some electricity price subsidy. This represents an increase o f slightly more than 3% in the full- cost o f electricity for the users providing the subsidy (the ones with monthly consumption over 100 kWh.). Background on Rural Electrification Electrification o f rural and remote areas was not explicitly addressed in the new legal and regulatory framework. The rural electricity market in Peru i s very small and dispersed. The distance and isolation of these communities make access to electricity in rural areas very difficult, which results in high installation, operation and maintenance costs for rural electric installations. These highcosts discourage, private investment inrural electrification. Furthermore, the inhabitants o f rural areas generally have very low income levels, which make their demand for electricity and ability to pay tariffs very low. Due to these factors, there i s little incentive to invest in rural electrification without government subsidization. Consequently, only 32% o f rural households in Peru have access to electricity, the second lowest electrification coverage inLatin America after Bolivia. Although no clear strategy or policy was established, the Government has invested a considerable amount of public funds in expanding electricity service to ruralhemote areas, and in non-served areas in the periphery and poor zones that surround the largest cities. Inparallel with the reform program o f the energy sector, in 1993, the Ministry o f Energy and Mines established the Direccidn Ejecutiva de Proyectos (DEP), as an entity in charge o f implementing electrification projects, to complement the investment activities o f the privatized distribution companies. The main centralized development strategy pursued by DEP was to extend the grid and increase levels o f rural electrification. Therefore, rural electrification inPeru has been thus far limited to direct investment by the central government - there i s no adequate framework to mobilize investments from communities, regional governments and the private sector inthe current centralized strategy. The activities o f the electricity distribution companies within their concessions, and o f the DEP and social funds such as FONCODES in rural areas and areas outside o f concessions have increased national coverage levels from 57% in 1993 up to 76% in 2004. Over this period, rural electrification increased from 5% to about 32%. The total investment by the DEP during this period was just over US$600 million, with an annual average o f about US$50 million. The DEP completed 608 projects during this time period. According to statistics from the DEP, about 4.8 million people were benefited by these projects (close to one million households). The average amount o f kilowatt-hours consumed per month by eachhousehold, which were beneficiaries o fthe DEPprojects, was around 20 kWh. 24 While progress has been made, there remain significant challenges in access and consumption o f electricity in Peru. Today, significant differences exist between urban and rural areas, leaving about six million inhabitants without access to electricity, almost exclusively inrural and remote areas o f Peru. In addition, the levels o f investments have dropped significantly since the 1996 figure (around US$135 million) with investments in rural electrification in 2002, representing only 13% o f the high in 1996. In 1995, the DEP executed 171 projects, while in 2003 only 23 projects were implemented. Many o f the early projects targeted provincial and district capital cities, with the objective to improve services andor connect urban populations to the grid. Most o f the remaining communities without electricity are highly dispersed and the difficult geography makes electrificationmuchmore costly. Currently, the DEP/MEM prioritizes rural electrification proposals based on technical criteria (project design status, existing electricity infrastructure, and provincial electrification index), economic criteria (socio-economic NPV, required investment per capita), and social criteria (poverty index, geographic location) and provides a 100% investment subsidy for the selected projects. However, the weighting factors result in priority being given to areas with low provincial electricity coverage and high incidence of poverty over other criteria such as economic efficiency, minimum subsidy and maximum economic benefit, underminingthe long-run sustainability o f these projects. Although the impact o f MEM's activities in improving the electrification level o f the country i s recognized, limitations o f fiscal budget allocations and experience with the existing approach indicate that an overhaulhmprovement o f the existing "model" i s required, to promote the involvement o f the private sector, and broaden the active involvement o f additional actors in rural electrification project development. Several attempts have been made to change the existing institutional and legal framework for rural electrification. Two laws have been passed by Congress in recent years, but not implemented because o f conflicts with provisions o f other laws (Law for Electrification o f Rural and Isolated or Frontier Areas in 2002, and Law to Regulate the Promotion o f Private Investment inRural Electrification in 2004). Both initiatives, while incomplete, contained a number o f positive elements, including incentives for private investment, increased role inplanning for regional governments, and the creation o f a Rural ElectrificationFund. MEM recently reiterated its commitment to reduce the electrification gap, aiming to increase rural coverage from 32 per cent to 75 per cent by 2012." With this goal inmind,the MEMi s contemplatingthe development o f a modern institutional, financial, legal and regulatory general framework for rural electrification (rural electrification - including for urban poor, remote and isolated areas) that would ..... address the following main shortcomings o f the present situation: Lack o f incentives to electricity service providers to invest inrural electrification Inadequate electricity tariffs for a sustainable development o f rural electrification Low levels o f electricity consumption inrural areas Centralized planning and selection o f projects based on social criteria, that results in unsustainable projects Lack o f a legal and regulatory framework for small and isolated systems, including renewable energy systems Background on Renewable Energy As usage levels of electricity in rural areas are low and the costs o f grid extension are high in Peru's difficult terrain, it is expected that there is potential for renewable energy to play a significant role in See the Rural Electrification Plan of 2004. This is estimated by MEM to require about US$860 million (US$86 million annually). 25 supplyingrural electricity. Renewable resources abound: (a) inthe highlands, the average solar radiation levels reach 5 k W m 2 / d a y , with small seasonal variations; (b) the wind velocity measurements in the coastal zone indicate average velocities o f 6 d s at 10 m level; (c) the hydroelectric potential i s vast, especially inthe highlands and higher parts o f the jungle; and (d) the potential for biomass projects inthe upper zone o f the jungle i s very promising. Groups such as the Intermediate Technology Development Group have carried out small-scale donor-financed projects to promote rural electrification using small hydropower, wind and solar energy, creating experience that the project can flu-ther buildupon. Work has been done by the MEM to investigate the potential o f renewable energy and promote its use within Peru. With the assistance o f the UNDP/GEF assisted Solar Photovoltaic Based Rural Electrification Project, MEM has investigated solar resources, prepared a solar map, and i s in the process o f developing a GIS system that will contain information on solar resources and the populations that could be served by PV systems. MEM has also prepared norms for the design, operation and maintenance o f PV systems. A preliminary evaluation has been made o f geothermal energy and there i s a map o f potential locations. A preliminary investigation has been made o f wind power potential, and there are two turbines installed inthe coastal areas o f Malabrigo and Marcona (the latter i s inoperative), Although recently the Congress has passed a general law for the promotion and utilization o f renewable energy sources (Law No. 28546 o f June 16,2005), this law does not contain details o f how it would work, leaving most o f its application to future specific regulations. Also, there i s a law to promote geothermal energy, but it has never been made operational due to lack o f regulations. The Direccidn General de Electricidad (DGE) is carrying out a study on how to promote use o f renewable energy for electricity generation, but MEMhas not yet developed an overall strategy for renewable energy utilization. With respect to rural electrification, the majority o f rural electrification projects implemented thus far have been main grid extensions and in more isolated rural areas, the construction o f local diesel generators. Thus there has been little diffusion o f renewable energy systems in rural areas. The UNDP/GEF Project mentioned above i s expected to result in the installation o f about 7330 solar home systems in Peru, and to remove some o f the barriers to the use o f solar P V systems such as lack o f resource information, norms and capacity o f technicians. However, many barriers to rural electrification using renewable energy remain, including a lack of specific regulations by DGE and OSINERG to govern operation o f renewable energy systems, lack of capacity in regional governments and in distribution companies and suppliers to develop renewable energy rural electrification projects, a lack o f data and information on renewable energy resources other than solar, a lack of systematic policy for renewable energy promotion in the MEM, and a lack o f promotion o f potential productive uses o f electricity from renewable energy. New ProposedRural Electrification Strategy Including Renewable Energy The estimated required amount o f annual investments to achieve the goal o f increasing rural coverage from 30% to 75% by 2012, i s US$86 million. The central government has been providing about US$40 million from the limited treasury hnds for this purpose; clearly not enough to achieve the indicated goal. The proposed Project will test a new strategy, in parallel with DEP activities, aimed at leveraging the treasury funds and increasing economic efficiency in the sector and attract broader participation and financing from communities, regional governments and private enterprises. Such a strategy would need to: (a) encourage planning and implementation o f demand driven projects; (b) introduce rural electricity concessions with specific regulations to ensure the economic and financial viability o f projects; (c) create incentive mechanisms for efficient rural electrification investments by existing and new distribution companies, and for local and regional governments to contribute toward subsiding investments; and (d) expand the use o f new technologies to serve remote populations, especially renewable energy. 26 In parallel to the preparation of the proposed Peru Rural Electrification Project, the World Bank is assisting MEM to prepare proposals to reform the Rural Electrification Sector inPeru. Under assistance from the Public Private Infrastructure Advisory Facility (PPIAF), a new general framework for rural electrification was proposed and agreed with major stakeholders at a workshop in January 2005, "Propuesta para un Nuevo Marc0 General para la Electrificacidn Rural en el Peru." The general framework i s being used to assist preparation o f a new model law and regulatory framework for rural electrification, with PPIAF support. The new proposed strategy reflected in the general framework would encourage planning and implementation o f demand driven projects. Regional and local governments would support demand evaluation and project planning at the regional decentralized levels. The strategy also aims to mobilize investments from communities, regional governments and the private sector to help co-finance these new rural electrification projects. Consequently, the new strategy would help address the current need for more efficient and decentralized planning and selection o f projects. The strategy would create subsidy incentive mechanisms for rural electrification investments by existing and new distribution companies. To provide incentives for investment inrural electrification, the strategy proposes to create a Fund for National Rural Electrification, which would be an entity specifically created to manage the mobilization, management and disbursement o f funds for rural electrification. The Fund for National Rural Electrification would be designated to provide a minimum subsidy for rural electrification projects, and mobilizeicatalyze other funds for project financing. Electricity service provision companies would propose rural electrificationprojects to the fund. The projects would compete for the subsidy, and would be evaluated on economic efficiency criteria such as minimum capital cost subsidy and maximum economic benefit. The electricity companies, together with local and regional governments, would identify, design, and propose projects to the fund. The electricity company also would provide an equity investment on the rural electrification project in order to be eligible for the subsidy. The capital cost subsidy would therefore provide incentive to companies to participate in rural electrification projects, including companies in the private sector. This approach has been successfully used inseveral countries with diverse distribution models, including El Salvador and Chile (private sector distribution) and Ecuador (public sector distribution). The new strategy will also promote the participation o f small private sponsors/concessionaries, ensuring long-term financial sustainability and adequate rate o f return on project equity contribution to these new rural electrification projects. Nevertheless, theoretical analysis and empirical evidence show that cost functions in electricity distribution exhibit important economies o f scale, increasing returns to scale and economies o f output and customer density. 12Therefore, existing distribution companies, already serving l2The costs of a distribution system are the costs of buildingand operating and maintaining the system of service lines, mains and transformers. These costs depend upon: (i) the total number o f customers served; (ii) maximum the demand on the system; (iii) the size o f the distribution area; (iv) the capacity o f the transformers; (v) the length o f distribution lines; (vi) the total kWh sold; (vii) the price o f labor; and (viii) the price o f capital. Cost functions showing economies o f scale in the electricity distribution industry are well documented theoretically and in empirical research; see for example: Salvanes, K.G. and Tjotta, S.,1994, "Productivity Differences in Multiple Output Industries: An Empirical Application to Electricity Distribution", The Journal of Productivity Analysis, 5, 23-43; Power Technologies, Inc., 1966, "An Approach to Define the Smallest Viable Distribution Company with the Perspective o f Restructuring," Commissioned by The World Bank, LAC Technical Department, Washington, DC; Thompson, H.G., 1997, "Cost efficiency in Power Procurement and Delivery Service in the Electric Utility Industry", Land Economics, 73, 287-296; London Economics, 1999, "Efficiency and Benchmarking Study o f the N S W Distribution Businesses," Commissioned by the Independent Pricing and Regulatory Tribunal of New South Wales, Sydney, Australia; Adonis Yatchew, "Scale Economies in Electricity Distribution: A Semiparametric Analysis", Journal o f Applied Econometrics, Vol. 15, No. 2, 2000, pp. 187-210; T. Jamasb and M. Pollitt, "Benchmarking and Regulation o f Electricity Distribution and Transmission Utilities: Lessons from International 27 relatively extensive territory with an established customer base, have a natural economic efficiency advantage in expanding their service to new areas. Then, it i s expected that most o f the new rural electrificationproject proposals will come from existing distribution companies. Another objective o f the proposed new rural electrification strategy i s to introduce rural electricity concessions with specific regulations to improve the economic and financial viability o f projects. A new institutional framework and regulations for grid-connected and off-grid rural electricity service are needed to improve the economic and financial efficiency of the sector, including procedures for issuing rural concessions norms for electricity provision and service quality. Furthermore, to ensure the economic and financial viability o f the new projects, the proposed new rural electrification strategy will focus on encouraging the distribution companies to extend their existing grids organically, focusing first on those projects that are nearer existing grids that have existing or potential productive uses. These areas would be more densely populated than isolated rural areas and would have higher demand due to the current or potential productive activities in these areas. Part o f the sub-project selection criteria will take into account the number o f connections (households) and the maximum economic benefit o f the project. This new approach would not only be more economically and financially viable, but also address the issues o f low electricity densification and low rural electricity consumption. The final objective of this new strategy i s to expand the use o f new technologies to serve remote populations, especially using renewable energy. The strategy recognizes that given the low usage levels inrural areas, it would be more economically efficient to serve some of the remote and isolated areas of the country, or areas where the populationi s dispersed, usingoff-grid renewable energy technologies such as solar P V systems, or isolated grids where the electricity i s generated usingrenewable energy, e.g. small hydropower, wind power, or biomass power alone, or in combination with diesel. The strategy proposes to include fully renewable energy in all aspects o f development o f the institutional framework, new concessions and regulations, to ensure that renewable energy technologies will be used for provision o f electricity where these technologies would be more economically viable than grid extension or diesel mini-grids. Work under the PPIAF grant on the general framework, the model law and the detailed framework still to be developed integrates fully renewable energy inall aspects. Experience," in DAE Working Paper. Cambridge, U.K.: Department of Applied Economics, Univ. Cambridge, 2001; and M. Filippini, J. Wild, and M. Kuenzle, "Scale and cost efficiency in the Swiss Electricity Distribution Industry: Evidencefrom a Frontier Cost Approach," in CEPE WorkingPaper 8.Zurich, Switzerland, 2001. 28 Annex 2: Major Related Projects Financed by the Bank andor other Agencies PERU: Rural Electrification Sector Issue:Rural Country OED Last ISR Latest Supervision(ISR) Ratings Electrification Rating Date Development I Implementation Objective Progress Renewable Energy inthe 7Argentina 1110912005 MS MU Rural Market (P006043) Electricity Services for Senegal 1212112005 S S Rural Areas Project 7 (P085708) Rural Electrification and Cambodia 0610612005 S MS TransmissionProject (PO71591) Rural Power Project 0611812005 MS S (P066397) Offgrid Rural Electrification Nicaragua 1112112005 MS MS (PERZA) (P073246) Rural Energy Project 0412912005 S S (P074688) System Efficiency Vietnam 0412912005 S S Improvement, Equitization &Renewables Project (P066396) Power and Communications Sectors Modernization and Rural Services Project (PROMEC) (P063644) DecentralizedInfrastructure for Rural Transformation (P073367) Energy Services Delivery Project (PO10498) Renewable Energy for Rural Economic Development (P077761) Rural Energy I1(P074688) Vietnam S- Sati, ictory MS-Moderately Satj IADB Projects Code Country Year Approval PPP Support to Rural Electrification and to the H00224 Honduras 2004 Energy Sector Rural Electrification Program CHO174 Chile 2003 29 Annex 3: ResultsFrameworkandMonitoring PERU: RuralElectrification ResultsFramework N s : As this is a fully integrated World Bank-GEF Project, the results framework presented below concerns the whole Project, The Project Development Objective outcome indicators refer to the overall Project. However speciJic outcomes and indicators on the GEF components are presented below and indicated by an asterisk (*). PDO ProjectOutcome Indicators Use of ProjectOutcome I Information Increase access to efficient and Vumber o f new electricity YR 1YR2 Measure effectiveness o f sustainable electricity inrural areas o f :onnections xoject inleveraging financing for Peru mral electrification and improving [ncrease inMWho f electricity zfficiency o f service delivery :onsumed for productive uses intarget areas (*reported YR 3 Mid-term review o f approach separately for projects using on subsidy provision and renewable renewable energy) energy promotion. I YR 5 Informthe rural electrification strategy o f the country and Global EnvironmentObjective: (*)Number o f new electricity development o f legal and regulatory (*) Reductionof greenhouse gas connections using renewable framework emissions through provision o f energy electricity using renewable energy. (*) MW Renewable energy based electricity generation capacity connected to grid (*) Reductionin tons of COZ emissions r IntermediateOutcomes IntermediateOutcome Use of IntermediateOutcome Indicators Monitoring Electricity distribution companies invest Total investments by YR 1YR2 Measure effectiveness o f insustainable rural electrification distribution companies inrural project inleveraging financing for projects. electrification rural electrification and renewable energy YR 3 Mid-term project review YR 5 Project completion report Regulations, norms and guidelines Issuance o f regulations, norms developed under Project are adopted for and guidelines and their YR1 YR2 Measure effectiveness o f all rural electrification projects, technical assistance component o f including (*)specific provisions for adoption inall rural electrification projects the project renewable energy YR3 Mid-term review o f effectiveness incost reductions and efficient service delivery 30 PDO Project OutcomeIndicators Use of ProjectOutcome Information YR1, YR2 Measure effectiveness o f Communities, Municipal and Regional Number o fproposals approved capacity building for stakeholders Governments collaborate with for financing by the project distribution companiesiproject sponsors YR 3 Mid-term review o ftechnical to develop rural electrification projects assistance YR 5 Informcountry's rural electrification and renewable energy strategy Rural populations intargeted project Number o f enterprises adopting YR1 YR2 Measure effectiveness o f areas (* including renewables) use electricity intargeted areas productive uses component electricity for productive activities Investment in electricity YR 3 Mid-termreview o f consuming equipment made by components design and enterprises. implementation YR 5 Informrural electrification strategy that would contemplate specific productive uses promotion activities (*) MW o f small hydropower YR 2 Measure effectiveness o f small provide funds for small hydro generation installed; MWh o f renewable hydro financing facility investments electricity produced by these YR 4, YR 5 Measure effectiveness plants o f refinancing mechanism 31 .- 0 E .c +c L sE + cc : P hL +U E: E I L a 0 9 0 F 2 '0 m cu 0 v! 0 F 3 hl d 0 2 3 3 m m 0 m 3 3 3 2 * 0 0 r CQ 2 - a * 0 3 m z 0 0 0 0 0 Annex 4: Detailed Project Description PERU: RuralElectrification The project seeks to increase access to efficient and sustainable electricity services inrural areas o f Peru. T o achieve this objective the project would actively engage all stakeholders while allocating to the electricity service providers a central role o f responsibility in the scheme. To ensure sustainability and efficiency, electricity providers would be responsible for the identification, design, investment co- financing, and long-term operation o f projects under the existing -or any future, specifically adapted to rural areas- electricity concession system. Communities, local and regional governments would: (a) coordinate with electricity providers in the identification, prioritization and planning o f specific sub- projects, and (b) possibly provide co-financing for sub-projects. The central government through the Project Executing Unit would be responsible for the competitive selection o f projects and the provision o f capital investment subsidies under transparent procedures. The regulatory body fOSINERG), together with the Directorate General of Electricity (DGE) o f the Ministry o f Energy and Mines, would be responsible for appropriate norms and guidelines for rural electrification projects, as well as monitoring the service delivery. The project components are aligned with the above project design and the allocation o f roles among different stakeholders: Component I refers to the specific investments for rural electrification sub- projects; Component 2 refers to technical assistance activities for stakeholders; Component 3 aims to enhance the economic and financial sustainability o f electrification by promoting productive uses for electricity; Component 4 addresses a key barrier in the implementation o f small hydropower generation investments -- lack o f appropriate financing inthe early risk stage o f projects; and Component 5 concerns project management needs. Component 1 Rural Electrification Sub-projects (Estimated cost US$114.325 million, US$43.375 - million IBRD, no GEF): Overall Description. The investment component o f the Rural Electrification Project i s financed by a World Bank loan, counterpart funds from the government o f Peru, investments by electricity service providers, and grant contributions by regional and local governments. The component provides capital cost subsidies for part o f the investment cost o f rural electrification sub-projects that would be implementedby qualified electricity services providers to extend services to rural consumers. Rural electrification sub-projects are defined as projects to provide service to new customers in rural areas outside o f existing concession areas, where the obligation to serve i s not mandatory. Examples o f such projects would be extension o f the existing grid to serve new customers grid (from the interconnected system or isolated networks), establishment o f new isolated systems with diesel or small hydro generation, or provision o f service to customers with individual renewable energy systems such as solar PV systems. Other types o f projectsthat meet the definition would be considered. Prior to receiving a subsidy, the service provider would need to have an electricity concession, which ensures adequate experience and technical, commercial and financial capacity. The geographical scope o f the Project i s national; a service provider can make an application for a subsidy for any project that meets the eligibility criteria described below. Project Procedures. The Project would provide a grant o f up to 90% o f the capital cost o f the rural electrification sub-project. The electricity service provider must also invest. The subsidy would be 34 determined as the amount needed to provide a 12% rate o f return on the share o f the investment provided by the electricity service provider at current tariffs. Any regionalAoca1 government grant contribution would reduce the subsidy required from the central government and increase the likelihood o f sub-project selection. The service provider must have an electricity concession to receive the subsidy. The service provider would present a detailed profile o f the Project including financing plan, with evidence o f commitment with application for subsidy. Other Project components would support preparation o f feasibility studies for the first sub-projects proposed usingrenewable energy. Training and capacity building would also be provided to MEM, electricity service providers, regional and local governments for project implementation and supervision. Productive use pilots, including in health centers, schools, etc., would be promoted through targeted technical assistance. MEM would sign a sub-project agreement with the electricity service provider, governing rights and responsibilities o f all parties. The sub-project installations would be owned by the electricity service provider. There would be two types o f criteria for sub-projects to be financed under the Project. All projects would be requiredto meet a set o f eligibility criteria. Ifthe amount o f subsidy required for eligible sub-projects i s greater than the amount available in a given evaluation period (two or three times per year), there would also be criteria for prioritization. Criteria would be specified in the operational manual and then adjusted with experience, based on mutual agreement between GoP and Bank. Illustrative criteria are supplied below. Eligibility criteria for sub-projects to receive a subsidy are: - profile sub-project document i s complete, including safeguards screening; - sub-project connects at least 1000new electricity customers; - sponsor makes a minimuminvestment o f 10% o f total capital cost; - - economic rate of return i s above SNIP requirement (currently 14%); subsidy requiredis no more than US$SOO per connection. To maximize the impact o f central government funds, the principalprioritization criterion for sub- projects i s minimumcentral government subsidy per connection. The above procedures would apply to both public and private sector projects. However, the lack o f a legal framework for the direct provision o f investment subsidies, or the transfer o f funds or assets (and some taxation implications), i s the principal outstanding issue for private sector participation. Inthe case of public companies, this situation could be solved by consideringthe subsidy as a capital infusion by the Government, or the transfer and holding o f assets by ADINELSA. In countries such as Chile and El Salvador, specific legal provisions have been adopted to overcome these problems and allow the Governments to provide these subsidies for rural public infrastructure. TA i s underway and would be continued within the Project to obtain similar exemptions in Peru. In'order to prevent inordinate delays in private sector participation, the fallback option o f proceeding through bidding o f concessions would be adopted within a year o f effectiveness ifno private sector proposals have been financed under the Project. Component 2 - Technical Assistance for Rural Electrification (Estimated cost US$3.75 million of which US$O.75million IBRD and US$2.5million GEF): Overall Description. This component i s designed to provide the technical support and build the capacity o f all project participants, in order to ensure that the Project i s successful. It includes sub-components to improve the regulatory environment, build capacity o f project participants, promote private sector investment and promote renewable energy as described below: 35 a. Regulations and norms. The electricity concessions law o f Peru, and the subsequent development o f regulations, has focused primarily on provision o f electricity inurban areas. As a result, standards o f design, construction and quality when appliedto rural areas cause over-sizing and over-designing o f systems which inturntend to rise per unit costs andhinder the economic viability o f projects. Furthermore, the lack o f a legal framework for the direct provision o f investment subsidies and the transfer of assets o f rural electrificationprojects implemented by the DEP, forced the creation o f ADINELSA as a public company with the sole objective o f holding the ownership o f the assets created by these public investments. ADINELSA has no mandate to operate and maintain the systems, therefore they sign management agreements with municipalities and other institutions to administer the assets and provide electricity service. Some DEP projects were transferred to public distribution companies as equity contribution, causing complaints from these companies, considering the non profitability o f the projects. This arrangement i s considered unsatisfactory and the Government is searching for an adequate solution. Inaddition, the option o f usingrenewable energy inelectricity provisionremains largely underused and its potential i s not sufficiently exploited. Taking into consideration the above situation, this component aims to address these issues through the provision o f technical assistance to develop and implement appropriate norms and guidelines for rural electrification including specific treatment o f renewable energy. The component i s expected to include activities such as: 0 Legal and regulatory arrangements for direct investment subsidies and transfer o f rural electrification assets; Concessions Regulations for Electricity Service Provision inRural Areas; 0 Regulations for Monitoring and Supervision o f Electricity Service Provision inRural Areas; 0 Tariff System for Grid-Connectedand Off-GridRenewable Energy Project; 0 Product and Service Quality Regulations for Rural Electrification; 0 Design and ConstructionGuidelines for Grid ExtensionRural Electrification; 0 Design and ConstructionGuidelines for Off-GridRural Electrificationwith Renewable Energy Sources. b. Capacity buildingfor stakeholders. Rural electrificationhas beenso far mainly organized and deliveredthrough the largely centralized mechanism o f the DEP. This component therefore aims to assist the various stakeholders that would have to work together under the proposed Project design. This component would strengthen the capacity o f local and regional governments to identify, plan and prioritize adequate projects incooperation with the electricity service providers who would be ultimately responsible for the construction and operation o f projects. The Project would also strengthen the capacity o f service providers to propose projects, especially projects usingrenewable energy. The Project would assist the selection o f appropriate, least-cost technologies --such as renewable energy-- to electrify remote areas, or regions with dispersed populations, where grid extension would not be economically viable. The component i s expected to include activities such as: 0 Development and Implementationo f a GIs-Based Project Information System; 0 Development o f Sectoral Institutional Structure inRegional (and Local) Governments; 0 Capacity Building and Training in Sub-Projects Development Procedures in Regional (and Local) Governments; 0 Capacity Building and Training for Development o f Electricity Distribution Business Plans for New Sub-projects Sponsors; 36 0 Capacity Building and Training for Sub-projects Technical Development for Existing Service Providers; 0 Capacity Building and Training for Development o f Renewable Energy Sub-Projects; 0 Computer Hardware and Software Support for Regional (and Local) Governments. c. Promotion of Private Sector Participation: While the distribution companies serving Lima are currently private, the majority o f the existing distribution companies serving rural areas are inthe public sector. This component aims to catalyze the participation o f new private entities in rural electricity distribution. This could include private distribution companies from Lima or other countries, or companies in other sectors such as mining. It i s expected to include activities such as the following: Definition o f Legal and Regulatory Measures for Provision o f Capital Cost Subsidies to Private Sector Service Providers; Development o f a Project Bidding Mechanism for Private Participation inREProjects; Preparation o f Bid Packages for Concessions; Capacity Building and Training for Development o f Electricity Distribution Business Plans for New Private Sub-projects Sponsors; Public Awareness and Promotion o f the Project's Renewable EnergyFinancingFacility; Development o f Electrification Projects as Part o f Private Investments in Other Sectors Like Mining,Agribusiness and Others; Business Development Activities for Identifying Potential Private Investors in Electrification. d. Renewable Energy Promotion: Annex 15 contains an analysis o fthe barriers to introductiono f renewable energy to Peru. The various components o fthe Project are designed to remove a number o f barriers for renewable energy inPeru. Each o f the above components addresses selected barriers. This component would address specifically the lack o f reliable renewable energy data and information, specific policies to promote renewable energy inthe country, and awareness among the general population and stakeholders. This component would focus on renewable energy for rural electrification and supply to the rural grid, especially usingsmall hydropower due to the resource availability inmany areas o f Peru. This component would include support to specific activities such as the following: Development o f Capacity within MEM/DGEfor Renewable Energy Promotion; Measurement and Other Technical Equipment for Evaluation o f Renewable Energy Sources; Complementary Evaluation o f Potential o f Renewable Energy Sources for Electricity Generation (mainly small hydropower); Development o f Policy and Regulatory Incentives and Overcoming Barriers for Renewable Electricity and Distributed Generation; Development o f Pre-Feasibility and Feasibility Renewable Electricity Projects; Development o f Financing Mechanisms for Renewable Electricity Projects Implementation; Development of Public Awareness and Promotional Printed Material Regarding Renewable, Clean and Sustainable Energy Development; Public Conferences, Seminars and Technical Presentation on Renewable Energy. 37 Component 3 - Pilot Program to Promote Productive Uses of Electricity (Estimated cost US$3.95 million of which US$2.0million IBRD and US$1.5million GEF): There i s almost unanimous agreement that energy plays an important role in increasing productivity o f enterprises and in improving livelihoods. In the context o f rural areas, this generally implies productive use o f energy for the provision o f power for agricultural and small industrial or commercial uses. For example, motors are used to grind grain, operate power tools, irrigate farmland, process agricultural produce, and facilitate many commercial activities. Electric power can result in productivity gains and economic growth, thus transforming the underdeveloped rural landscape - if ancillary services such as market access, human and enterprise capacity, financial services, and resources/raw materials are available. From an electricity service company viewpoint, productive uses are essential to establish the long-termeconomic viability and sustainability o f rural electrification. Load factor and capacity utilization in rural areas o f Peru are currently low. Power demand peaks usually occur at night while daytime loads are minimal, indicating that electric power i s mainly used for domestic lighting and appliances (e.g. radio, TV). Load factors are often under 50%, and sometimes under 25%. For example, Electrosur reports that in its rural service areas, the load factor i s only around 25% with a two hour evening peak from 6-8pm. Many hydro grids have similar low load and capacity factors. According to MEM data, 50% of the hydropower plants with total installed capacities o f 580 MW have capacity factors less than 60% (implying that daytime loads are typically less than 50% o f peak generation capacity). Achieving increases in productive uses o f electricity in rural areas confronts constraints on both the supply (electricity service company) and demand (enterprise) side. On the enterprise side these have included: (i) lack o f knowledge on adopting electricity to improve productivity; (ii) inadequate access to investment financing to obtain an electricity connection and electric equipment; (iii)lack o f trained personnel; (iv) uncertainties or difficulties with regard to increased availability o f raw materials or access to larger markets; and (v) lack of knowledge in dealing with the electricity service company. On the electricity service company side, these have included: (i) the selection criteria for rural electrification areas, w h c h inthe past did not explicitly include existing or potential productive uses; (ii)the lack o f 24- hour service in some isolated systems (particularly true in the case o f municipal isolated grids in Peru); (iii) quality, particularlyoutagesandvoltagefluctuations; (iv)delaysinrespondingtobusiness service requests for connections and upgrading o f contracted power; (v) the tariff structure which hinders both initial connection and the expansion o f installed capacity; and (vi) an incentive structure which does not encourage electricity service company staff to promote productiveuses. The component concept is based on several successful productive uses promotion projects in Peru, including the Marenass Project and the Incagro Project (by the Ministry o f Agriculture); the Corredor Puno-Cusco Project (by FONCODES and MIMDES); as well as the Rural Business Services component inthe Indonesia Second RuralElectrificationProject financed bythe IBRD. Principal lessons from these projects are that targeted marketing interventions and price incentives which address information constraints and business needs o f small enterprises in rural areas are effective in load promotion. Furthermore, for success, cooperation and support from the local electricity service company i s essential to facilitate grid connections. Access to investment resources are also needed to finance the switch to electricity. The objective o f this Productive Uses Promotion component i s to contribute to increase the productivity o f rural businesses by promoting a more intensive use o f electricity, which would inturn improve living conditions inrural areas o f Peru, as well as improve the utilization o f electricity supply infrastructure and electricity service company revenues. Priority would be given to those energy intensive operations that 38 currently employ diesels or other power sources, and those with strong potential for electricity use if additional value-added processing i s done inthe region. Since this component i s financed both by IBRD and GEF, the component would focus on two distinct "market" segments: (a) isolated hydroelectric grids or hydroelectric-dominated grids where GEF assistance would be offered; and (b) other rural grids, isolated or interconnected where IBRD resources would be deployed. Target areas would be selected based on four criteria: (i) low load factor inthe grids serving the regions due to underutilizedcapacity, and not due to supply side constraints, and an electricity service company with interest and commitment to support productive uses promotion; (ii) presence o f a significant potential for energy intensive productive activities in farm and off-fann enterprises that might benefit from a shift to electricity; (iii) existence o f basic supporting infrastructure; (iv) for the renewable energy-focused "market" segment, service areas predominantly supplied with renewable energy-based electricity. Screening o f candidate areas based on the four criteria notedabove i s being undertaken during preparation. The MEMwould approve the target areas. The proposed approach for this component relies on providing cost-shared and targeted technical assistance to entrepreneurs, associations or communities in rural areas interested in expanding their businesses through the use of electric energy. The proposed approach i s broadly one o f capacity building. It is a marketing approach in the broadest sense -identifying target markets and segments; increasing awareness and skills, assisting potential productive users, user groups and communities to identify opportunities, barriers and solutions; working closely with the electricity service suppliers to ease access; and facilitating access to other necessary services, including financing. The proposed core steps indesigning a marketing-based productive uses program could be as follows: (i) conduct diagnostic to screen for promising areas/communities with significant opportunities for increased productive uses o f electricity where there are no electricity supply constraints; (ii) identify constraints to productive uses inthese areas and develop approaches to mitigating the barriers; and (iii) test them out in several marketingpilots, evaluate, adjust, reiterate, replicate. The implementation approach proposed i s that the productive uses capacity building activities be implemented on a campaign-like basis inthe different areas that would include: (i) having the PEU lead the effort with support from an organization (either an NGO or private company), to administer the program, and supervise and coordinate the work o f a number o f regionally-based consultants; (ii) giving the beneficiaries key decision making authority in selecting services and service providers, with appropriate guidance and ensururing the cost sharing o f services; (iii) locally based implementers as using much as possible, with guidance and support as necessary from others. They would use locally appropriate promotional and instructional materials, and standardized material; (iv) working collaboratively with and building alliances with the critical facilitative services and with the electricity service company to resolve issues and ensure support services are available. Component 4 - Small Hydropower Financing Facility (Estimated cost US$15.0 million, of which US$5million isfrom the GEF): Peru i s a country with significant hydroelectric resources due to its geography (Andean mountain range) and climatic conditions. Inaddition, various irrigation projects and water resources management projects have already created civil engineering structures that could result in competitive hydroelectric generation insmall and micro schemes. Through its carbon financing activities inthe country, the World Bank has reviewed a significant number o f privately sponsored small hydro schemes that would be viable and could likely provide least-cost solutions for supply o f electricity in Peru. Nevertheless, although the financial system inPeru i s relatively liquid, commercial banks are not experienced, and in general are unwillingto provide financing on a project recourse basis. Project sponsors, therefore, have to finance projects fully 39 on equity, borrowing on their balance-sheet, or pledging other assets for collateral. This has created significant financing barriers to investment in small hydro plants for sale to the grid, despite the viability o f the potentialprojects. This project component would address the above barriers by using GEF funds to leverage private and commercial debt financing for small hydro generation plants to supply electricity to the grid. The project would provide bridge-financing for small hydro plants during the period o f construction and initial operation, after which the loan would be refinanced by commercial banks. The project sponsor would provide an equity contribution (at a minimumo f 30% o f total capital cost) while the GEF funds (as well as other commercial financing) would provide debt finance for the remainder, during the period o f construction and initial operation. The debt component o f the GEF would then be refinanced by commercial financial institutions, after the construction risk had been eliminated. This component would not finance electricity connections or distribution grids, which would be financed only under Component 1. The facility would include an investment decision-making function and a separate revolving loan facility under a financial administrator-- to handle the disbursement and recuperation o f specific project loans (lending "back-office'' functions). A qualified company would be competitively selected to act as Fund Manager with responsibilities that would include: marketing and promotion o f the facility, preliminary screening o f project proposals, detailed evaluation and due diligence on projects, negotiation o f conditions and terms for specific loans and supervision o f investments. A separate three-member Investment Committee would be appointed by the Project Directory Committee to approve investments proposed by the Fund Manager. For approved investments, the disbursement and repayment o f the loans would be handled through an administrative financial agreement with a qualified bank. Project sponsors would present hydro projects to the facility which would evaluate them on the basis o f their financial, technical and economic soundness. Qualified projects would be presented to the Investment Committee for final approval. Once investments are approved, the financial management functions o f the lending operation would be handled under an administrative financial agreement. At the end o f the construction and initial operation period, the debt would be financed by commercial financial institutions. The financing o f small hydro would be possible because an already constructed and operating hydro system i s a valuable asset, which can be used as collateral to comply with the requirements o f commercial banks. Because o f the minimum equity requirement under t h s financing scheme, an operating plant would have a value o f about 140%o f the debt component to be refinanced. The facility would continue its operations after the project i s completed for another five years under similar rules aiming to continue leveraging financing. The costs o f the administrative financial agreement would be covered after the initial operation period through revenues from interest payments. It i s estimated that during the ten years o f the operation o f the facility, at least 30 MW o f small hydro projects would be thus financed, while it i s expected that as the scheme proves the concept o f project financing for small hydro systems, financial institutions would increasingly start to provide funds for such schemes assuming earlier project risk. At the end o f the period, after financing about 30 MW o f renewable energy projects, it i s expected that funds would still be available in the facility. At that time, the GoP and the World Bank, in consultationwith the GEF Secretariat, would agree on the further use o f any remaining funds inaccordance with GEF Climate Change Mitigation objectives. 40 Component 5 Project Management (Estimated cost is US$6.4million of which US12.75million is - IBRD and US$I million is GEF): This component would include support for overall management of the proposed Project including the Project Executing Unit which would consist of a Project Manager; an administrative unit with staff to handle procurement and financial management; a technical unit that would evaluate sub-project applications and oversee the functioning o f the finance facility and the productive uses component; and a monitoring and evaluation unit. I t i s expected that the actual administration o f the subsidy and the renewable energy finance facility would be carried out by a qualified bank under an administrative financial agreement. 41 Annex 5: Project Costs PERU: RuralElectrification 42 Annex 6: ImplementationArrangements PERU: RuralElectrification GeneralInstitutionalandImplementationArrangements The project would be implemented over a five-year period by the Ministryo f Energy and Mines (MEM). Project implementation includes partnership among MEM,MEFand the regulator, OSINERG ina Project Directory Committee, which would approve the subsidies for sub-projects. Implementationalso includes a partnership with a bank that would assist in implementation o f the renewable energy finance facility and NGOs that would assist in implementing productive uses technical assistance activities, as well as with distribution companies and regional governments. The project would have an implementation organization, under the Ministryo f Energy and Mines, guided by a Project Directory Committee, and executed by a Project Executing Unit (PEU). The Directory Committee would be presided over by the Vice-Minister o f Energy, and it would have two other members, the Vice-Minister o f Economy and the President o f OSINERG, the energy regulatory entity. A Project Manager would direct PEU activities. The PEU would be organized in three basic units, the Technical Unit, the Administration, Financial and Procurement Unit,and the Monitoring and Evaluation Unit. As explained before, the main function of the TechnicalUnit is the evaluation of sub-projects for subsidization. Other activities o f the Technical Unit would include technical support to the local and regional governments, and to the distribution companies or projects' sponsors, on sub-project formulation, and management o f the technical assistance and productive uses promotion components o f the Project. The Administrative Unit would be incharge o f general administration, financial management and procurement activities for all Project components. The Monitoring Unit would be in charge o f Project progress evaluation, reporting and other follow up activities. Figure 6.1 shows the specific project implementation institutional arrangement. Figure6.1: Project OrganizationSetup Project Directory Committee ExecutingUnit 2 I Administration, Monitoringand TechnicalUnit Financial Management, Evaluation Unit ProcurementUnit 43 Rural ElectrificationSub-projects Public intervention in rural electrification requires interactions between different institutions, from the central government to the final beneficiaries. In the case of a particular project its institutional organization must manage and guide these interrelations. The implementation o f the proposed Project reflects this situation at different levels. First, rural electrification sub-projects would compete for the subsidy. Sub-projects to be presented for financing under the project would be prepared, starting at the community where the demand for electrification i s manifested. The community may request electricity service either directly from the service provider, or from the local or regional government. If requested from the local or regional government, these requests would be initially screened by the local (municipalities) and regional governments that would define regional priorities and interest inproject co- financing. The local or regional government would coordinate with the existing regional distribution company or with a qualified project sponsor (hture service provider/distribution concessionary), for project preparation and submission to the Project Executing Unit for evaluation. The Project would be open to, and would promote the participation o f newly created private sponsorsiconcessionaries, while ensuring sub-projects long-term financial sustainability and adequate rate o f return on project equity contribution. Sub-projects selected for subsidy would be contracted for construction and subsequently operated and maintained by the service provider. Figure 6.2 shows the overall institutional arrangement, '+'7 Figure 6.2: Overall Rural Electrification Sub-project ImplementationArrangements I 4 1 ProjectExecuting Unit Participating I Existingor Potential Contractors ' Electricity Service 4 Provider Regional Government Government I I I Community /Users The second institutional arrangement deals with sub-project preparation, evaluation, prioritization, selection and subsidy allocation by the Project. For the proposed sub-project, the electricity service providers would prepare documentation following standard guidelines, at the level o f a detailed profile, including an analysis o f demand and estimation o f length of distribution lines. The Technical Unit o f the PEU would be in charge of carrying out a detailed technical, economic and financial evaluation o f sub- projects, preparing a prioritized list of selected projects and estimating the initial amounts o f sub-projects' subsidies. The Technical Unit would prepare an evaluation and recommendation report to be considered by the Directory Committee. The Directory Committee would approve the selected sub-projects and the subsidy amount. To implement the selected sub-projects, a sub-project agreement would be signed between MEM and the electricity service providers that would carry out the sub-projects. T o ensure economic efficiency in sub-project implementation, their construction would be bid out by the service providers. Details o f the roles and responsibilities are given below. Figure 6.3 shows the sub-projects' processing cycle. 44 Figure 6.3 Sub-project Cycle: Rural Electrification Project Pro.ject Request Gov't or Qualified ServiceProvider &provides basic data Qualification of ServiceProvider and funds Eligibility of Sub-pro,jectsdetermined by PEU TU of PEUdeterminesthe sub-project OPI/SNIP System PEU submits report Basic Engineering Completed & Service Providercontinues with projectpreparation for bidding SafeguardReauirements Met Bidding FollowingBank Procedures Service Providerbids out sub project turn-key construction Construction Contract BetweenService Providerand Contractor Subsidy will be provided according to sub-project agreement Evaluation & I Final Payment on Construction 1 45 Project Executing Unit of MEM: The PEU i s responsible for: 0 Creation o f awareness among communities, provincial authorities, other national agencies and other donors; 0 Capacity buildingo f regional and local governments, electricity service providers, communities; 0 Evaluation o f subsidy proposals according to criteria set forth in Section 3, and presenting the selected projects to the Directory Committee; 0 Ensuringthat each sub-project conforms to GoP and Bank environment and social safeguards, as required; 0 Preparing a sub-project agreement for each sub-project, between MEM, the electricity service provider and third party investors, if any; 0 Supervising bidding procedures by service providers to ensure they comply with Bank procurement procedures and rules; 0 Review o f financial performance o f sub-projects on an annual basis; 0 Monitoring and evaluation o f sub-projects' impacts. Participating Bank The participating Bank would have the following responsibilities, under an administrative financial agreement with PEU: 0 Payment o f subsidy to electricity service provider; 0 Financial management and reporting with respect to subsidy funds. Electricity Sewice Provider: The electricity service provider would: 0 Receive request from community or regional/local government for electricity project; 0 Coordinate with regionaUloca1 government and community, including arrangements for their grant contributions; 0 Prepare and submit proposal for subsidy including profile sub-project proposal, financing plan, and preliminary safeguards screening; 0 Have or obtain an electricity concession; 0 Ifsuccessful, signsub-project agreement with MEM; 0 Carry out detailed engineering and safeguards studies; 0 Conduct tendering process for turnkey construction o f sub-project according to Bank procedures; 0 Sign contract with construction contractor; 0 Supervise construction and authorize payments against progress; 0 Evaluateand accept asset; 0 Operate and maintain system, providing electricity service to rural customers that meet quality requirements. Regional/Local Government 0 Coordinate with community and service provider; 0 Prepare indicative rural electrificationplans; 0 Participate inprioritizing by optionally providing grant that reduces central government subsidy. Community 0 Make request for service to electricity service provider and/or local or regional government; 0 Provide necessary information on demand, potential connections, identifying special loads, etc.; 0 Provide contribution inkind or cash and commit to pay electricity tariffs. 46 Implementation Arrangements for Technical Assistance and Productive Uses Promotion Activities The TU would contract out technical assistance activities under Component 2 to national and international consultants that would carry out the required investigations, studies, workshops and capacity building activities. The PEU would administer the Productive Uses Promotion Component which would be implemented through a number o f regionally-based consultants with assistance from a Support Services Contractor. The regional offices would be contracted separately. The organizational relationships are shown inFigure 6.4. The PEU would have overall responsibility for implementing this component, including administration, production o f training and capacity buildingmaterials, establishing operating procedures, and financial management. Each regional consultant would implement the Productive Uses Promotion Component inits regional area o f responsibility under the supervision o f the PEU. Capacity buildingand promotional services would be conducted by regional consultants. Cost sharing with the beneficiary would be required where individualized assistance i s provided to a specific enterprise. Specific responsibilities are shown below. Figure 6.4 Productive Uses Component Organization I----------- ; Contracts Project Execution Unit I---r ------ -- -------------- I I Promotion Support Services I L - - - - - - - - - - - - - I-- ---------- -I--- ----------r - -----------I I I I I I Regional Regional Regional Regional Regional Contractor 1 Contractor 2 Contractor 3 Contractor 4 Contractor N Associations/Communities Assisted m.The PEU would have overall responsibility for implementing this component, including the following: (i) OverallmanagementresponsibilityoftheProductiveUsesComponent; (ii)Approvethetargetregionsforfocusingtheworkofthiscomponent; (iii)UpdatetheOperationsManualandpreparethedetailedImplementationPlan; (iv) Direct and supervise the performance o f the support services contractor(s) and the regional consultants; (v) Overall fiduciary responsibility; (vi) Monitor and evaluate performance of regional consultants and program effectiveness; (vii) Issue quarterly and annual report to the Steering Committee and WorldBank, as required; 47 (viii) Help build relationships and liaise with partner organizations, including financing institutions, electricity service companies, training and capacity building organizations, and trade and marketing associations; and (ix) Organize technical and financial support through alliances with existing programs with similar objectives. Support Services Contractor(s). Specific tasks would include the following: (i) AssistthePEUtosupervisetheperformanceoftheregionalconsultants; (ii)AssistPEUupdatetheOperationsManualandpreparethedetailedImplementationPlan; (iii)LeadthediagnosticworkandrecommendtothePEUanychangestotheprioritygeographicareas and priority sector/application to support; (iv) Prepare standardized marketing brochures, leaflets, advertisements, posters, training videos and all other instruments; (v) Organize training sessions for regional branches and subcontracted institutions on the wide range o f businesses that could be helpedto shift from manual and/or diesel source o f energy to electricity; (vi) Help build relationships and liaise with partner organizations, including financing institutions, electricity service companies, training and capacity buildingorganizations, and trade and marketing associations; (vii) Arrange to leverage technical and financial support through alliances with existing programs with similar objectives (e.g., Peru Emprendedor, SENATI); (viii) Assist PEUmonitor and evaluate regional consultants and program effectiveness; and (ix) Prepare quarterly and annual report to the PEU, as required. Regional Consultants. Each regional consultant would be responsible to implement the Productive Uses Promotion Component in its regional area o f responsibility under the supervision o f the PEU. The responsibilities would encompass the following: Conduct a diagnostic of specific energy intensive opportunities to increase productive loads and o f constraints faced by local entrepreneurs towards more electricity intensive operations or switch to electricity from usingdiesel or other power sources; Conduct targeted promotionallmarketing campaigns to inform the local Communities about the advantages o f switching to electricity use and o f the availability o f cost-shared assistance; Facilitate access to information on electrical equipment, performances and costs; Using facilitators, visit potentially energy intensive enterprises, associations or communities to encourage their participation and assist interested organizations in seeking assistance. Priority would be given to those energy intensive operations that currently employ diesels or other power sources, particularly those needing electricity duringthe daytime; Screenievaluate requests for assistance and select promising proposals for cost-shared assistance; Provide direct assistance and advice in the most cost-effective manner possible, e.g. providing standard documentation, advice and training, or group advisory services. In exceptional cases, it may be necessary to support the implementation o f the proposed work by assisting beneficiaries to select and contract for technical assistance. The funds available under the project along with a 10- 20% contribution from the beneficiary would pay for technical services where individualized assistance i s provided to an enterprise or association. It i s expected that during the period o f implementation, about 15,000 rural enterprises would be assisted; Establish relationships/partnerships with local electricity service companies as well as regional organizations that can provide supplementary services and investment financing and assist beneficiaries in obtaining such services. This may include assistance inpreparing loan applications and electricity connectionapplications; (viii) Conduct baseline and post-assistance surveys to determine effectiveness o f services provided. Monitor electricity consumption changes and other key performance indicators; and 48 (ix) Monitor and supervise the provision o f services, manage finances and report to the PEU on a regular basis. Implementation Arrangements for FinancingFacility for RenewableEnergy Projects The Facility includes an Independent Investment Committee, a Fund Manager (investment advisor) and an Administrative Financial Agreement where financial administrationwould be handled. The Facility would be managed by a competitively selected qualified FundManager. The FundManager would be responsible for: 0 Promoting the Facility to prospective sponsors and financial institutions; 0 Analyzing potential projects proposedby sponsors; 0 Performing due diligence for short-listed projects (technical design assessment including resource assessment, costing and timing of works, and operational requirements; financial and economic assessment; compliance with environmental and social framework; risks assessment); 0 Actively seeking co-financing and closure o f refinancing upon end o f construction and initial operationperiod; 0 Preparing necessary documentation and presenting investment recommendations to the Independent Investment Committee; 0 Advising the PEU on issuing instructions for loan disbursements under the Administrative Financial Agreement for approved projects; 0 Supervising the project sponsor as necessary duringthe investment period. The FundManager would be rewarded based on proportion o f co-financing that i s brought to the deal and successful refinancing of the hydropower facility after its commissioning and operation for a period o f time. The Independent Investment Committee would be composed o f three adequately qualified members, to be appointed by the Project Directory Committee. The Independent Investment Committee would review investment recommendations provided by the Fund Manager and provide its approval for worthy investments. The Participating Bank would operate based on an administrative financial agreement with PEU, as instructed by the PEU (disbursement o f funds as necessary to ensure project completion and costs minimization) issuing invoices and receiving loan repayments from project sponsor company, record- keeping and management o f legal documents. 49 Figure6.5 ImplementationArrangements for Small Hydropower GeneratingFinancingFacility Independent 4 w Investment Fund Manager Trust Fund Committee (Investment Advisor) Revolving Loan Small Hydro Facility (Appointed by PDC) b 50 Annex 7: Financial Management and Disbursement Arrangements PERU: RuralElectrification A FinancialManagement Assessment was performedinaccordance with OPiBP 10.02 and the Guidelines for Assessment o f Financial Management Arrangements in World Bank Financed Projects. The evaluation was initiatedjointly by the FM and Procurement teams, on June 24, 2005 and performed, in the offices o f the Ministry o f Energy and Mines (MEM) with a team led by the Project Preparation Manager and the Coordinator. Executive Summary and Overall Conclusions Project design and implementationrequire a robust financial management system, which at the time o f the assessment are not yet inplace, since according to local regulations the Project ExecutingUnit (PEU) can only be established after the signing o f the loan agreement and the participating institutions and private enterprises have not yet been selected. Nevertheless, as one o f the products o f the preparation grant, a draft operations manual has been prepared, which, along with the proposed FM action plan, will bring together planning, budgeting, .accounting, financial reporting, internal control, auditing, disbursement, physical performance for the project, and will, finally, determine the necessary steps to achieve adequate resources management and to reach the project development objectives. Currently, the overall inherent and control risks have been assessed as moderate. More specifically, at the country and entity level the risks are moderate, while at the project level the riskprofile i s high. However, successful implementation o f the FM action plan, highly qualified professionals in key positions and adequate capacity building would generate acceptable financial management arrangements, resulting inmoderate residual inherent and control riskratings at the project level, too. Risk Assessment Overall:- both inherent and control riskshave been assessedas moderate. At the country level, CFAA findings and experience with the existing country portfolio in the areas o f financial accounting, reporting, audit quality and compliance, and the quality o f the FM profession, indicate that country risks are m~derate.'~ At the entitv level, the MEM has traditionally operated acceptable financial management arrangements, based on national control norms, and MEM i s staffed with high level professionals with excellent capacity inplanning, budgetingand financial management as well as internal controls. Entitylevel riskis therefore assessedas moderate. At the project level, the risk profile is high, due to the relative size o f the loan, the multiple actors described in Annex 6 Implementation Arrangements, the flow o f funds mechanism, including a participating bank, which would make payments for Components 1 and 4, through an Administrative Financial Agreement "comisidn de confianza", the need for robust coordination in planning and budget preparation, and technology capacity that would allow timely and accurate consolidation and reporting of financial and disbursement information. l4See the Country Financial Management Strategy note for a fuller description o f the country context. 51 Inorder to mitigatethe risksposedbythe lackofanestablished PEUandlackofrecent engagement with the Bank, the following will be required: (a) highly qualified professionals inkey positions (profiles inthe Operations Manual); (b) a highly qualified and experienced Financial Manager (profile in the Operations Manual); (c) considerable degree o f technical assistance and capacity strengthening measures (to be provided by the financial management and disbursement Bank teams); (d) successful implementation o f the FM action plan; and (e) close supervision by the Bank FM team, during the first year o f project implementation. Full analysis and development of financial management issues will be included in the Financial Management Assessment, included inthe Project files. DisbursementArrangementsandFlow of Funds Disbursement Arrangements During project implementation, disbursements may be transaction based (ie against Statements of expenditure (SOEs), full documentation, direct payments or special commitments) or Report-based. The Bank and client have discussed the use o f report-based disbursements for all components. However, given that the Project team will be newly created and the IT systems are not yet operational, the Project will use the transactions based disbursements mechanism (SOEs), duringthe capacity buildingperiod. Indeed, report-based disbursements call for a substantial amount o f technical assistance to the PEU inthe design o f the Financial Monitoring and additional disbursement required reports. Satisfactory IT systems that will produce the reports and staff technical capacity will be necessary for timely disbursement and satisfactory flow o f funds. On the client side, the key elements for successful implementation o f report- based disbursements are the following: 1) the ability to make projections o f cash flow requirements; 2) synchronization with the annual operating plans, procurement plans; and 3) finalization o f the inter- institutional arrangements to ensure: (i)accountability in the different project levels; and (ii) timely transfers o f funds to the bank accounts o f the participating bank for payments and loans. The project will have access to funds advanced by the Bank to two Special Accounts in U S dollars (one for the loan and one for the GEF), for processing disbursements to beneficiaries for those eligible expenditures under project activities. The Special Accounts (SA) will be opened by the Borrower in the Banco de la Nacion (Government commercial bank) andwill be managed by the central PEU, established within the MEM, responsible for implementing the project. Designated accounts will be set up in coordination with "Credit0 Publico" and will consist o f both USD and Local Currency accounts, Counterpart funds will be financed from the National Treasury and the Peruvian system i s set up to force two payments from the two sources o f funds. Funds will be deposited into the Special Account as advances and will follow the Bank's disbursement operating policies and procedures. Inthe casethat withdrawals ofloanproceeds are madeusingReport-basedDisbursements, the Bankwill deposit into the Special Account an amount, which the Bank has determined, based on the reports submitted (FMRs and additional reports for disbursement purposes), required to finance eligible expenditures during the next period (no more than 9 months) following the reporting period o f such FMRs. The disbursement of up to 9 months cash flow needs to the sub-accounts managed by the ParticipatingBank was deemed necessary to provide contractors sufficient payment assurances. 52 Transaction-based disbursements may include direct payments to consultants and service providers, reimbursement to the Government for the Bank's share o f pre-financed expenditures and Bank advances. Report-based disbursement would be used almost exclusively for Bank advances to the project. The counterpart funds from MEF and possibly from Regional Governments, that will be used for the current project in the percentages stipulated in the Legal Agreement will be monitored by the PEU according to the Operations Manual. The project should design detailed procedures for the opening o f Bank Accounts, which include acceptable internal controls, as well as procedures for the transfer o f resources from the Special Accounts to the Rural Electrification Designated (sub) account and to project local currency accounts (Second Generation Special Accounts, or SGSAs), established by the PEUin a commercial bank acceptable to the Bank. Financial management capabilities o f the ParticipatingBank should be a criteria o f selection. The Bank FM team will assess the Participating Bank to ensure that it i s capable o f managing Bank and GEF resources and that it meets minimumBank FMrequirements. Flow o f Funds Both sources o f external financing (IBRD loan and GEF grant) will be managed by the PEU.Funds will flow from the World Bank Loan account to a USD Loan Special Account and from the GEF Grant Account to a USD Grant Special Account. Both USD special accounts will have corresponding project local currency accounts for disbursements. The PEUwill make disbursements to suppliers and contractors from the special accounts for Components 2, 3, and 5. The PEU will transfer funds from the Loan Special Account to the Rural Electrification Designated (sub) account managed by the Participating Bank, under the Administrative Financial Agreement, for expenditures to be made under Component 1. The PEUwill similarly transfer funds from the GEF Grant Special Account to a second designated sub-account managed by the Participating Bank for loans to be made under Component 4. Counterpart funds will be transferred from the Peruvian Treasury to the Project's counterpart account, managed by the PEU for the Government's share o f project expenditures, according to the percentages established inthe Loan and Grant Agreements. 53 More specifically, the flow of funds will pursuethe following schema for each component: 1. Component One: Selected rural electrificationservice providers, under PEU's supervision, will sign contracts with construction contractors. They will make payments corresponding to their co financing share, while the Participating Bank will pay directly the construction contractors the remaining part, corresponding to the subsidies (loan, and counterpart and other funds) form the designated sub-account, uponPEU's instructions and under the conditions o f the Administrative FinancialAgreement against bills and construction progress. Initial payments and progress payments made by the Participating Bank will be reported or summarized on SOE's to be presented to the Bank by the PEU for the Special Account replenishment on (at least) a monthly basis. World Bank b Project Special Account (Banco de la Naci6n) I National Budget Allocations Counterpart Funds Rural Electrification Designated Account (inthe name of PEU, Banco de la Nacion) 4 Regional Government Funds (managed by Participating Bank) Executina Others (Donations, Grants to the Project) Rural Electrification Sub-project Agreement Electricity Service Contractor for Provision Company Contract for Rural Electrification Sub-project 2. Component Two: The technical unit, within the PEUwill handle this component's activities, contracting out technical assistance activities to national and internationalconsultants. The PEU will make payments from the Special Account andthe Counterpart funds account, and will keep all original documentation. 3. Component Three: The PEU will leadthe implementation of this component with the support o f a service contractor and regional consultants. The PEU will make payments from the Special Account and the Counterpart funds account, and will keep all original documentation. 54 4. Component Four: A FundManager will select and proposeto the Independent Investment Committee (within the PEU), renewable energy projects, according to a Facility Agreement. The Participating Bank will finance selected projects with GEF grant funds, under the conditions o f an Administrative FinancialAgreement. It will provide loans to the selected small hydro projects, based on the instructions received from the PEUand receive and administer repayments (including interest). Upon signinga small hydro project loan agreement, the ParticipatingBank will send an original copy of the loanagreement to the PEU for filing. The PEU will determine the amount o f loan disbursements and make monthly or biweekly transfers from the GEF special account to the ParticipatingBank GEF account. Loan disbursements reported by the ParticipatingBank will be considered eligible expenditures for purposes o f the GEF grant and will be reported or summarized on SOE's to be presentedto the Bank by the PEU for the Grant Special Account replenishment, on (at least) a monthly basis. The loan repayments will be deposited into the Participating Bank GEF reflow account and be used for additional small hydro project loans. Original documentation corresponding to loan repayments will then be sent to the PEU's archives. Finally, the ParticipatingBank i s expected to send to the PEU a GEF bank account statement, on a monthly basis. I I I I I World Bank Project GEF Grant Special Accoun (Banco de la Naci6n) Rural Electrification GEF Grant Designated Account (in the name of PEU, Banco de la Nacion) I I I Proiect I 1 (managed by Participating Bank) Executing Participating Bank Unit Small Hydro I iall Hydro Sub-project Agreement an Agreement Contractor Payment: I I Contractor for Rural Electrification Sub-project 5. Component Five: The PEUwill carry out this component, make payments from the SA and the Counterpart funds account, and will keep all original documentation. The budgeting process necessary for Project's implementation and disbursements would use in many cases a bottom-up approach, while the final budget would have to be consolidated by the PEU, for the 55 final approval from the MEF. The information would flow from the service providers, the TU, the ParticipatingBank and the FundManager to the PEU for consolidation. Accounting The PEU will maintain all Project records, consolidated accounts and financial statements, for disbursements and reporting. Therefore, the accounting function should be centralized at the PEU, making sure that: (i)all the participating entities maintain adequate accounting systems inorder to operate all the sub-accounts, and (ii) adequate charge codes are attributed to the upcoming expenses, harmonizedamong the implementing entities, thus identifying the origin and use o f the funds by category and by component. This is necessary, inorder to buildthree series o f financial statements for: 1) the IBRD loan; 2) the GEF grant; and 3) the consolidated or Project's financial statements. InformationSystems At present, the MEM is using the Sistema Integral de Administracidn Financiera (SLAF) and the GESTOR, a parallel system compatible with SIAF, which allows the registration o f more detailed accounting information. Those systems will be used by the PEU for project financial statements consolidation, reporting and disbursements. Audit Arrangements hzternal Audit: Project transactions undertaken by the PEU will be subject to review by the Internal Audit Department of the MEM.This Department is independent and reports the findings o f its ex-post control directly to `the country's supreme audit institution (Contraloria General de la Repziblica). However, as the rhythm o f implementation increases, the PEU will need to ensure that its own internal control structure i s sufficiently strong, and the FM function i s adequately staffed with professionals conversant with Bank policies and procedures in order to: (i) avoid ineligible expenses and delays inthe flow o f hnds and Project implementation; (ii) safeguard o f Project's assets; and (iii) misuse o f avoid funds. External Audit: The PEU will be responsible to provide the Bank annually with consolidated financial statements for the Project, including funds from the World Bank loan, GEF Grant and counterpart funds (including funds from loan repayments), audited by an independent auditing firm acceptable to the Bank and under terms and conditions satisfactory to the Bank, which will include an opinion on the project financial statements and a management letter on the internal control structure. The auditors should have access to all supporting records and make on site examination o f all participating companies and institutions (including the Participating Bank). Annual audit reports with the related statements will be submitted to the Bank within six months o f the end o f the Borrower's fiscal year. All supporting records would be maintainedat the Project and at all participating companies and institutions sites for at least one year after submission to the Bank o f the audit report covering the year in which the final project expenditure was incurred. The Bank's audit guidelines will be used by the Borrower in determining the format and content o f the annual financial statements and in preparing the audit terms o f reference (TORS).The costs o fthe Project audits may be subject to financing from loanproceeds. Auditors would perform at least one interim inspection per year in order to promptly identify areas that require attention of the Project's management. Such reviews will identify problems related to accounting or/and internal control in a timely manner. After each interim visit, a memorandum on internal controls (management letter) would be producedto ensure that corrective actions are addressed prior to year end. 56 Annual project financial statements will be audited in accordance with International Standards on Auditing (ISAs) issued by the International Federation o f Accountants (IFAC), by an independent firm acceptable to the Bank. The audit will be performed in accordance with terms of reference (TORS) approved by the Bank, and the audit opinion should cover the project financial statements, Special Account, Statement o f Expenditures (SOEs), compliance with Loan Agreement and applicable financial laws and regulations. FinancialManagement SupervisionduringImplementation Duringthe first year o f implementation, supervision intensity will be increased, considering the overall risk profile, and will take the form o f technical assistance to the project, and will review controls and transactions as appropriate. This will be complemented by desk reviews o f the Financial Monitoring Reports and annual audit. Thereafter, in addition to the main annual supervision mission, visits may be scheduled to follow up on the findings o f the desk reviews, as appropriate. FinancialManagementActionPlan The Financial Management Assessment concluded that the Project arrangements will not meet minimum Bank requirements at signingas the PEU will not exist. As a result, the Action Plan that follows was proposed by the Bank FM team to strengthen institutional capacity. The action Plan was agreed with the Borrower during negotiations. Inthe discussions with the Project task team, it was decided that all important considerations for Financial Management should be included in the Operations Manual. A Draft Operations Manual was submitted for the Bank's Review during negotiations. While FM conditions of effectiveness are not proposed, as part of fiduciary due diligence leading up to effectiveness, the Financial Management team will visit the project and confirm that financial management capacity i s in place to ensure that the Operations Manual can be effectively implemented. Activity 1Responsible 1 TargetDate 1-7 Negotiations Legal Preparation o f the standard institutional and operational PEU Negotiations Accomplished arrangements between the PEU, Privet Electricity Providers, Fund Manager, Participating Bank (for Loan and Grant). Flow of Funds Flow o f Funds Design PEU During appraisal Accomplished Flow o f Funds Chart (Comp. 1 & 4) WB Before negotiations Accomplished Training in financial management, including planning WB Project Launching and budgeting using country systems and Report-based Disbursements. I Organization and Staffing PEU Organization Chart PEU Inclusion in Operations Manual Accomplished Preparation and submission o f TOR for staff o f the PEU PEU Inclusion in Operations Manual Accomplished to Bank for non objections. Formal nomination o f the Project Preparation General MEM Prior to negotiations Accomplished Manager Formal nomination o f the Project Preparation FM MEM Prior to negotiations Accomplished 57 I Activity Responsible TargetDate Statusat Negotiations PEU Three months from effective date (Dated covenant, under Article 111, Section 3.04 of the Legal Agreement) Full staffing inplace PEU Condition of disbursements for Category 4 (Schedule 1, A3(h)(ii) o f the Legal Agreement -Loan and Grant) IBRD/PEU Project launching; Internal audit staff in Bank Disbursement, Procurement including institutional arrangements, f l o ~o f funds PEU Prior to negotiations Accomplished design, staff functions, accounting policies and procedures, basis o f accounting, chart of accounts =- tailored to include project components. disbursement catcgories and financing source, internal controls, segregation o f duties, fixed assets and records management procedures. Pro\,ision o f comments and recommendations. IBRD Prior to effectiveness PEU Prior to effectiveness Preparation o f draft TORS for audit and submission to PEU Prior to negotiations Accomplished Bank for no-ob'ection. Submission o f approved TORSto the CGR to initiate the Within three months after process o f selection and contracting o f external auditors. PEU effectiveness Obtain waiver from the CGR for hiring of the external auditors. Appointment o f external auditors. CGWPEU Within six (6) months after effectiveness Internal Controls Establishment o f own internal control mechanism PEU To be reviewedbv external auditors I Safeguard over Assets (physical and information) I i Imolementation o f Fixed Asset Policics and Procedures PEU n k d i n g physical inventories, storage/transfer/ distributionhetirements of assets etc. PEU PEU collection and report generation o f same, for the Bank to (attached to the minutes) provide its no-objection. Integrated Financial llanagement System Implementation o f Integrated Information systems. PEU Three months after effectiveness I 58 Annex 8: ProcurementArrangements PERU: RuralElectrification General Procurement for the proposed project would be carried out in accordance with the World Bank's "Guidelines: Procurement Under IBRD Loans and IDA Credits" dated M a y 2004; and "Guidelines: Selection and Employment o f Consultants by World Bank Borrowers" dated M a y 2004, and the provisions stipulated in the Legal Agreement. The various items under different expenditure categories are described in general below. For each contract to be financed by the Loan, the different procurement methods or consultant selection methods, the need for pre-qualification, estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank in the Procurement Plan. The Procurement Plan will be updated at least annually or as required to reflect the actual project implementationneeds and improvements ininstitutional capacity. Procurement of Works: Works to be procured under this project would include construction of infrastructure to extend the scope o f grid-connected electrification services and to develop off-grid electricity services in isolated communities with use o f renewable energy sources in rural settings. Procurement processes would be managed directly by awarded electricity distribution companies -under close monitoring o f the PEU- using Standard Bidding Documents under N C B procedures acceptable to the Bank. Procurement o f civil works will be carried out in 12 rounds throughout project implementation. At each round, contracting packages will be sub-divided in seven contracts, each one estimated to cost US$1.2 million on average, to be procuredunder NCB. Whenever service providers are not available, the sub-projects could be proposed by communities or localhegional governments. In these cases, bidding processes for contracting o f civil works and operational activities required for the provision o f electricity services will be managed directly by the PEU staff following the procurement methods described above. Details on procedures to be followed in cases where community participation i s expected shall be described inthe procurement chapter o f the project Operations Manual. Procurement of Goods: Goods to be procured under this Project would include office equipment and supplies, technical equipment for evaluation o f renewable energy sources, computer hardware and software support for the PEU and regional and local governments. Procurement will be carried out by using Bank Standard Bidding Documents under ICB procedures, and National SBDs proposed by the PEUand agreed with or satisfactory to the Bank. Procurement of non-consulting services: Expenses related to training activities for capacity building purposes -other than consultants- would be procured as non-consulting services. Under this sub-category, expenses such as rental o f facilities, purchase or reproduction o f training materials, food and other relevant expenses would be financed by the project. Also, contracts for administration o f GEF funds by financial institutions in support o f small electricity supply companies would be procured under this contract category. Non-consulting services with estimated values less than US$50,000 per contract will be procured with the use o f price comparison (shopping) procedures o f at least three quotations obtained from qualified local suppliers. For the use o f this procurement method, the PEU will submit project standard procurement documents to be acceptable to the Bank. Selection of Consultants: Consultant services to be provided by firms and individual consultants under the project would include advisory services, technical assistance and training in activities related to the development o f institutional frameworks and regulations for grid-connected and off-grid rural electricity services, capacity building o f service providers and regional governments for development of grid and off-grid sub-projects, promotion o f private sector investment and renewable energy, design and 59 implementation o f promotional/marketing campaign for productive uses o f electricity, assistance in business development for purchase o f electricity using equipment, and consultant services o f a technical and project administrative nature to enable project management and coordination and the carrying out of project administrative tasks insupport o f the PEU. Short lists o f consultants for services estimatedto cost less than US$350,000 equivalent per contract may be composed entirely o f national consultants in accordance with the provisions o fparagraph 2.7 o f the Consultant Guidelines. Consultant firms will be employed with the use o f QCBS; QBS, FBS, LCS, CQS and SSS procedures. Contracts for employment o f firms to be procured under FBS and LCS methods may not exceed a ceiling o f US$200,000 equivalent per contract. Individual consultants will be employed for assignments meeting the requirements established in para. 5.1 o f Section V in the Bank Consultant Guidelines and selected on the basis o f their qualifications for the assignment required under TOR agreed with the Bank team. Such consultants will be competitively selected through the comparison o f at least three candidates among those approached directly by the project agency or who have expressed interest, as the case may be. OperatingCosts: Under this cost category, the Project would finance expenses needed to support project management and coordination tasks and monitoring, including rental o f the PEU facilities, utilities, operation and maintenance o f PEU computer and office equipments, travel, per diem, supervision costs and local contractual staff salaries but excluding salaries o f non-proj ect staff o f the Borrower's civil service at the national and regional levels. Except for local contractual staff salaries, expenses to be financed under this category will not have to be included inthe procurement plans. Implementation o f project procurement shall be systematically monitored on the basis o f yearly-submitted procurement plans that will include the particular contracts and proposed methods for procurement o f works, goods and consulting services, consistent with the ones agreed inthe Loan Agreement. Therefore, aggregated amounts for project financing under each type o f contract are not necessary to include. A detailed description of the particular methods for procurement of works, goods and non-consulting services, and selection o f consultants agreed for project implementation shall be included in the Operations Manual. Project standard procurement documents will be also incorporated in a specific Annex to the Manual. The procurement methods and prior review conditions proposed for the project are indicatedinTable 8.1 below. Assessment of the Agency's Capacityto ImplementProcurement Procurement activities will be carried out by the Ministry o f Energy and Mining -through a dedicated Project Executing Unit- and awarded distribution companies. This Unit will closely oversee the procurement processes managed by service distribution companies. The PEUwill be staffed with a total o f 14 professionals headed by a Project Manager acting as Project Team Leader; 1 Administrative- Financial Coordinator supported by 1 Procurement Officer; 1 Accounting Officer; 1Treasury Officer; and 1 Budget Officer; 1 Technical Coordinator assisted by 2 Technical Specialists; 1 Economist; 1 M&E Specialist; 1 Legal Specialist; and 1 Internal Auditor to be provided by MINEM. The procurement function will be staffed by 1 Procurement Officer who would coordinate procurement planning and oversight tasks and provide technical assistance to MEM's line units involved in specific component implementationand Distribution Companies participating inthe project. An assessment o f the capacity o f the Implementing Agency to implement procurement actions for the project has been carried out on June 24, 2005. The assessment reviewed the organizational structure for implementing the project and the interaction between project staff responsible for procurement and the Ministry's relevant centralunit for administrationand finance. 60 The key issues and risks concerning implementation o f project procurement have been identified and include: i)an organizational structure not yet defined for the PEU by MEM; ii)lack o f prior experience and skilled staff in both MEM and in potential electricity service providers to implement Bank-financed project procurement; iii)some degree of uncertainty around the choice o f provision o f physical space, and computer and office equipment to enable the PEU's full operation and; iv) lack o f an integrated project information system necessary to enable timely project monitoring, control and reporting. The corrective measures to be taken by MEM are: i)submission of an organizational structure and a staffing list, and its final decision on the physical location; ii)hiring of a procurement consultant with experience in MDB- financed projects to provide project procurement coordination, supervision and technical assistance to MEM's executing units and staff, and electricity service companies participating in the project; iii) incorporation in sub-project agreements to be entered into by MEM and Electricity Service Providers in rural areas whereby the latter will adhere to the Bank rules for procurement o f civil works and to close oversight and monitoring o f the PEU's designated procurement specialist; and iv) full implementation by MEM of an integrated PMIS with the capability of recording timely information and monitoring procurement and FM related transactions not later than the end of first year o f project implementation. Bank basic procurement training to both PEUstaff and Electricity Service Provider's will by provided by Bank Procurement Specialists not later thanproject launching mission. The overall project risk for procurement i s moderatelyHIGH. ProcurementPlan The Borrower, at appraisal mission, developed a procurement plan for project implementation which provides the basis for the review o f proposed procurement methods. This plan has been agreed between the Borrower and the Project Team and i s available at the offices o f the Vice-Ministry o f Energy and Mining (MEM) in Lima. It will also be available in the project's database and in the Bank's external website. The Procurement Plan will be updated in agreement with the Project Team annually or as required to reflect actual project implementationneeds and improvements ininstitutional capacity. Frequencyof ProcurementSupervision Inadditionto thepriorreview supervisionto becarriedout fromBankoffices, the capacity assessment of the Implementing Agency has recommended one annual supervision missionto visit the field to carry out post review o f procurement actions. Table 8.1: Thresholds for ProcurementMethodsandPriorReview* Contract Value Contracts Subject to Expenditure Category Threshold Procurement Method Prior Review (US$thousands) (US$thousands) 1.Works Contract = > 3,000 ICB All 30004 Contract >250 N C B Contracts = > U S $ l.O mill; the first 2 contracts; and annual review o f procurement plan. Post-review: Random sample of contracts Contract < = 250 3 quotations (Shopping) First 2 contracts and 61 Contract Value Contracts Subject to ExpenditureCategory Threshold Procurement Method Prior Review (US$ thousands) (US$ thousands) annual review o f procurement plan. Post-review: sample of contracts 2. Goods and Non-Consulting Contract = > 250 ICB All Services 250 > Contract 7 50 NCB Contracts = > 200; the first two contracts; and annual review of procurement plan Contract < = 50 National Shopping First 2 contracts and, annual review of procurement plan. Post-review: Random sample of contracts 3. Consulting Services and Training 3.1 Firms Contract = > 100 QCBS, QBS, FBS, LCS All contracts, including TOR, RFP, shortlist of firms, full review of technical and final evaluation reports, and final negotiated contract. Contract < 100 QCBS, QBS, LCS, CQS, TOR and annual review FBS or SSS of the selection plan. Post-review: Random sample of contracts 3.2 Individuals Contract = > 50 I C All contracts, including TOR, CVs, and Form o f Contract Contract < 50 IC, and SSS TOR, and annual review of the selection plan Post review: Random sample of contracts `Thresholds generally differ by country and project. Consult Operational Directive (OD) 11.04, "Review o f Procurement Documentation," and contact the Regional Procurement Adviser for guidance. Total value of contracts subject to prior review: [US$109.97 million] 62 Details of the Procurement Arrangements Involving International Competition 1. Goods, Works, andNonConsulting Services 1 2 3 4 5 6 7 8 9 Ref. Contract Estimated Procurement P-Q Domestic Review Expected Comments No. (Description) . Cost Method Preference by Bank Bid- (yesho) (Prior/ Post) Opening Date None (b) ICB awarded contracts estimated to cost above US$3.0 millionfor procurement o fworks; and NCB awarded contracts above US$1.O million for procurement o f goods per contract; and all direct contracting will be subject to prior review by the Bank. 2. Consulting Services (a) List of consulting assignments with short-list o f internationalfirms, 1 1 2 3 4 5 6 7 Ref.No. Description of Estimated Selection Review Expected Comments Assignment cost Method by Bank Proposals (Prior / Submission Post) Date Development and Implementation o f a Gis-Based Project Information 2.b.l System 0.23 OBS Evaluation o f Prior 2.d.3 0.32 Jan-07 1 1 1 Prior 3.a.l.l krm) 0.50 May-06 Region 1 Office &Promotional Consultancy Prior 3.b.1 Services 0.46 Aug-06 Region 2 Office Prior 3.b.2 &Promotional 0.46 Aug-06 63 1 2 3 4 5 6 7 Ref. No. Descriptionof Estimated Selection Review Expected Comments Assignment cost Method by Bank Proposals (Prior / Submission Post) Date Consultancy I Region3 Office I QBS Promotional Consultancy 3.b.3 Services 0.46 Region 4 Office & Promotional I Consultancy 3.b.4 Services 0.46 I Region 5 Office I QBS & Promotional Consultancy 3.b.5 Services 0.46 Region6 Office I QBS & Promotional Consultancy 3.b.6 Services 0.46 Dec-06 Fund Prior Management 0.27 QCBS Jun-06 (b) Consultancy services estimatedto cost above US$lOO,OOO for employment o f firms; andUS$50,000 for employment of individuals per contract; and single source selection o f consultant firms and individuals will be subject to prior review by the Bank. (c) Short lists composed entirely o f national consultants: Short lists of consultants for services estimated to cost less than US$350,000 equivalent per contract, may be composed entirely of national consultants in accordance with the provisions o f paragraph 2.7 o f the Consultant Guidelines. 64 Annex 9: Economic and Financial Analysis" PERU: RuralElectrification A. RURALELECTRIFICATION SUB-PROJECTS Background The main economic objective o f the project i s to improve the cost-effectiveness o f the Government's rural electrification program presently implementedby MEM.Inthe past, MEM's project selection was largely based on social criteria (to serve the poorest inthe most remote communities), with little regard for cost- effectiveness. As a result, many such schemes have low electricity consumption, and some, following population migration to urbanized areas, have been effectively abandoned. Rural electrification (RE) schemes built by MEM have been handed over to distribution companies for operation, an unpopular arrangement since these often inadequately designed schemes typically incur high financial losses, Table 9.1 shows MEM's existing Rural ElectrificationPlan. Average connection costs over the 2006-2012 plan period are US$940/HH (household): in the past, this entire amount has been provided as a subsidy since the full construction cost was borne by MEM. Table 9.1: Average US$/connection in each year of MEM's existing Rural ElectrificationPlan Year Investment Households $HH Cumulative Cumulative US$million connected Investment, HH US$million connected 2006 49,124 59,227 840 49,124 59,227 2007 58,050 62,78 1 925 107,774 122,008 2008 67,502 17,704 869 175,276 199,713 2009 62,835 67,953 925 238,111 267,666 2010 36,392 38,925 935 274,503 306,591 2011 66,O 12 62,144 1062 340,515 368,735 2012 60,533 61,407 986 401,048 430,142 2013 71,324 72,217 988 472,372 502,359 total 472,372 502,359 940 Source: MEM, Plan Nacional de Electrificacion Rural 2004-2013 A new approach i s proposed by the project. Its emphasis will be to provide rural electrification to rural areas adjacent to existing distribution company franchise areas (where demand levels will generally be higher, and investment costs per household lower), and to ask the distribution companies themselves to design (and construct) rural electrification schemes for which they will be responsible for operating. This i s expected to improve the prospects for financial sustainability, and provide higher rates o f economic return than under the existing approach. Outlineof the Analysis The economic and financial analysis consists o f five steps: 1. Preliminary screening: 49 proposals submitted by the distribution companies to MEM in May 2005 were evaluated for general economic and financial feasibility: this resulted in the selection o f a short-list o f 16 sub-projects. l5 This is a summary taken from the detailed report on Economic and Financial Analysis. It reflects the preliminary analysis o f results of the Rural Energy Survey conducted in June-July. It i s unlikely that the main findings would change significantly when survey results are finalized, 65 2. Detailed analysis o f the short-list, including comparison o f key assumptions (e.g. for monthly consumption per household) against the results o f the survey, and discussions with the distribution companies to verify technical assumptions. 3. Extrapolation o f the o f the initial sub-project results to the entire program, again using survey results, for example to assess the market size o f potential grid-based rural electrification (RE) projects. 4. Estimatingthe ERR for the project as a whole. 5. Comparison o f the proposed project against the project alternative (Le. a continuation o f the existing approach to RE). Inthe sections that follow we first present the financial and economic modelusedto assess each sub- project: key assumptions on assessing economic benefits are described inAttachment 1. We thenpresent the main conclusions o f each step enumerated above. Financial Analysis A standard project finance model was applied to each project proposal to assess the amount o f capital subsidy necessary to enable the implementing institution (the majority o f which are distribution companies) to obtain a 12% pre-tax financial rate o f return.I6 Table 9.2 shows the demand forecast that i s the basis for the subsequent revenue projections for a typical sub-project. Inmost cases, the initial rate of connection is substantially below the rate achieved in the final year, especially in growing regions. The critical assumption for establishing financial sustainability i s the consumption rate per household (to ensure that tariff revenue exceeds the (largely fixed) costs o f O&M plus energy expenditures. All calculations are at constant 2005 prices. l6 These financial calculations are from the perspective o f the distribution companies, and therefore exclude the cost for the house connection and meter, which i s assumed financed by the distribution companies, and recovered from consumers over the first year of service, as is present practice. These connection costs are of course included inthe economic analysis. 66 Table 9.2: Demand Analysis Consumption Project 3 Company I NW 0 I 2 3 4 5 6 7 8 9 10 I1 Connexions domestic [#I 6583 6846 7120 7405 7701 8009 8330 8663 9009 9370 9744 "on-domesric [#I 65 68 70 73 76 79 82 86 a9 93 96 genenl [#I 0 0 0 0 0 0 0 0 0 0 small indusrty [#I 0 0 0 0 0 0 0 0 0 0 rpcrlal loads [#I 0 0 0 0 0 0 0 0 0 0 total 6648 6914 7190 7478 7777 8088 8412 8748 9098 9462 9841 Monthly Consumption domestic kwhlmer 300 30.3 30.6 30.9 31.2 31.5 318 32.2 32 5 32 8 33.1 non-domesri< kWhlmeS 900 909 91.8 92.7 937 946 955 96 5 97 5 98 4 99 4 general kwhlmes 0 0 0.0 0.0 0.0 0 0 0.0 0.0 0.0 0 0 0.o 0.o small induitv kwhlmes 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0 0 0 0 0.o speclal loads kwhlmes 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0 0 0.o 0.o Annual consumption domerrk 30 MWh 0 0 24.6 51 5 80 8 I12 6 147.1 184.5 1 1 5 0 268 7 316.0 367 0 non-domestic MWh 702 73.7 77.5 81.4 85.5 89.8 94.3 99 0 1040 109.3 I14.8 genenl MWh 0 0 0 0 0.0 0.0 0.0 0.0 0.0 0.0 0 0 0.0 0 0 small in6ustry MWh 0 0 0 0 0.0 0 0 0 0 0.0 0.0 0.0 0 0 0 0 0 0 special loads MWh 0.0 0 0 0 0 0 0 0.0 0.0 0 0 0 0 0 0 0 0 0 0 Annual ronsumptlon MWh 2440.1 2563.1 26922 2817.9 2970.4 3120.1 3277.4 34426 3616 I 3798.3 3989.7 public lighting n t c 5 0% public lightlng MWh 1220 128.2 1346 1414 148.5 1560 1639 1721 1808 1899 199.5 T O S l MWh 2562 I 2691 2 2826.8 29693 31190 3276.1 3441.3 3614.7 37969 3988.2 4189.2 I O S l C S PI 10% energr required [MWhl 28468 29901 31409 32992 3465.5 36402 38236 40163 42187 44314 46547 e n e m 'OSt IUS$lkWhl 0 0599 mi m nowdomesti30 kWh [$1000] 208 0.0 4.2 8 8 13.8 193 25.2 31.6 38.6 46.1 54.2 62.9 non-domestic first90 kW [$1000] 506 642 67.4 708 74.4 78.1 82.1 86.2 90.6 95.1 99.9 104.9 0 >PO [$10001 0 0.0 0.0 0 0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 small Industry [$ IO001 0 0 0 0 0 0 0 0.0 0 0 0.0 0 0 0 0 0.0 0 0 0 0 special loads [$ I0001 0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0 0 0.0 public lighting [$10001 330 41 8 43.9 46.2 48 5 50.9 53 5 542 59.0 62.0 65 I 68.4 neteconomicflows [$lOOO] 3866 -46292 1035.2 1082.9 1132.7 11848 1239.2 1296.1 13555 1417.5 1482.4 1550.1 1620.9 ERR 1b.5cs T O ~consumption I [MWhlYr] 20203 2562 2691 2827 2969 3119 3276 344 3615 3797 3988 4189 levelired economii cost [$US/kWh] 0.32 levelizednet economic bent [$US/kWh] 0 51 [Soles/kWh 1.78 Distribution of costs and benefits INW@I4%, $USIOOOs1 proleit beneficiaries 8 domestic now otherdbtributton In consumers domestic consumers company GoP net benefit n benefits Lil 8 - Electriciq Benefla 9419 506 9925 2 Publlc Llghting 330 330 =? 'z'P costs 4 - Meters -384 -384 Ppoject cost -3889 117 .3772 - O&M -890 ago -1344 -1344 r-- 384 $ 0 1 - 1 I Table 9.6 shows the results of the financial analysis screening, on the basis o f which 10 projects meet all of the first three (financial) criteria. Projects 20, 19 and 43 show distribution company contributions that are negative: these projects require a subsidy greater than the construction cost to make up for future revenues that are below O&M costs (i.e. they fail the test o f financial sustainability). These projects also fail on grounds o f a subsidy requirement>US$800/HHH. Project 23 i s financially (and economically) attractive, but the beneficiaries are owners o f groundwater irrigation systems rather than HH, and therefore lie outside the scope and objectives o f the project (which i s to electrify rural households). Overall, among the projects that meet the criteria, the average distribution company contribution i s 25.3%. The nine sub-projects have an average subsidy o f US$457/HH, which would take up US$l5.2 million o f the available subsidy funds. 70 Table 9.6: Results of the Financial Analysis Screening [ I ] [3] [4] [5] [6] D1 PI [ I O ] accepted I Project I Company I 3264 35 35 2292 702 1931 592 I 5 8% 3 Project3 Company I 6583 30 70 4433 673 3762 57I 15 I% 4 Project4 Company I 9034 32 97 5731 634 4971 550 I 3 3% 54 Project 54 Company2 I188 23 29 657 553 480 434 270% 14 Project 14 Company 3 2195 15 17 1021 465 827 377 189% 21 Project21 Company4 I590 55 19 713 448 378 238 469% 46 Project46 Company 5 436I 25 1242 3237 742 2591 594 200% 47 Project47 Company 5 3677 20 2685 1636 445 I93 53 88 2% 49 Project49 Company2 I343 25 77 615 458 67 50 89 1% toed (average) accpeted p r o p c h 33235 4272 20335 612 15200 457 25 3% repcted, rubr1dy~800$ HH 5 Project 5 Company I 2444 42 26 2333 955 2126 870 8 9% 2 Project2 Company I 2428 35 26 3331 1372 2658 1095 20 2% 20 Project20 Company6 2108 35 8014 7208 3419 7209 3420 -0.0% 19 Project 19 Company8 I980 15 14 1584 800 1752 8 8 5 -106% 43 Project43 Company 3 I058 15 I1 1526 1442 1595 1508 -4 6% repcted. less dtvt 1000 H H 23 Proiect23 Company7 0 0 I163 434 I70 60 8% Table 9.7 shows the corresponding economic analysis. W e note the close alignment o f the results o f the economic analysis with the financial analysis. Projects with ERR less than the 14% hurdle rate also fail one or more o f the financial criteria; and three out o f four projects (2, 19, and 20), rejected on grounds of too high a subsidy, also have ERRSonly marginally above the hurdle rate (15.5-16.1%). Whatever may be the uncertainty in estimating WTP, one may be confident that strict adherence to the financial screening criteria will also select the best sub-projects from the standpoint o f economic returns. Because the economic costs include connection costs, even when taxes and duties are omitted, the average cost per HH(US$644/HH) remains higher than that showninTable 9.5 (US$612/HH). Table 9.7: Results of the Economic Analysis Screening 3 Project 3 Company I 6583 30 2370 70 4629 703 0.32 26.5% 4 Project4 Company I 9034 32 3469 97 601 I 665 0.30 27.8% 54 Project 54 Company2 I188 23 326 29 697 587 0.32 27.7% 14 Project 14 Company 3 2195 15 395 17 1100 50I 0.46 21.756 21 Project21 Company4 I590 55 IO49 19 77I 485 0.18 42.4% 46 Project45 Company 5 436I 25 1308 1242 3358 770 0.26 35.3% 47 Project47 Company 5 3677 20 882 2685 1771 482 0.16 59.1% 49 Project49 Company2 I343 25 406 77 663 494 0.33 35.9% 33235 I I577 4272 21387 644 31.7% rejected, sribsidy>8001~HH 5 Project 5 Company I 2444 42 1232 26 2385 474 0.30 21.5% 2 Project2 Company I 2428 35 I020 26 3353 883 0.42 15.5% 20 Project20 Company6 2108 35 885 8014 7097 2631 021 15.5% 19 Project19 Company8 I980 15 356 14 1636 663 0 74 16.1% repcted, less than IO00 HH 23 Project23 Company7 0 0 0 1163 42 I 0.1 I 40.4% 35 Project35 Company7 630 15 113 3 253 282 0.36 38.2% repcted, ERR< 1.1% hurdle rate 43 Prolect43 Company 3 1058 15 I90 I I 1533 1189 0 97 10.9% (I) including connexton cost excludingwes and duties 71 Criteria for Selection of Projects The criterion o f minimum size o f 1,000 HH is based on a judgment o f transaction costs, and the likely ability o f the Project Implementation Unit (PIU) to process applications. In the first 49 proposals received from the distribution companies, 15 were for small projects o f less than 100HH, for which clearly the transaction costs for evaluation, approval, management and monitoring do not warrant consideration. The target number o f HH to be electrified is 154,000, in projects ideally to be identified over four years, say 40,000 per year. If the average size i s 4000, that means that 10 subprojects must be processed per year. Clearly if too large a proportion o f these were below 1000 HH, the workload on the PIU would be unreasonable. The specific choice o f 1,000 HH therefore represents the judgment o f the Steering Committee o f what i s a reasonable minimumsize. The principal selection criterion o f minimizing subsidy per HH corresponds to the main objective o f the program, which i s to maximize the number o f rural households that can be connected with the available funding. Subsidy per HHand economic rate o f return are closely correlated, as shown inFigure 9.1, In other words, projects with the lowest subsidy per HH are highly likely to have the highest economic rate o f return (ERR). Figure 9.1: ERRv. Subsidy per HH,Projectsin the Short List o'81 E accept reject L c 0.4 E 0.2 w reject 0 0 1 2 3 4 subsidy/HH, 1OOO$ One could o f course introduce multiple objectives (minimize subsidy per HH, maximize ERR or economic NPV, etc), but these would then require weighting schemes to produce rankings whose resulting rank order would be sensitive to the (subjective) weights chosen. However, the precision that results from such a weighting summation scheme i s judged spurious, and i s offset by the simplicity and transparency o f a single objective. Inany event, no project less than the 14% SNIP hurdle rate will be implemented. In sum, there i s high certainty that choosing the projects with the lowest US$ subsidy per HHalso corresponds to a selectionofprojectsthat maximizestotal economic benefits. Environmental Benefits Most o f the projects have negligible environmental effects: there i s some local air quality benefit to the displacement o f kerosene for lighting and diesel for battery charging, and some small increment to GHG 72 emissions from grid-based thermal generations2' The only sub-projects that have more significant environmental impacts are those with significant industrial loads that displace diesel self-generation: however, many o f these projects would be financially viable without subsidy (and therefore did not enter the short-list). Reconciliation of Financial and Economic Flows Table 9.8 shows a reconciliation o f the aggregate financial and economic flows o f the nine accepted projects o f Table 9.7. The Government o f Peru (GoP) funds include those borrowed from the World Bark2' The distribution o f costs and benefits follows the general pattern observed inindividual projects. The ERR i s 31.7%, and the NPV (of economic benefits at 14%) is US$25.8 million. project beneficiaries domestic non- other distribution 40 consumers domestic consumers company GoP net benefit - benefits Electricity Benefits 44632 12238 56870 30 - Public Lighting 1128 2128 $t CWtS ;20 - Metem -1902 -1902 Project cost -17838 535 -17303 5,G O&M -3985 -3985 10 - Energy cost -10012 -10012 2 Tariff m e t e E - I902 I902 0 0 0 . I consumption -13118 -3916 17035 0 =.s public lighting -820 820 0 ; Transfer Pxynients = -10 - ; FOSE 5053 642 -5694 0 Investment Subsidy 13572 -13572 VAT -1688 -622 -1082 3392 -20 Overall Program and RiskAssessment While the economic returns and financial sustainability o f the nine projects selected from the shortlist may be confidently assumed, these account for only US$15.2 million in subsidy and electrify only some 33,235 HH (in the first year), and take up only 16.5% o f the US$92.5 million available for subsidy. Therefore three additional questions must be answered: 0 Are there a sufficient number o f additional rural electrification schemes -- that all meet the required SNIP criterion for ERR, and are financially sustainable -- to justify a US$92.4 million subsidy program? 0 Ifthere do infact exists a sufficient number ofadditionalprojects, what is the likely ERR for the project as a whole (which must meet the SNIP criterion no less than must individual projects)? 0 How does such an overall program compare to the business-as-usual alternative (Le. to MEM's current approach to rural electrification)? 2o These are preliminary calculations based on general assumptions. Carbon emissions are valued at US$20/ton carbon equivalent. Local air emission damage costs are based on Lvovsky et al., "Environmental Costs o f Fossil Fuels: A Rapid Assessment Method with Application to Six Cities", World Bank Environment Department. October 2000. The Economic Analysis Report provides hrther details. 21 The additional transaction costs of the loans (fees, charges and interest) are sufficiently small to be ignored inthis summary. 73 I s there likely to be a sufficient number ofprojects to warrant a $92.4 million program? From the preliminary screening it was observed that the key issue in both economic and financial feasibility i s monthly consumption, whose average was 22 k W H H / m o n t h for satisfactory projects, but only 16 kWh/HH/month for projects that failed the ERR criterion, Therefore, a narrower question can be posed, namely whether there are a sufficient number o f projects whose monthly consumption i s 2 2 / k W H H month or more. The survey results can be used to answer this question. First,we hypothesize an average reference project based on the characteristics o f the projects submitted to MEM to date. If we assume a representative subproject size o f 4,000 HH, and an average subsidy o f US$600iHH, then we need to identify a total o f 39 projects to justify a U S 9 2 . 4 million in total subsidy. As shown in Table 9.9, the assumptions are more conservative than those o f the average project that passed the short list. Table 9.9: The Reference Project Reference Passed project Shortlist (Table 9.7) Key assumptions Typical consumption [KWhiHHimonth] 22 25 Average distribution company share [ ] 20% 25% Average subsidyIHH [$IHH] 600 457 Costs per HH [$IHH] 750 612 HHperproject [HHI 4000 3,690 Total Projects to be identified Subsidy amount [$million] $92.4m $15.2m Number of HH connected [# HHI 154000 33,235 Number of subprojects [#I 39 9 The survey results are easily aggregated by "conglomerate" (the basic unit used by INEI), each o f which represents some 4,900 HH. The universe o f unelectrified HHi s 2.2 million. The average consumption in each electrified conglomerate i s readily calculated, and i s distributed as shown in Figure 9.2A: from this figure it i s evident that 70% o f all conglomerates have consumption o f 22 kWh/HH/month or more. However, this includes conglomerates that are in Departments already heavily electrified (such as Lima and Tacna). These are likely to have a disproportionate number o f high consumptionHH, and represent Departments not likely to be targeted by the proposed program. Therefore, if Departments with present overall electrification rates greater than 80% are excluded (Arequippa, Junin, Ica, Lambayeque, Lima, Moquegua, Tacna and Tumbes), then the universe o f unelectrified HH reduces to 1.19 million, and the number o f potential projects (at the reference project size o f 4,000 HH) reduces to 298 potential projects. How likely i s it that 39, or 13% o f these, have consumption o f 22 k W H W m o n t h ? 74 Figure9.2: Percentagesof Conglomerates(villages)with Monthly ConsumptionGreater than a GivenValue A. All conglomerates B. ExcludingDepartmentswith high electricity coverage 1.2 1 -.-a10.6 ....*0.8 n e 0.4 0.2 0 10 20 30 40 50 60 70 80 90 100 0 average kW hlHHlmonth 0 10 20 30 40 50 60 70 80 90 100 average kW hlHHImonth From the recalculated probability curve shown in Figure 9.2B, 52% o f (electrified) conglomerates have average electricity consumption o f 22 kWWHWmonth or more. Therefore 52% o f 298, or 155 projects, are likely to have the necessary consumption. Since 9 projects are already identified, 145 projects remain, out o f which the remaining 30 must be identified. Provided that consumption in unelectrified areas i s similar to consumption in electrified areas (captured by the survey), then there are over four times as many actual projects with 22 k W H W m o n t h as we needto find to consume US$92.4m in subsidy. Infact, this condition is met, because inthe past, MEM's REprogramemphasized electrification of areas o f high poverty (but this also meant in areas o f low consumption). As shown in Figure 9.3, the distribution o f rural electrification by expenditure decile i s flat. In other words, the presently electrified areas (captured by the survey) have roughly similar average incomes as the unelectrified areas, Thus there i s no reason to suppose that potential consumption in the presently unelectrfzed areas (i.e. the market for the proposed project) would be any lower than in the presently electrified areas (which are represented inthe curve o f Figure 9.2). 75 Figure 9.3: Electrification Rates of Conglomerates by Expenditure Decile 22 0.2 m % 0.1 0 I I I 1 1 42% I 40% 1 4 5 34% 1 6 37% I 40% I 34% 1 7 8 9 lO[hig"l] 42% Thus we may reasonably conclude that: 0 The risks o f not finding 30 additional projects over the next three years, among 145 projects that are likely to have more than 22 kWh/HH/month, i s small. The market effort required to find these i s surely withinthe capabilities o f the project implementationunit; 0 The risk that consumption in the presently unelectrified areas will prove lower than in the presently electrified areas (whose actual electricity consumption i s known from the survey) i s very small; 0 The risk o f not consuming US$92.4million in subsidies, on projects that meet the SNIP and financial sustainability criterion, i s extremely small. AggregateERR of the entireprogram The reference project, based on the assumptions of Table 9.8 - namely a cost per connection of US$750, and 22 kWh/HWmonth, has an ERR o f 20.5%. If the additional 30 reference projects are assumed implemented inyears 2 to 5 o f the project, then the aggregate ERR o f the overall program i s 23.8%. The plausibility o f the reference project, and the use of 22 k W H W m o n t h as its monthly domestic consumption, may be confirmed by a simple calculation of sustainability. Even without non-domestic consumption, a project of 22 k W H H / m o n t h would still be financially viable, as shown in Table 9.10: this project has an average net revenue to the distribution company o f 30 soles/HH/year. This is clearly not true of a project with an average o f only 11k W H H / m o n t h . 22Use o f income deciles would be preferred, but these are still inpreparation from the survey database. However, INEIdata show highrank correlation between average income and expenditure aggregates (the Department with the highest average income also has the highest average expenditure, etc.), so the effect o n decile classifications i s not expected to be significant. 76 Table 9.10: IllustrativeMinimumRevenueCalculations(assuming residentialloadsonly) consumption kWh/HH/month 22 I I k WhlHHlyear 264 132 variable charge SoleslkWh 0.482 0.482 fixed charges I .9 I .9 revenue soleslmonth 12.5 7.8 soleslyear 150.1 93.1 connexion cost $lHH 750 750 soies/HH 2625 1625 0 & M as % of connexior 2.5% 2.5% solelyeadHH 66 66 Energy cost US$lkWh 0.057 0.057 soles/kWh 0.20 0.20 public lighting a s % o f H H 4.6% 4.6% k Whlyear 12.1 6. I public revenue soledyear 5.9 2.9 tom1 consumption [kW hlyr] 276 138 losses [ I 0.08 0.08 energy requirement k Whlyear 300 150 energycost soles/year 60.0 30.0 Tom1 COSG 125.66 95.64 Net (Tariff rev.-O&M-energy) 30.32 -2.58 Figure 9.4: SwitchingValue for Aggregate ERR 0.3 s 0.2 cc cc w REFERENCE PROSECT 0.1 ERR=20.5% 22 kW hlHHlrnon h SWIT HINGVALUE iRR= 4%13 kW hlHHlmonth F 0 10 15 20 25 30 35 kWhIHHlmonth Risk analysis The estimate of ERR for the aggregate US$92.4million subsidy program is subject to several uncertainties, notably in the assumptions for WTP and the actual monthly domestic consumption. The uncertainty in construction and O&M costs i s lower, given the consultations with the distribution companies. The robustness of the aggregate ERR estimate has been tested with a Monte Carlo risk assessment, in which these key input assumptions are specified as probability distributions rather than as deterministic values; by repeating the analysis several hundred times, at each step drawing input assumptions from these probability distributions, the ERR i s turn generated as a probability distribution, 77 as shown in Figure 9.5. 23The probability that the program does not meet the 14% SNIP hurdle rate i s simply the area under the curve to the left o f 14%, which is estimated at 4.6%. Figure 9.5: Probability Distribution of the Aggregate Project ERR 0'3I 0.25 II n-.-sme sr 0.2 94 P 0.15 0.1 0.05 0 Comparison to the project alternative (continuation of the MEMprogram) MEMmakesno estimateofthe aggregate ERRontheprojects inits Plan, andtherefore direct comparison o f ERRSi s not possible. However, the overall savings achievable from the new approach are readily demonstrated by a few simple comparisons. InFigure 9.6 we start withthe present MEMplan: the curve shows the (cumulative) number ofHH connected (Y-axis) as a function o fthe (cumulative) investment (X-axis). For the US$92.4 million that i s actually likely to be available over the next five years, we see that the MEMprogram would provide electrification o f around 100,000 HH(recall Table 9.1 for details on MEM'splan). Now if all that were done i s to re-sequence MEM's program in strict least-cost order - i.e. if no new projects o f the type anticipated were forthcoming - then assuming an average 100% subsidy, around 150,000 HH could be electrified under the new approach, rather than 100,000 households in MEM's original plan. (One could state this in a different way by comparing probable costs for electrifying a given number o f HH: to electrify the first 150,000 HH under the proposed approach costs US$92.5 million (with 100% subsidy), as opposed to US$130 million under MEM's existing program). With an average 20% contribution from the distribution companies, the number o f HHthat can be electrified with the US$92.5 million o f central government. funds increases to around 175,000. Thus these savings may be taken as the lower bound o f the aggregate impact of the proposed new approach: it i s the lower bound simply because it supposes that no additional projects would be forthcoming. Since the MEM's existing inventory o f candidate projects are generally inremote (and very poor) areas, this analysis does not include the many potential projects inthe areas immediately adjacent to the service areas ofthe distribution projects, few o f which were considered for MEM implementation, and 23 See the detailed Report on Economic and Financial Analysis for afull presentation ofmethodology and assumptions. 78 which are likely to have lower capital costs (per connected household) because they have higher load densities, and are more likely to have productiveuses. Figure 9.6: Comparisonof the ProposedProgram with the MEMAlternative MEM PLAN RESORTED IN MEM PLAN RESORTED IN LEAST COST ORDER, 80% LEAST COST ORDER, 100% 50 100 150 200 cumulative investment, $million B. SMALL HYDRO Peru has significant potential for small run-of-river hydro schemes, both as adjuncts to existing irrigation schemes (in the coastal regions), as well as in the hydro-rich Selva. Table 9.11 shows a sample o f identified projects, the first o f which, Santa Rosa, i s currently being implemented (with carbon sales to the Community development Carbon Fund). Most have satisfactory ERRs in the range o f 14-22%; only one (El Sauce) fails to meet the hurdle rate. When carbon emission reduction benefits are valued at US$5/ton C02(the purchase price obtained by the Santa Rosa project), ERRs increase by 1-1.5%. Table 9.11: SmallHydro Schemes Tarucani Moche CMulato El Sauce Graton Tanguche QuitaracsaI Santa Santa Z&ZZ zz Rita R~~~ Data Installed capacity [MW] 49 20.6 8.6 9.4 5 30.3 114.6 170 4.1 capital cost [$USml 54.3 16.7 8.7 11.7 5.1 27.5 119.9 137.0 3.6 construction time [years] 2 3 2 2 2 1.5 3 3 1.5 costikw [MWI 1108 812 1008 1239 1029 908 1046 806 872 annual O&M cost [$USm] 2.56 0.50 0.24 0.21 0.13 0.74 2.00 3.16 0.11 [as%of capital] [ ] 4.7% 3.0% 2.8% 1.8% 2.6% 2.7% 1.7% 2.3% 3.0% load factor [ ] . 85.7% 55.5% 69.1% 48.1% 63.2% 80.3% 63.5% 66.4% 83.5% Generation [GWhgiyear] 368 100 52 40 28 213 638 989 30 Economic returns ERR 16.6% 14.7% 16.0% 8.6% 14.3% 21.9% 13.5% 18.3% 22.6% ERRwith carbon 17.7% 15.7% 17.1% 9.3% 15.3% 23.3% 14.3% 19.4% 24.0% 79 As shown in Figure 9.7, the estimated ERRSare strongly correlated with load factor: those with load factors above 70% are typically associated with irrigation schemes that benefit from upstream regulation. Figure9.7: ERRv. Annual LoadFactor 025 I I 0.2 0%t;fata 6 0C.MuIil0 8auca 015 0Moche1811 Grdon 0QuitaazaI 01 0.05 0.4 0.5 0.6 0.7 0.8 0.9 annual load factor The critical assumption i s the assumption for valuation of economic benefit: the calculations shown above use the Santa Rosa PPA price (based on the busbar price o f the interconnected system at the Huacho substation namely power: US$lO/kW-month, and energy 3.86 UScentdkWh peak, and 2.85/kWh off- peak). This matches well the average (energy only) spot market price o f 3.35 UScentdkWh, used as the baseline benefit estimate. The ERR is robust with respect to this assumption, as shown inthe sensitivity analysis o f Figure 9.8. One estimate o f LRMC (that pre-dates the recent increases ininternational oil and gas prices) i s somewhat lower, at 2.27 UScentdkWh; the resulting ERR i s still 18.8%. Indeed the switching value i s 2,05UScents/kWh, which implies world oil prices below US$25/bbl. One may therefore be confident that there exist many small hydro projects with good economic returns, that warrant support from the proposed small hydro finance facility. Figure 9.8: ERR v. BenefitAssumption (for Tanguche 11) I O 3 025 m 02 0.15 0.1 15 2 25 3 35 4 Eco~ion~ic I,rncfit, UScc~its/l~WI~ 80 Financial Cashflow to the Small Hydropower Facility Table 9.11A below contains a cashflow for the proposed facility. It i s an excerpt from a larger financial model for the Small Hydropower Finance Facility that is available in the Project files. This analysis shows that the revenues from interest payments would be more than sufficient to cover the costs of the facility, after the first two years. 81 N 00 PvSOLAR HOMES The economic cost o f a 50 Wp PV system, (based on quotations for 1,000 systems, including retail margin, but excluding all taxes and duties) i s estimated at US$564. Operating and maintenance costs are as shown in the economic and financial analysis o f a representative system shown in Table 9.12. The general business model would be analogous to that proposed for grid extension, with enterprises bidding for subsidy on similar criteria. Table 9.12: Economic and Financial Analysis, PV Systems RMefitS KWhhonth [KWhhnonth] 10 10 10 10 10 10 10 10 IO 10 BWhMW 12013 12013 I1013 I2013 I2013 I2013 12013 11013 12013 12013 WTP 389 [SolaskWh] 1 . 1I W W h ] [U~*wl 1332 1332 1332 1332 1332 1332 1332 1332 1332 1332 corn Capid Cost [Bus1 5636 Battery 60 [8US] 60 60 Reglators PUS1 45 Li$?tc WJSI 1513 1513 Balance of maintenance co[BUS] 121) I213 I213 1113 1213 I213 1213 I213 1213 1213 tota costs w 5 1 56364 12130 12130 12130 87130 12130 12130 12130 87130 12130 57130 Net economic flows 5 6 4 1212 1212 1212 462 1112 1212 1212 462 1212 762 ERR 18.1% The economic benefits are based on the P V system delivering the same level o f service as a grid customer consuming 10 kWh/month (sufficient for lighting, radiohound equipment, and possibly even for B&W TV) -a patterno fuse verified by the survey results. The capital costs include the costs o ftwo 11W CFLs for each HH.This consumption i s valued at the WTP for lighting (US$1.1 l/kWhfor the initial tranche o f kWhconsumption, see Annex below), andwhich results inanERRo f 18.1%. The financial analysis, and the determination o f financial cost, i s complicated by VAT, the business model that applies, and the region inquestion. One o f the difficulties i s the VAT exemption that applies in the Selva, but only provided the company in question is headquartered in the Selva. "Electricity service" i s VAT exempt in the Selva, which as noted above creates problems even for conventional grid- based service. Three cases may be considered, as indicated inTable 9.13. Table 9.13: Business Models ( 1 ) (2) (3) Region Costa/Sierra Costa/Sierra Selva Implementingentity Distribution Other Distribution company company company (e.g.Tenesoi) Consumerspay VAT on electricity Yes No existing No, VAT service customers exempt Effectivefinancial cost of system USS591 USS708 USS618 83 Table 9.14 shows the financial analysis for Business Model 1, which involves a VAT neutral distribution company. The distribution company requires a 49% subsidy, US$292/HH, to obtain a 12%rate o f return. The incremental VAT revenue collected by the Government occurs only once customers are billed for their monthly service charge: this i s analogous to the grid extension case, which i s similarly VAT neutral inthe construction phase. Table 9.14: FinancialAnalysis, BusinessModel 1 NW 0 I 2 3 4 5 6 7 8 9 I O II I2 & c l b d i l 5 Monthlychay 20 [Soleshonth] 531 [BUShonth] Relenue [BUS1 398 69 69 69 69 69 69 69 69 69 69 69 69 Cor6 Capital Cost Wl 518 591 Battery 60 BUS] 67 60 60 60 Replaton [BUS] II 45 Li*o [BUS] 17 15 15 15 G M olerheads [BUS] 70 12 12 I2 12 I2 I1 12 12 I2 I2 I2 I1 total cos8 [BUS] 682 591 I2 I2 I2 87 12 I2 I2 87 12 57 I1 87 Net financial flow -284 591 57 57 57 -18 57 57 57 -18 57 I2 57 -18 FlRR no subsidy 29 % Subsidyrequired to achiew 12%FlRR -256 -292 IS %ofcapital cost 49% Disbibution companyequity 51% clolrrrllnrl carlrn4wr connefion cost monthlysenice c h a y 70 l2D I1D 12D 12D 12.0 120 120 120 1213 I1D I1D 12D VAT 13 13 13 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 tot4 cost 83 OD 143 143 143 143 143 143 143 143 143 143 143 143 Govr Rcveirnr Subsidy -156 -291 VAT 13 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 13 tot4 -243 -292 13 2 3 2 3 2 3 13 2 3 2 3 2 3 2 3 2 3 2 3 2 3 Ifthere is no VAT exemption (business model 2 of Table 9.13), the subsidy required increases to 58% (US$41O/HH). However, overall, the Government i s better off (in NPV terms), with a net cost (subsidy and VAT) o f US$267 (as opposed to US$243 inbusiness model 1). Finally, inthe case o f business model 3 (distribution company in the Selva), the subsidy required i s US$320/HH, and the net cost to the Government i s US$280. The influence of VAT regime differences will need to be considered in any competitive solicitation for PV subsidy. A metered tariff is not meaningful for a P V system, and therefore the business model requires a flat monthly charge (that would be set according to the size o f the panel, here assumed at 50Wp). The subsidy requirement will then be inversely proportional to the value o f this flat monthly charge as shown inFigure 9:9 (The amount actually paid by the consumer is reducedby FOSE to 50% ofthis). For a 15 Sole/month charge, the distribution company would require a 75% subsidy contribution (US$508/HH, which i s lower than the subsidy proposed for grid electrification in four o f the nine projects shown in Table 9.5). Clearly the subsidy requirement would be further reduced by whatever up-front contribution i s made by the household: for the sake o f equity (compared to households charged for a grid connection) and in the interest of motivating due care and attention to the system, some such contribution should be made. 84 Figure 9.9: Subsidy Requirementfor PV Systemv. Monthly Charge I 120 ' loo ' s -0- ,:3 80 E 3 4 60 v) 40 20 ' 0 1 I I I 0 10 20 30 40 Fixed monthly charge, Soles 85 Attachment 1to Annex 9: Methodologyfor EstimatingWillingness to Pay (WTP) The methodology adopted for the economic analysis to establish WTP follows that used in a number o f other countries for rural electrification projects (Philippines, Bolivia, Vietnam, among others). Section 4 o f the economic analysis report provides a complete description o f the methodology. Willingness-to-pay i s the area under the demand curve, as illustrated in Figure 9.10; for the case o f lighting (similar curves may be drawn for other services such as TV viewing). The demand curve i s downward sloping, and typically has a shape that is concave (with respect to the origin). This shape frequently emerges where more than two points on the curve can be plotted (here only the points x andy are assumed known). The concave shape also follows from the (convenient) assumption o f constant elasticity (an assumption often made ineconometric models). Figure9.10:Demandcurve for lighting price Before electrification, these services are typically provided by a mix o f kerosene, candles, dry cells and car batteries (for lighting) and dry cells and car batteries (for radio and TV). Inthis example, for simplicity, assume that the only service provided is lighting provided by kerosene lamps: the quantity o f services so consumed is QKERO,at the price PKERO. The total household expenditure on lighting is therefore QKERo xPKERo, equal to the area B D. + The total willingness to pay (WTP) for the service at level Q m R o i s the total area under the demand curve to that level o f consumption, Le. areas A +B +D. This is the total benefit to the consumer. However, the cost is areaB + D, and therefore the net benefit, also called the consumer surplus, is the difference between the two, namely the area A. After electrification, the level o f service (inthe case o f lighting, the number o f lumen-hours) typically increases substantially; consumption increases from QKERo to QE, but the price paid for the electrified service also falls (typically) from PKERO to PE. N o w the household's expenditure for electricity i s PEx QE, equal to the area D+E. At this level o f consumption, the total area under the demand curve to +C+D +B +E. Therefore the net benefit, or consumer surplus, after subtracting the costD +E, isA B + C. Thus it QE, i.e. the total benefit, is now the area A + follows that the net economic benefit o f electrification is the increase in consumer surplus, which is the area B C. + Areas B, D and E are readily calculated from knowledge o f consumption before and after electrification, from the household budget for kerosene (and battery charging), and from the tariff o f electrified service: i.e. given knowledge of the two points on the demand curve x andy, the areas B, D andE are immediately calculable. But area C is more 86 difficult to estimate, since it requires knowledge o f the shape o f the demand curve between pointsx andy. The most convenient assumption- and therefore the one most frequently encountered -- i s that the demand curve is linear. Unfortunately such an assumption will lead to an overestimate o f the area C, and o f the net benefits o f electrification, because the empirical evidence i s that in fact the demand curve i s much more likely to have a concave shape, as shown in Figure 9.10.24 Given some functional form for such a demand curve, the area C is readily calculated as the definite integral: here we use a standard functional specification with constant elasticityp r Dip L 'JJ whose corresponding area C (e.g. between QKERoand QE) easily calculates from the corresponding definite integral. TV viewing TV viewing is one o f the most desired aspects o f electrification, and many non-electrified households devote significant money and time for auto-battery charging. In Peru, the survey estimates that 17% o f non-electrified households use car-battery charging, the main use o f which i s for TV. The cost can be calculated from survey- provided information about appliance wattage and appliance use, and from expenditure data on the cost o f batteries, and the costs o f recharging. The average HH using auto-batteries spends 15.3 Solesimonth on this TV viewing (including some use o f radios, sound equipment). Calculations show that on average, auto-batteries provide 4.2 kilowatt hoursimonth, from which point x in Figure 9.11 calculates to 3.61 solesikWh (US$l.O4ikWh). Once electrified, on average, kilowatt-hour use for TV (and related equipment) increases to around 11 kWh (in consequence o f increased use o f color TV and higher-wattage appliances and to a greater number o f TV-watching hours. The average price o f electricity o f course falls dramatically to about 0.61 SolesikWh. The total area under the demand curve(areas B + C + D + E in Figure 9.10) then calculates to 24.9 solesiHHimonth, and hence the average WTP (over the 11 kWhconsumed for TV-viewing) is 2.26 SolesikWh. Figure9.1 1: Demand curve for N-viewing 4 3 7 -' 2 B=I? 3 v) 0 1 D=? 5 E l 4 2 0 0 2 4 6 8 10 1 2 kWh'nboiitli Lighting Table 9.15 shows the assumptions for the derivation o f WTP for lighting, which is estimated at US$1.1likWh for HHmaking the transition from kerosene lighting to electricity. 24 Recognising this problem, some studies (e.g. the World Bank's Solar Homes project inBolivia) take the area Cas one third o f the area determined by a linear demand curve. 87 Table 9.15:Lumenconsumption Peru Bolivia Philippines Laos Assumptions QKERO kLhimonth 4.6 7 4.1 20 QELEC kLhimonth 363 90 204 435 PKERO $ per kLh 0.57 0.48 0.36 0.195 PELEC $ per kLh 0.01 0.04 0.0075 0.003 Results Elasticity [ I -1.08 -1.03 ** -0.74 B $US 2.58 3.08 1.45 3.84 C $US 9.95 5.56 35.20 6.05 D $US 0.05 0.28 0.03 0.06 E $US 3.58 3.32 1.50 I.25 total WTP (per HWmonth) $US 16.16 12.24 38.18 11.20 average kwh KWh 14.5 average WTPlkWh $USkWh 1.11 kLh=kilo-lumen-hour Bolivia data from Annex 9, ERTIC Project PAD, 2003. Philippines data from ESMAF', Rural Electrijkation and Development in the Philippines: Measuring The Social and Economic Benejts, Report 255102, May 2002. Laos data from PAD, 2"d Southern Provinces Rural Electrification Project, 2004 ** Based on linear demand curve! Table 9.15 also shows the comparable results from three other studies, Bolivia, Laos and the Philippines. The Peru results are consistent with those in Bolivia and Laos, but significantly lower than those o f the Philippines. This i s due to the latter's use o f a linear demand curve: when the constant elasticity demand curve i s used, the Philippine result reduces to a total benefit o f US$7/HH/month. As can be seen from Figure 9.12 which shows the lumen-hour demand curve for Peru, the benefit is almost entirely determined by the area C, and hence the assumption made for the shape o f the demand curve is critical. Figure 9.12:Demandcurve for lighting (lumen-hours) 0.4 0 50 100 150 zoo 250 Idll,IllOlltll Table 9.16 shows the estimates o f average WTP for lighting by region. Table 9.16: Estimatesof WTP for lighting,by region(US$/kWh) Peru Costa Costa Costa Sierra Sierra Sierra Selva Norte Centro Sur Norte Centro Sur average WTP/kWh 1.19 1.29 1.08 1.13 1.20 1.17 1.45 1.19 88 Attachment 2 to Annex 9: Summaryfor TypicalRural ElectrificationSub-project Project 3 Company 1 PROJECT CHARACTERISTICS FINANCIAL VIABILITY First-year domestic connexions 6583 Avenge domestic load per connxion 30 Project FlRR before subsidy -4.2% Produductive use [MWhlyr] 70.2 Distribution company equity share 15.1% [as%tOUl] 3% (92 1%) domestic (2 9%) non-domestic (5 0%) public lighting EC O NOMI C V IAB1LlTY Summary investment, s ubsidyl ERR 26.5% H H Investment H H subsidy H H ieveiized economic cost [BUSlkWh] 0.32 first year H H connected 6583 4433 673 3762 57i ieveiized net economic benefit [BUSlkWh] 0.51 at end of project (5th year) 7777 4433 570 3762 484 Foles/kWh i .78 avenge numberofHH 10226 4433 434 3762 368 economic cost per [first year H H connexion) [BIHH] 703 end of planning horizon I3869 4433 320 3762 271 subsidyas % ofinvestment cost 85% Diroibution ofrora ondbenefia I 0 2 hurdle rate: FIRR=12% er --u- I I - 4 -0.1 I ~ doinertic other coiisiiiiiers OoP 0 0.2 0.4 0.6 0.8 1 1.2 tion domertic Dirtr.Co. N e t Benefit D i s t r i b u t i o n coiiiyany equity share 89 Annex 10: Safeguards Policy Issues PERU: RuralElectrification Environment The Project is expected to have a positive environmental impact due to the reduction o f COz emissions through the use o f renewable energy in rural areas for provision o f electricity. This is a National Project with specific locations for projects that were determined duringproject preparationand others expectedto be identified during implementation. Such locations include rural areas o f Peru currently without electricity service. An environmental assessment has been undertaken, identifying any possible negative environmental effects due to the installation o f equipment and other minor works proposed by the project. The assessment has concluded that the probability o f negative environmental effects i s very small. The Project i s classified as Environmental Category: B (Partial Assessment). The Environmental Assessment (EA) includes: (i) a brief summary o f the potential for renewable energy projects in Peru; (ii)a proposal for screening criteriaiguidelines and management procedures for all investment sub-components, ensuring compliance with the Bank's safeguard policies and the local legislation; (iii)an outline o f the main environmental issues, and (iv) main environmental aspects to be included inthe biddingdocuments. What are the mainfeatures of the EMP and are they adequate? Each investment activity will be screened using the environmental framework, and Environmental Management Plans (EMPs) will be developed consequently using the environmental guidelines provided inthe EnvironmentalAssessment. EMP will be developed as an inherent part o f the preparation o f each transaction, and its conclusions and recommendations will be integrated into the contracts with private sector providers that will be responsible to install, operate and maintain the electricity systems. The appropriate procedures will be described inthe Operational Manual. Both the environmental framework and guidelines include specific provisions mandated by OP 4.37 Safety o f Dams for the construction o f new small dams (