Document of Report No. 19603-GZ - World Bank...Document of The World Bank Report No. 19603-GZ PROJECT APPRAISAL DOCUMENT ONA PROPOSED TRUST FUND CREDIT IN THE AMOUNT OF US$15.9 MILLION

Document ofThe World Bank

Report No. 19603-GZ

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED TRUST FUND CREDIT

IN THE AMOUNT OF US$15.9 MILLION

TO THE

WEST BANK AND GAZA

FOR AN

ELECTRIC SECTOR INVESTMENT AND MANAGEMENT PROJECT

August 12, 1999

Infrastructure Development GroupWest Bank and Gaza Country Management UnitMiddle East and North Africa Region

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CURRENCY EQUIVALENTS(exchange rate effective January 22, 1999)

Currency unit = New Israeli Shekel (NIS)NIS I = US$0.25US$1 = NIS 4.05

FISCAL YEARJanuary 1 - December 31

ABBREVIATIONS AND ACRONYMS

DSCR Debt Service Coverage RatioEIB European Investment BankEMP Environmental Management PlanERR Economic Rate of ReturnESIMP Electric Sector Investment and Management ProjectGWh Gigawatt HourHEPCo Hebron Electric Power CompanyICB International Competitive BiddingIDA International Development Association (as administrator of the TFGWB)IFC International Finance CorporationIEC Israel Electric CompanyIPP Independent Power ProducerIS International ShoppingJDECo Jerusalem District Electric CompanykWh Kilowatt HourLACI Loan Administration Change InitiativeLRMC Long-run Marginal CostsLSDP Letter of Sector Development PolicyMEA Ministry of Environmental AffairsMIDP Municipal Infrastructure Development ProjectMOLG Ministry of Local GovermmentMVA Mega Volt AmpereNA Not ApplicableNCB National Competitive BiddingNGO Non-governmental OrganizationNORAD Norwegian Agency for Development CooperationNS National ShoppingO&M Operation and MaintenancePA Palestinian AuthorityPCB Polychlorinated BiphenylsPEA Palestinian Energy AuthorityPIP Project Implementation PlanPLC Palestinian Legislative CouncilPLO Palestine Liberation OrganizationQCBS Quality-and-Cost-based SelectionRKD Rust, Kennedy and DonkinSA Special AccountSCADA Supervisory Control and Data AcquisitionSELCo Southern Electric CompanySOE Statement of ExpendituresTA Technical AssistanceTATF Technical Assistance Trust FundTFCA Trust Fund Credit Agreement for the ESIMPTFGWB Trust Fund for Gaza and West BankWBG West Bank and Gaza

Vice President: Kemal Dervi*Country Director: Joseph SabaSector Director: Jean-Claude VilliardSector Manager: Zoubeida Ladhibi-BelkTeam Leader: Rama L. Skelton

West Bank and GazaElectric Sector Investment and Management Project

Project Appraisal Document

Table of Contents

Page No.Project Financing Data .........................................................1I

A. Project Development Objective ......................................................... 21. Project development objective ......................................................... 22. Key performance indicators .......................................................... 2

B. Strategic Context .......................................................... 21. Sector-related Country Assistance Strategy Goal supported by the project ...................22. Main sector issues and strategy for development of the power sector ............................33. Sector issues to be addressed by the project and strategic choices ..................................4

C. Project Description Summary and Financing Plan .........................................................41. Project components and financing plan .......................................................... 42. Key policy and institutional reforms supported by the project ....................................... 53. Benefits and target population .......................................................... 54. Institutional and implementation arrangements ......................................... . . 6

D. Project Rationale ............................................ 81. Project alternatives considered and reasons for rejection ............................................ 82. Major related projects financed by IDA and/or other development agencies .................93. Lessons learned and reflected in the project design ...................................................... 94. Indications of borrower commitment and ownership .................................................... 105. Value added of IDA (TFGWB) support in this project .11

E. Summary Project Analyses ................ I 111. Economic assessment ......................... 112. Financial assessment ......................... 123. Fiscal impact assessment ......................... 164. Technical assessment ......................... 175. Institutional assessment ......................... 186. Social and stakeholder aspects .......... .............. 197. Environmental assessment ........................ 208. Participatory approach ......................... 21

F. Sustainability and Risks ........................ .. 211. Sustainability ......................... 212. Critical risks ......................... 233. Possible controversial aspects .......... .............. 24

G. Main Loan Conditions .......................... 241. Effectiveness conditions ......................... 242. Other ......................... 24

H. Readiness for Implementation ........................ 25

I. Compliance with IDA Policies ........................ 25

Table Of Contents (continued)Page No.

AttachmentLetter of Power Sector Development Policy and Action Program ...................................... 26

AnnexesAnnex 1. Project Design Summary .33Annex 2. Detailed Project Description .36Annex 3. Estimated Project Costs, Financing Plan, and Implementation Schedule . 39Annex 4. Cost-Benefit Analysis Summary .44Annex 5. Financial Summary (HEPCo, JDECo, SELCo) .53Annex 6. Procurement and Disbursement Arrangements .68

Table A. Project Costs and Procurement Arrangements .70Table B. Thresholds for Procurement Methods and Prior Review .71Table C. Allocation of Credit Proceeds .72

Annex 7. SELCo Management Contract Performance Criteria .73Annex 8. Project Processing Budget and Schedule .84Annex 9. Socioeconomic Issues .85Annex 10. Environmental Management Plan .90Annex 11. Statement of Loans and Credits and IFC Investments .96Annex 12. West Bank and Gaza at a Glance .97Annex 13. Documents in Project File .99

Map No: IBRD 29383

West Bank and GazaElectric Sector Investment and Management Project

Project Appraisal Document

Middle East and North Africa RegionWest Bank and Gaza Program

Date: August 13, 1999 Task Team Leader: Rama SkeltonCountry Manager/Director: Joseph Saba Sector Director: Jean-Claude VilliardProject ID: 40506 Sector: Power Focal Area: InfrastructureLending Instrument: Sector Investment Credit Program of Targeted Intervention: [ ] Yes [x] No

Project Financing Data [] Loan [] Credit [ Guarantee [x] OtherTFGWB credit

For Loans/Credits/Others:

Amount (US$ million): 15.0Proposed terms: [] Multicurrency [ x] Single currency, specify: US$

Grace period (years): 10 [] Standard Variable [ ] Fixed [ LIBOR-basedYears to maturity: 40Commitment fee: 0.50%

Service charge: 0.75%

Financing plan (US$ million):

Source Local Foreign TotalHEPCo/JDECo/SELCo 2.0 1.0 3.0European Investment Bank (EIB) 9.5 28.5 38.0Government of the Republic of Italy (Italy) 14.0 21.0 35.0Trust Fund for Gaza and West Bank (TFGWB) 2.5 12.5 15.0

Total 28.0 63.0 91.0

Borrower: West Bank and GazaGuarantor: N/AResponsible agencies: Palestinian Energy Authority (PEA); Hebron Electric Power Company (HEPCo; to be

created); Jerusalem District Electric Company (JDECo); Southern Electric Company(SELCo)

Estimated disbursements (IDA FY/US$m)': 2000 2001 2002 2003 2004Annual 2.5 5.0 4.0 2.0 1.5

Cumulative 2.5 7.5 11.5 13.5 15.0

Project implementation period: FY2000-2004Expected effectiveness date: October 30, 1999Expected closing date: June 30, 2004Main implementing agencies: PEA; JDECoContact Person: Dr. Omar Kittaneh, General Manager, PEA Mr. M. Ali Husseini, Chairman of Board

P.O. Box 3591, Albireh, West Bank and Managing Director, JDECoTelephone: 972 2-298-6190 P.O. Box B 19225, JerusalemFax 972-2-298-6191

iAll references to IDA in this document mean IDA as administrator for the TFGWB.

Project Appraisal Document Page 2Country: West Bank and Gaza Electric Sector Investment and Management Project (ESIMP)

A: Project Development Objective

1. Project Development Objective:

The development objective of the proposed Electric Sector Investment and Management Project is tobenefit electricity consumers, predominantly households, through sustainable improvements in the qualityof electricity supply. This objective will be achieved through fundamental power sector institutionalreforms (the policy components), implemented in parallel with reinforcement of the power system (thephysical components). In particular, the project will:

(a) Initiate restructuring of the power sector in accordance with the Palestinian Authority's(PA's) Letter of Power Sector Development Policy (Attachment). This will involve thecorporatization and commercialization of two new entities: the Hebron Electric PowerCompany (HEPCo) and the Southern Electric Company (SELCo)-the latter taking over theelectric utility operations of five small municipalities in the area;

(b) Strengthen the Palestinian Energy Authority's (PEA's) capacity to put in place power sectorreforms and sector environmental regulations, and to establish an overall institutionalbasis-building on international best practices-for the sustainable operation of the powersector and the safeguarding of consumer interests;

(c) Reinforce the power system in the central and southern regions of the West Bank (areas Aand B only), as the first step in the least-cost power system expansion plan aimed at theefficient and reliable provision of electricity.

2. Key Performance Indicators:

The key performance indicators to assess progress in carrying out these components are shown in Annex1. In addition, the management contract for SELCo will establish a set of performance targets for projectimplementation. The management contract operator's progress toward these targets is linked, via asliding scale, to performance incentive compensation paid to the Operator each year. Annex 7 presents anindicative set of performance targets for the management contract.

B: Strategic Context

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

CAS document number: not applicable (NA) Date of latest CAS discussion: NA

The project is fully consistent with the World Bank/IDA assistance strategy presented in the paperentitled "A World Bank Group Strategy for the West Bank and Gaza," considered by the Board on May28, 1998. The strategy identifies the infrastructure gap, including in power, as one of the key constraintsto economic growth in the West Bank and Gaza (WBG), and calls for the restoration of infrastructure,strengthening of institutions, and facilitation of private sector involvement in the economy. The proposedlproject is formulated in the context of this strategy, and would directly contribute to its fulfillment by:

* Rapidly improving the quality of supply and access to electricity in the central andHebron govemorate regions of WBG;

* Providing a framework for the efficient implementation of donor-funded capitalinvestments;

* Laying the basis for a sustainable institutional structure in the future;* Attracting private operators in the management of the sector.

The project would build on the work of the two emergency rehabilitation projects (ERP I and II) and theMunicipal Infrastructure Development Project, and complement ongoing works under the Water andSanitation Services Project in Gaza, the Southern Area Water and Sanitation Improvement Project and the


Bethlehem 2000 Project. The project would play a critical and catalytic role in maintaining donor supportand cofinancing in the electric sector.

2. Main sector issues and strategy for development of the power sector:

Issues

* The institutional and regulatory framework is weak. Except for JDECo, municipalities havehistorically been the major providers of electric utility services in WBG. They are confronting a hostof managerial and financial challenges, an uncertain political mandate, and a complicated andconflicting overlay of authorizing legislation.

* The neglect of regulation and control has been costly. Inadequate institutional relationships havecontributed substantially to unclear objectives, suboptimal performance, and inappropriate PAintervention in the sector. Long neglect has led to pronounced deterioration of existing infrastructuresystems and services, and has hindered economic growth and efforts at rehabilitation. There is arturgent need to create new institutions, in order to rationalize and consolidate services and to developlocal managerial talent.

* Tariff designs are out of date. Tariffs fail to respond to market signals and provide inadequateincentives for efficient energy use. The structure of rates is inadequate; there is no time of dayelement, no demand charge, and no power factor penalty. There is also no lifeline tariff block forlow-consumption (lower-income) consumers.

* Demand will be increasing. Credible forecasts completed under the project have served as the basisfor drafting the distribution, transmission, and generation plans. Load is expected to increase by about6 percent a year over the period 1995-2005.

* There is a need for rehabilitation and expansion of the power system. In WBG, almost 20percent of system demand (some 55 MW) is not being met due to lack of capacity along with severevoltage drops. It is reasonable to expect that rapid reductions in non-technical loss levels are possibleas commercial discipline is reestablished. Rehabilitation and reinforcement of the low voltage andmedium voltage systems are urgently required yet remain largely unfunded. In addition, emergencyrehabilitation works in the central West Bank and the Hebron govemorate (requiring roughly US$90million) are thus far unfunded.

Approximately US$330 million for distribution development (including the emergency rehabilitation)will be needed to meet projected system growth in the coming five years. The long-term expansioninvestment program costs for WBG over a I 0-year horizon are in excess of US$600 million.

Strategv

The project is supporting four elements of the PA strategy, as outlined in the Statement of SectorDevelopment Policy and Action Program (LSDP) issued by the President of the PA and the Chairman ofPEA (see Attachment). Their key policy objectives for the power sector include rehabilitation of existingnetworks and services and extension of services to currently unserved communities; separation ofregulatory from commercial functions; encouragement of private participation in sector operations anddevelopment; improving the operating efficiency of distribution utilities; and setting pragmatic tariffs thatwill promote the commercial viability of sector enterprises while providing lifeline rates for needyconsumers.

In support of this broad sector strategy, IDA assistance will focus on:

(a) Rehabilitating existing networks and services, and extending services to unservedcommunities;


(b) Encouraging maximum private sector participation in sector operations and development,particularly in generation and distribution, thus minimizing the need for public sectorfinancial support;

(c) Establishing autonomous and commercially oriented regional distribution utilities inGaza, in the northern West Bank, and in the southern West Bank, by consolidating thelocal electricity departments of the municipalities and villages;

(d) Increasing the operating and technical efficiency of the distribution utilities through end-use energy efficiency, energy conservation, and better load management.

3. Sector Issues to be Addressed by the Project and Strategic Choices

By limiting its focus to the priority issues set out by the PA and the PEA (and which can be addressed inthe five-year implementation period), the proposed operation would lay the foundation for the Palestinianauthorities to achieve their long-term goals for the sector. The creation of independent, shareholder-helddistribution utilities in the Hebron governorate would help to reduce technical and non-technical losses inthe rehabilitated systems; improve consumer metering, billing, and collections; and improve servicedelivery to consumers.

C: Project Description Summary and Financing Plan

1. For a detailed description of each component, project financing plan, and implementation scheduleplease refer to Annex 2 and Annex 3.

There are three main components of the project, as shown below. The table displays major projectcomponents, costs thereof, and the portion of IDA financing; see Annex 2 for details:

Component Category Cost including Percent IDA Percentagecontingencies of total financing of IDA

(US$m) (US$m) financing(a) Rehabilitation and upgrading of electric utility Physical 76.3 83.9 5.2 6.8distribution facilities in the central West Bank and theHebron governorate, and implementation of adistribution dispatching center (SCADA) for JDECo.(b) Management contract and technical assistance Institution 12.2 13.4 7.3 59.8(TA) to strengthen sector institutions. This component buildingcomprises four subcomponents: (i) the three-year cost(fixed fees and performance incentive) of a performance-based management contract for SELCo; (ii) TA to JDECoin areas where its own capacity has potential forimprovement; (iii) TA to help the municipality of Hebroncorporatize and commercialize its electric utility operations(business plan implementation); and (iv) TA to PEA toimplement the actions specified in the LSDP.(c) Initial startup and operating expenditures. This Institution 2.5 2.7 2.5 100.0component, financed by IDA, would help to strengthen buildingboth HEPCo's and SELCo's capacity to operate asfinancially sound and technically capable powerdistribution companies.

Total 91.0 100.0 15.0 16.5

Details of the project costs, financing plan, and implementation schedule are at Annex 3. Provision forcontingencies (price and physical) total US$12.2 million, or 13.5 percent of the total project cost.Counterpart funding is US$3 million, just over 3 percent of the total project cost.

On-lending terms: the Borrower, through the PA, would on-lend the EIB, IDA and Italian loans asfollows:

Project Appraisal Document Page 5Country: West Bank and Gaza Electrc Sector Investment and Management Project (ESIMP)

* JDECo (US$54.2 million) at six percent interest rate with repayment of principal in 20years, including three years of grace;

* HEPCo (US$14.3 million) and SELCo (US$16.6 million) at two percent interest rate withrepayment of principal in 25 years, including ten years of grace;

* PEA (US$2 million), IDA credit would be on-lent on a grant basis.

2. Key Policy and Institutional Reforms Supported by the Project:

(a) Commercialization of utility management, including cost recovery via consolidation of thesix largest municipal electricity departments in the Hebron governorate of the West Bank;

(b) Preparatory engineering and legal work to bring non-electrified regions of the Hebrongovernorate into the SELCo service franchise;

(c) Corporatization and phased introduction of private sector operators into electricitydistribution;

(d) Strengthening of JDECo as a corporate entity and improvement of its management effective-ness;

(e) Drafting of enabling legislation (new electricity law); establishment of arms-lengthregulation of the sector, and of new environmental regulations.

3. Benefits and Target Population:

The project would restore the quality and quantity of utility-grade electric service across the central andsouthern regions of the West Bank, to jump start the economy and create an enabling environment forprivate participation in development of the sector. The ultimate project beneficiaries would be Palestinianelectricity consumers in the region. Principal project benefits (not all of which are quantifiable) wouldinclude:

(a) An upgrade in availability and quality of service for some 150,000 connected Palestiniancustomers (households and enterprises)-a population of approximately 1 million.Rehabilitation would provide for increased levels of reliability (fewer outages, with improvedresponse time to return service following interruptions, service voltage within norms), andmeet the demand growth anticipated over the implementation period. It would also form thebasis for much-needed power system expansion within a least-cost system developmentprogram;

(b) An increase in distribution efficiency. Technical and non-technical power losses, whichcurrently are as high as 20 percent, would be reduced to the levels found in well-managedsystems. Efficiency gains would also be achieved by installing reactive capacity on distributionfeeders to correct for low power factors and avoid the power-factor penalty imposed by thebulk power supplier;

(c) The creation of sufficient institutional capacity to plan subsequent expansions, including theability of sector institutions to finance a substantial portion of sector needs from their owninternal cash-generating resources;

(d) A better base for rural electrification (where grid extensions are economically justifiable), asa result of the strengthened networks and the creation of requisite institutional capacity;

(e) A reduced accident risk for the population at large, as well as for utility employees in therehabilitated system;

(f) Minimization of air pollution through the replacement of less efficient, unsightly, and morepolluting small-scale diesel generators;

(g) Possibly an improved bargaining position for the distribution utilities in negotiations forwholesale bulk power purchases, resulting in lower-cost imports.


4. Institutional and Implementation Arrangements:

(a) Each responsible agency shall be accountable for the proper implementation, monitoring,and reporting of progress for those project components (see detailed project description,Annex 2; financing plan, and project implementation schedule, Annex 3) under its purview.Where implementation capacity is deemed insufficient, this shall be supplemented bytechnical assistance and/or a performance-based management contract, as follows:

(i) JDECo (electric system distribution rehabilitation, distribution expansion,corporate restructuring, institutional strengthening). A project implementationunit (PIJ) shall be set up within its organizational structure. The PIU will beheaded and managed under a technical assistance consultancy for the four-yearperiod of project execution. Full line authority for implementation of thecomponents shall be given to the PIU. The PIU will be responsible for the overallcoordination and day-to-day management of the JDECo component of theproject, both physical and institutional elements. In addition, the PIU will beresponsible for coordinating annual project reviews, preparing and submittingquarterly project progress reports, and preparing disbursement applications;

(ii) SELCo (electric system distribution rehabilitation, putting in place and initialoperation of a new shareholder-held distribution utility organization).Implementation of this component of the project shall be executed under aperformance-based management contract, acceptable to the Administrator.Disbursements shall begin only after such contract, acceptable to the donors, islet;

(iii) HEPCo (electric utility distribution rehabilitation, putting in place and operatinga new shareholder-held distribution utility organization). Implementation willproceed under the guidance of the new board of directors nominated by the cityof Hebron, and duly supported by a technical assistance (TA) service contract. Adetailed business plan shall be presented by HEPCo, and agreed to by the projectdonors, prior to disbursements being initiated under the project;

(iv) PEA (TA consultancies to modernize and reform the power sector's legal andregulatory and environmental monitoring framework). The PEA shall beresponsible for the execution of this component.

(b) Project oversight and overall coordination (guidance on the application andimplementation of the new sector policies). General project oversight shall be theresponsibility of the steering committee, composed of representatives of the Ministry ofFinance, PEA, Ministry of Local Government (MoLG), JDECo, SELCo, and HEPCo.Monthly progress reports shall be prepared under the general guidance of the PIU to beestablished within JDECo, which shall act as the secretariat to the steering committee.

(c) Financial management (accounting, financial reporting, and auditing arrangements). Eachyear the borrower will carry out a financial audit of the above entities by independentauditor(s) acceptable to the administrator of the TFGWB, and furnish such audits to IDA assoon as available but no later than six months after the end of each fiscal year. Projectmonitoring reports, following Loan Administration Change Initiative (LACI) reportingrequirements, shall be submitted to IDA. During the project launch mission-to beconducted before project effectiveness-verification of LACI compatibility will be carried


out. JDECo is currently considered to have appropriate financial management system inplace (adequate internal controls, auditing, accounting policies and practices, staffing,project accounting capability, external auditing by international firm, clean audit reports). Amanagement letter prepared by the external auditors of JDECo shall be submitted to IDA tobuttress this judgment prior to initiation of LACI disbursements. LACI disbursement.activities shall not commence until the full adequacy of the financial management systemscan be certified by IDA. Detailed terms of reference (TORs) for this assessment areincluded in the project file. This work shall be completed by no later than February 2000.

Neither HEPCo (which has yet to be created) nor SELCo (which has been created but is notyet operational) are LACI compatible. For both of these entities, new financial managementsystems, staffing, and training are to be provided either under the business plan (HEPCo) orby the system operator to be retained under the management contract (SELCo).

PEA (created in 1995), on the other hand, has already developed an initial internal set ofproject controls and does have a limited project accounting, auditing, monitoring, andreporting capability, since it has been implementing various donor-funded packages (EU,NORAD, UNDP, Czech Republic, Belgium). This limited capability is deemed adequate tomonitor the three to four consultancy service contracts that the PEA will implement underthe project. Nonetheless, a management letter issued by PEA's external auditors relative toLACI compatibility shall be submitted to IDA, as stated above for JDECo. The financialmanagement system assessment shall be completed in accordance with the timing and theTORs noted above for JDECo.

(d) Monitoring and evaluation arrangements:

(i) Supervision and annual reviews. Supervision by IDA would focus on theperformance indicators shown in Annex 1, which were agreed upon atnegotiations. In addition to two supervision missions per year by IDAheadquarters staff, staff from the local Resident Mission would monitor theprogress of the project on a regular basis during the implementation period.

(ii) Midterm review. A midterm review would be conducted at the end of the secondyear of project implementation. The borrower would submit a complete midtermprogress report to the administrator at least four months prior to the review,explaining activities and progress on each component. The borrower has agreedthat if progress has not been achieved according to the performance indicators,changes in approach, staffing, and technical assistance will be undertaken at themidterm review and that components may be removed from the project.

(iii) Evaluation of SELCo's management contract. The performance of themanagement contractor would be assessed annually by an independent auditor todetermine the magnitude of incentive payments, if any.

(iv) An Implementation Completion Report (ICR) will be prepared and submitted toIDA within six months of the closing date of the TFGWG Credit.

(e) Network Rehabilitation Implementation. Implementation of the distribution networkrehabilitation shall proceed as follows: (i) JDECo shall retain a consulting firm with provenproject management experience in similar activities; (ii) SELCO activities related toimplementation of the distribution rehabilitation component shall be included as a discretemanagement delivery item within the scope of the performance-based management contract;(iii) HEPCo shall retain the services two electric utility distribution utility engineers,following the practices used under the NORAD-funded rehabilitation work done in Gaza and

Project Appraisal Document Page 8Country: West Bank and Gaza Electnc Sector Investment and Management Project (ESIMP)

in the Nablus region. HEPCo's business plan (to be agreed upon) shall provide detailedTORs for this assignment. Given the decentralized nature of the distribution works, use willbe made, where practical, of geographically distributed supply-and-erect turnkey contractpackages.

D: Project Rationale

i'. Project Alternatives Considered and Reasons for Rejection:

While there are no viable alternatives to the urgent rehabilitation work, several alternatives wereconsidered with respect to the institutional component (creation of SELCo with management assistance,and the corporatization of the Hebron Municipal Electrical Department into HEPCo). These alternativeswere:

(a) Implementation of the physical component without the requirement of establishingshareholder-held distribution companies. While efficiency gains would result from thereduction of technical and non-technical losses, the lack of an appropriate long-termcorporate structure for the sector would mean that the sustainability of operations could notbe ensured. Increased cash flows generated by the physical improvements would be quicklysubsumed into the general coffers of the municipalities. Thus they would probably not beavailable to ensure debt repayment or, more importantly, the financial sustainability of theelectric sector.

(b) The original implementation arrangements for the establishment of SELCo envisaged the useof the local utility management capacity existing within the West Bank (i.e., the use ofJDECo as the management contractor, with JDECo strengthened through targeted technicalassistance). This solution was believed to make good economic use of existing local utilitymanagement capacity. However, the newly named board of directors of SELCo (mayors ofthe constituent shareholder towns) rejected the approach of a sole-sourced contract with thisfirm. Instead, the plan now is to recruit a management contractor using commercialprocedures (Bank's Guidelines).

(c) A combined program for the northern and southern West Bank, with a management contractto serve both regions, could have been a cost-effective option. However, there was clearresistance to this solution by the PEA, and coordination with the Norwegian Agency forDevelopment Corporation (NORAD) rehabilitation program in the North wouldconsequently have been more difficult.

(d) Merger of the entire Hebron governorate distribution system with another utility: the powermarket in the West Bank is relatively small, and a structure with one additional distributionutility (Northern Electric Utility, in addition to the existing JDECo, with the entire Hebrongovernorate served by either of them) may be an efficient structure. However, the projectfollows the Palestinian preference for an independent southern utility. Involving JDECo inthe management of SELCo remains an option, as is the further consolidation of distributionservice territories in the West Bank. Initially, the merger between SELCo and the soon-to-be-created HEPCo is anticipated to take place during the period of project implementation,provided that this is warranted by the performance of these two new utilities. The chosensolution minimizes the political risks that an immediate merger with the Jerusalem-basedJDECo would have imposed. A solution involving the northern municipalities would haveled to delays, given the slower pace of institutional reform there.


(e) Further rebundling to create a fully vertically and horizontally integrated electricitycompany: a fully integrated system would be incompatible with IDA policy guidelines forlending in the power sector. International experience clearly shows the advantage of verticaland horizontal separation.

(f) Downsizing the operation with focus solely on the central West Bank (JDECo) distributionsystem. This option was rejected, since mobilization of donor funding for the project wouldhave been severely reduced, and expansion of power to the already lagging Hebrongovemorate would have been deferred by several years.

If this project is implemented as planned, a follow-on project could support: (i) continuation of the sectorreform program begun under the current project; (ii) possibly an independent power producer (IPP)operation in the Gaza area, following establishment of an acceptable regulatory framework; and (iii)investment in the expansion of the distribution facilities of the new distribution companies. Progress inimplementation of the current project, and particularly of the reform program, would be a prerequisite forthe processing of a future TFGWB power project.

2. Major Related Projects Financed by IDA and/or Other Development Agencies (completed, ongoingand planned):

Sector issue Project Latest Project Status Report(Bank Group fina ced projects only)

IDA projects Implementation DevelopmentProgress (IP) Objective (DO)

Water (ongoing) TFGWB, Southern Area Water and S SSanitation Improvement Project

Water (ongoing) TFGWB, Water and Sanitation S SServices Project in Gaza

Urban (ongoing) TFGWB, Municipal Infrastructure S SDevelopment Project

Power (planned) IFC, Gaza Independent Power Under preparation Under preparationProject

Other developmentagencies

Power (completed) NORAD, Electric Sector NA* NARehabilitation in Gaza

Power (ongoing) NORAD, Electric Sector Rehab. In NA* NANorthern West Bank

Power (ongoing) Belgium, Czech Republic and other NA* NAdonors, rural electrification projects

IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory)* Project implementation progress has been satisfactory; see Section E(4) below.

3. Lessons Learned and Reflected in the Project Design:

(a) Need to combine rehabilitation work with institutional reform to ensure sustainability: theproposed operation has a strong institutional component, which in turn is embedded in anoverall sector development strategy (outlined in the LSDP);

(b) Risk of delays to fundamental sector reform: the LSDP was promulgated at the presidentiallevel, and SELCo has been registered with the Ministry of Trade and the Economy as autility distribution company. However, registration of HEPCo as a shareholder-ownedcompany under the Companies Law remains incomplete. It is important to maintain a


certain flexibility with respect to issues related to sector reforms. The Electric SectorInvestment and Management Project is not a blueprint investment project. Project legaldocuments therefore have included a disbursement conditionality for the Hebron projectcomponent.

(c) Need to secure support of local municipalities, which up to now remain responsible forelectricity supply. Project preparation has included workshops and consultations with themunicipalities. Such efforts at building trust among sector institutions need to be continuedthrough the participation by each entity in the project steering committee. Every effort shallbe made to achieve early successes during project implementation, as there is a risk ofmunicipalities feeling they have been compelled by the national government to enter into acorporate structure with which they are not fully comfortable.

(d) Importance of using existing municipal capacity to the maximum extent possible, and toinvolve the local private sector.

(e) Deep reforms depend on a positive political environment. The Bank Group's experience inthe power sectors of other countries, buttressed by OED findings, clearly shows that makingregulation armn's length, enforcing cost-reflective pricing, unbundling assets, and divestiturerequire strong local champions with a political mandate and a sound road map. The mandateand road map come easier when incomes are high and the market is dominated by industrialusers concerned about the reliability and competitiveness of the energy supply.

(f) The political economy of reform has received too little attention. Its complexity is oftenoverrated by politicians but underrated by their technical advisers. To succeed, reformshould be swift and its champions put in strategic places at the outset. The public should bewell informed and there should be careful negotiations with the various stakeholders.

4. Indications of Borrower Commitment and Ownership:

(a) LSDP signed by the President of the PA and the Chairman of the PEA on July 6, 1997 (seeAttachment). Upfront action completed;

(b) Memorandum of Understanding among PEA, NORAD, and IDA on cooperation in thedevelopment of the power sector signed on June 26, 1997;

(c) Creation of SELCo: on December 14, 1998, SELCo was registered as a company under theCompanies Law, under registration number 562439422. Upfront action completed;

(d) SELCo concluded a shareholders' agreement December 16, 1998, which, inter alia, namesmembers and chairperson of its board (latter has now been installed). The agreementprovides for a provisional allocation of shares among shareholders (municipality that hadbeen providing their own power) pending completion of the valuation of assets currentlybeing prepared under the Arthur Anderson consultancy contract. Upfront action completed;

(e) MoLG named as an initial shareholder in SELCo to conserve a place within SELCo for thesmaller municipalities in the Hebron govemorate not currently included within the initialgroup of shareholders. Upfront action completed;

(f) Creation and incorporation of HEPCo: a municipal council resolution was passed to proceedwith the registration of HEPCo and to develop its first corporate business plan;

(g) Rehabilitation of the distribution system, as prepared under the project, has been fundedunder NORAD, and such works have already been successfully implemented in Gaza andare underway in the Nablus region of the West Bank;

(h) JDECo and the PEA have approved the terms proposed for their components under theproject; see Agreed Minutes: Technical Discussions, April 22, 1999 (in project file);

Project Appraisal Document Page 1ICountry: West Bank and Gaza Electric Sector Investment and Management Project (ESIMP)

(i) On April 27, 1999 the Minister of Finance, after consultation with the Chairman of the PEAand the PA Council of Ministers, formally approved the negotiated Trust Fund CreditAgreement (TFCA);

(j) On June 18, 1999 PEA signed an agreement with the first IPP in the WBG; the consortiumplans to build a 136-MW combined cycle power plant south of the city of Gaza, at anexpected cost of US$140 million.

5. Value Added of IDA (TFGWB) Support in this Project:

The financial contribution of the TFGWB to overall project costs amounts to 16 percent; i.e., the IDAresources have been leveraged by a 6.1 multiple. There is considerable donor interest in funding therehabilitation work, provided that an acceptable institutional framework is put in place. IDA'scontribution to the project is, therefore, critical in two respects:

(a) Aid coordination and mobilization: The project cofinanciers have clearly stated their wishto work under an IDA umbrella; hence, IDA has taken the lead in securing andcoordinating funding for the rehabilitation work, which is based on an earlier rehabilitationmaster plan funded by the Technical Assistance Trust Fund (TATF).

(b) Institutional component: Continued IDA dialogue with the PA on institutional issues hasresulted in an effective, private-sector oriented LSDP with an associated action program.The IDA-financed institutional component of the project is a core element in thefulfillment of the LSDP. Experience has shown that institutional reforn is crucial for thesuccess and sustainability of efficiency gains achieved under such operations, and it isseen by cofinanciers as a precondition of their involvement.

E: Summary Project Analyses (Detailed assessments are in the project file, see Annex 13)

1. Economic Assessment (supported by Annex 4)

(a) Electric power marketExisting. The proposed rehabilitation of the power distribution systems in the central andsouthern regions of the West Bank covers parts of the electric power markets served byJDECo, and parts of the isolated power distribution grids in the governorate of Hebron. Themarket served by JDECo accounts for approximately 80 percent of the electricity market inthis region. Net electricity consumption (excluding distribution losses) in the JDECo servicearea increased from about 290 GWh in 1990 to about 581 GWh in 1998, an average growthrate of 9.1 percent. Consumption in the Hebron govemorate grew about the same amountover the period. Electricity imports from Israel Electric Company (IEC) to meetconsumption in the JDECo area also grew at about the same rate. In addition to the importsfrom IEC, the market is also served by a number of small diesel generating units owned byprivate individuals (auto-generation).

Future electricity demand. Growth is projected at 5 to 6 percent per year in the project area,based on population growth, extension of service to new consumers, and increases inhousehold consumption, in line with improvements in living standards. The growth indemand is to be met by reduction in distribution losses and additional imports from the EECsystem, as well as from auto-generation, but imports will be lower than they would havebeen without the project. In addition, improvements in metering, billing, and collectionattributable to the project will lead to reduction in non-technical losses and conservation,further reducing the need for imports. Furthermore, the reliability of supply would improve.All of these factors justify the need for the project.


(b) Least-cost justification. The proposed project was compared with self-generation fromsmall diesel units as the next best alternative to meeting incremental demand in the projectarea. The analysis compared the costs associated with the project to the economic cost ofauto-generation. The costs of the project comprise capital, fixed operation and maintenance,and incremental electricity imports from IEC; and the cost of the alternative comprisecapital, fixed operation and maintenance, and fuel costs of the diesel generating plants. Theresults, summarized in the table below, confirm the project as the least-cost means ofmeeting the forecast incremental demand. Details are provided in Annex 4.

Summary Results of Least-cost Analysis(net present value, US$ million

@10 percent @12 percent_ _ discount rate discount rate

Proposed project 190.5 164.6

Self-generation 287.2 236.5

(c) Economic rate of return. The economic rate of return (ERR) on the project is estimated tobe about 23.0 percent, based on comparison of the quantifiable costs and benefits of theproject over the expected 20-year life of the physical works. The costs are as discussedabove. The quantifiable benefits comprise: savings in technical losses, reduction in powerfactor penalty payments to IEC, and incremental electricity sales due to increased capacity ofthe distribution system as a result of the upgrading achieved under the rehabilitationprogram. The savings in losses and incremental sales were valued at the cost of supply fromdiesel generation at US150/kWh, as a reflection of consumers' willingness to pay forelectricity, as compared to the prevailing average electricity tariff of about US11¢ to1 2¢/kWh.

(d) Sensitivity analysis. A sensitivity analysis was carried out to test the robustness of theproject's economics to changes in key parameters that could affect project outcome. Theparameters are: (i) low and high load growth scenarios; (ii) supply with and withoutrehabilitation; (iii) variation in the willingness to pay (US 130-180/kWh); (iv) the prevailingaverage electricity price; and (v) a rebate in the bulk supply price from IEC. For all thesecases, the ERR ranges from about 17 to 25 percent, significantly above the 10 percentestimated opportunity cost of capital in the WBG. Details of the analysis are provided inAnnex 4.

2. Financial Assessment of Project Entities-JDECo, SELCo, HEPCo (see Annex S for assumptions andproformafinancial statements):

(a) JDECo

Past performance and present financial position. JDECo, a shareholder-held company establishedshortly after the First World War, is the major supplier of electricity in the WBG. It serves approximately105,000 consumers (as of end 1998) in the cities, towns, and many smaller communities of EastJerusalem, Jericho, Bethlehem, Ramalah, and El Bireh. The latest audited figures are for 1998; the outsideauditors expressed a clean opinion on JDECo's financial statements. Debt financing has been constrainedand represented only 3 percent of long-term capitalization at end 1998. In the six years since the interimagreement between the State of Israel and the PLO, revenues from the sale of electricity have consistentlyincreased, as has liquidity. Nonetheless, there is room for improvement in its commercial operations;e.g., technical and non-technical losses, at 19 percent, were more than twice the level expected for a well-

Project Appraisal Document Page 13Country: West Bank and Gaza Electdc Sector Investment and Management Project (ESIMP)

run power utility; and the average age of its accounts receivable, 143 days, has substantial margin forimprovement.

Average tariff levels in 1998 yielded NIS 0.35/kWh (US8.70/kWh), above the estimated LRMC of aboutUS6.7¢/kWh. (The LRMC estimate is a provisional figure, and reflects marginal costs includinggeneration, transmission, and distribution. The generation component of the LRMC reflects the peakermethod, whereby the cost of a reasonably sized peaking unit, including a 25 percent reserve margin, isused to estimate the capacity costs at the generation level.) Tariff levels have made it possible for JDECoto achieve reasonable financial performance levels and to fully recover the costs of purchased power(purchased from the IEC at a flat rate of US6¢/kWh), as well as its operating costs and investments indistribution. The after-tax return in 1998 on year-end shareholder equity was 14 percent. JDECo paiddividends in 1996-1998.

Financialforecasts 1999-2004. Based on the base case financial forecast done under a conservative setof assumptions, outlined in Annex 5, JDECo's financial position is projected to remain stable or improveeach year of the forecasted period. Key assumptions include: (i) a conservative growth rate in kWh salesof 4 percent a year, instead of the robust growth experienced in recent years (e.g., an average of 9.1percent per year over the period 1990-98); (ii) JDECo's own electricity price increases (as well asincreases in the price of power purchased wholesale from the IEC) limited to 6 percent a year from year2000 onward; i.e., 2 percent below the CPI; (iii) JDECo's share of the project (US$57.2 million) to bedebt financed by a 20-year loan, with three years of grace for the repayment of principle, at an interestrate of 6 percent; (iv) improvements in commercial operations, with technical and non-technical lossesreduced to 9 percent by the end of the forecasted period. The company is thus expected to remain in aposition to maintain or increase its dividend payout during the forecasted period; and its capital structureat end-2004 is expected to remain relatively robust (48 percent debt/52 percent equity), with debt servicecoverage 2.6 times. As a result of the rehabilitation program and improvements in managementorganization, JDECo is thus forecast to be able to finance, from internal cash sources, a reasonablepercentage (at least 25 percent) of the future expansion of its power system.

Sensitivity analysis. The above financial forecast was tested under various tariff regulatory models andfound to be robust. For example, even if rate relief were limited to half the rate of inflation used in thebase case ( i.e., consumer price index increases at 8% p.a., however tariff (and purchase power ) priceincreases are limited to 4%), then even under these circumstances, JDECo would still end the forecastperiod in year 2004 able to meet its covenant for long-term debt (DSCR at 2.4 times would be well abovethe 1.5 times covenant), would recover slightly more than its operating costs from revenues (operatingratio at 97%), and it would be able to contribute from internal funds to its construction program. Grantedhowever, that in this instance its financial health would be weakened i.e., after tax return on total assetswould drop to 5%, and be below its cost of capital.

Financial covenants. Because of the uncertain regulatory framework, the on-lending agreement for theJDECo loan shall provide for three financial covenants: (i) a minimum debt service coverage ratio of atleast 1.5 times before JDECo may contract any new debt; (ii) a minimum current ratio of 1.5 times toensure adequacy of working capital and short-term liquidity; and (iii) a limitation on dividend payout,requiring JDECo to obtain the prior approval of IDA in case payment of the dividend would cause thecurrent ratio to fall below 1.5 times. Given JDECo's past prudent management practices, and the resultsof the above financial forecasts done under a conservative set of key economic parameters, it is expectedthat JDECo would not find compliance burdensome.

(b) SELCo

Pro forma financial forecasts 2000-2004. The firm was registered as a shareholder-held company inDecember 1998 but has not yet started operations. Initial operations would consist of the merger of themunicipal electric departments and service areas of five municipalities (the shareholders) in the Hebrongovemorate: Beit-Omar, Dura, Halhul, Thahriah, and Yata. The accounts for these municipalities are not


maintained according to sound accounting principles; i.e., a cash system is used instead of accrualaccounting, and the financial statements are not audited. In the past, the municipalities made noconnection between revenues received from electric sales and cost of supply. Cost is budgeted andrevenues go straight into the communal purse, where they are regarded as fungible. The municipalitiesthus have had little reason to collect the normal statistical data that a utility would require for medium-term planning. This factor will continue to cause problems until resolved under the proposed project.Thus figures should be viewed as indicative only.

The population served totals about 150,000, with 15,500 electric consumers (households and enterprises).'Year 2000 sales are estimated at 38.2 GWh, with billings of NIS 19 million. The forecast reflectsinformation collected from the five municipalities under a consultancy contract with Arthur Anderson(funded by IDA under the ongoing Municipal Infrastructure Development Project).

rhe base case financial forecast reflects the following key assumptions: (i) an average annual growth of9 percent in electricity sales. This rate may appear high when compared to JDECo's, but it reflects theproportionately higher gains expected under the project, including additional kWh sales (billings)resulting from improvements in commercial operations; i.e., the reduction in non-technical losses (seeitem (vi) below) as well as the expansion of the SELCo system into areas not currently served; (ii)SELCo's own electricity prices (and its wholesale power purchases from IEC) limited to an increase of 6percent a year; i.e., 2 percent below the CPI; (iii) SELCo's share of the project is US$17 million), to bedebt financed by a 25-year loan, with 10 years of grace for the repayment of principal and an interest rateof 2 percent on outstanding balances; (iv) SELCo enters into a performance-based management contractto start its operations, with incentive payments to the operator tied to improvements in commercialoperations (see Annex 7); (v) the cost of the management contract (fixed fees and incentive payments) isestimated at US$2.2 million and, for prudent management purposes, these costs are not capitalized but arestated as income expense items in the year they are incurred; (vi) SELCo's commercial operations wouldimprove; i.e., technical and non-technical losses would be gradually reduced from an initial 20 percent inyear 2000 to 11 percent at the end of the forecast period; and (vii) dividend payout begins once steadystate is achieved; i.e., after the third year of operation.

I'he tariff level used as a basis for the projections (NIS 0.469/kWh, or US11.6¢/kWh) reflects theweighted average rate actually used by SELCo municipalities in 1999. The range in tariff levels used bythese municipalities in 1999 varied from a low of NIS 0.35/kWh for commercial customers in Yatta, to ahigh of NIS 0.48/kWh for residential consumers in Dura. Tariffs are near double the estimated LRMC(see JDECo above). The structure of tariffs is inadequate-it reflects a single energy rate, as does IEC'stariff. There is no time of day or demand element, and no power factor penanty-see also discussionunder Section B-2 above. The projections reflect a 2 percent per year real reduction in tariffs for SELCoconsumers over the forecast period.

T'he forecast under the above set of assumptions shows that the company's operating efficiency wouldimprove and it would be financially viable during the entire forecasted period. Its capital structure at theend of the forecast period would be relatively highly levered (debt as a proportion of permanentcapitalization at 77 percent) but would be supported by a robust debt service coverage ratio (DSCR) ofmore than 7 times. Working capital would increase by more than three times, with strong liquidity(current ratio of slightly more than 7 times, with the cash component at more than 6 times), which couldsupport a heavier dividend payout than that envisaged in the forecast. Even though rate levels would havebeen reduced in real terms, nonetheless all operating costs (including cost of the management contract)would be recovered from revenues, and there would also be strong internal cash generation fromoperations to support future expansion of the company. The self-financing ratio at the end of the forecastperiod (at 105 percent) is abnormally high because the investment program used in the forecast reflectsonly the impacts of the project and does not yet reflect subsequent investments needed to expand thecapacity of SELCo's power system.


Sensitivity analysis. As done for JDECo (above) the SELCo financial forecast was tested under varioustariff regulatory models and found to be robust. For example, even if rate relief were limited to half therate of inflation used in the base case ( i.e., consumer price index increase maintained at 8% p.a., withtariff increases (and purchase power price) increases limited to 4% p.a.), then even under thesecircumstances, SELCo would still end the forecast period (year 2004) in relatively good health: wouldrecover more than its operating costs from revenues (operating ratio at 86%), and it would be able tocontribute from internal funds to its construction program. Granted however, that in this instance itsfinancial health would be weakened i.e., after tax return on total assets would drop to 3.3%, and be belowits cost of capital.

Financial covenants. Because of the startup nature of the new company and the uncertain baseline data,other than the standard general conditions applicable under the TFCA, no specific financial covenants areproposed. However, no disbursements to SELCo will take place until and unless a management contractacceptable to IDA has been executed.

(c) HEPCo

Pro forma fnancial forecasts 2000-2004. The company, to be created from the municipal electricdepartment of Hebron, has yet to be formed. It will be larger than SELCo; at end 1998 Hebron hadapproximately 22,000 customers (6,500 more than SELCo) within a similar size but more urbanpopulation base of 150,000. Total sales in year 2000 are estimated at 78.4 GWh (2 times the level ofSELCo), with revenues (excluding VAT) of approximately NIS 40 million. As with SELCo, HEPCo'saccounts are not maintained on sound accounting principles, and Hebron has also regarded electricityprovision as a revenue-raising activity. Thus HEPCo, too, has had little reason to collect the normalstatistical data that a utility would require for medium-term planning. Forecast figures should therefore beviewed as indicative only.

A base case financial forecast was prepared reflecting the same key assumptions as for SELCo, except forthe following: (i) the same growth in customer count was used and relative increase in kWh billingsresulting from improvements in commercial operation; however, because of different specificconsumption by the urban customer category, a slightly higher overall rate of increase results forelectricity sales (10 percent for HEPCo versus 9 percent for SELCo);(ii)HEPCo's share of the project isUS$14.9 million; (iii) as establishing BEPCo would be less complex than establishing SELCo, it wasagreed to use a technical assistance service contract rather than a management contract to start operations;(iv) the cost of the TA service contract (fixed fees and incentive payments) totals US$0.5 million, andcosts would be stated as income statement expense items in the year they are- incurred; (v) HEPCo'scommercial operations would improve; i.e., technical, and non-technical losses would be graduallyreduced from an initial 20 percent in year 2000 to 9 percent at the end of the forecasted period; (vi)because of HEPCo's relatively stronger initial financial position, dividend payout would start from thefirst year of operation; and (vii) tariff levels used as a basis for the projections (NIS 0.48/kWh orUS11 .9¢/kWh) reflect the weighted average rate actually used by the Hebron utility in 1998.

The forecast under the above set of assumptions shows that the company's operating efficiency wouldimprove and that it would be financially viable during the entire forecasted period. Capital structure at theend of the forecasted period would be appropriately leveraged for an operating power utility (debt as apercentage of permanent capitalization at 36 percent in year 2004), and would be supported by a robustDSCR of more than 38 times. Working capital would increase by more than two times, with strongliquidity (current ratio of nearly 6 times, with the cash component of this at near 5 times), which couldsupport a heavier dividend payout than that envisaged in the forecast. Even though rate levels would havebeen reduced in real terms, nonetheless all operating costs (including cost of the technical assistanceconsultancy contract) would be recovered from revenues. There would also be strong internal cashgeneration from operations to support future expansion of the company. As with SELCo, the self-financing ratio at the end of the forecasted period, at 325 percent, is abnormally high, as the investment

Project Appraisal Document Page 16C ountry: West Bank and Gaza Electric Sector Investment and Management Project (ESIMP)

program used in the forecast reflects only the impact of the project and does not reflect subsequentinvestments needed to expand the capacity of the power system.

Sensitivity analysis. As done for SELCo (above) the HEPCo financial forecast was tested under varioustariff regulatory models and found to be robust. Under the same change case as above, HEPCo would endthe forecast period (year 2004) in good health: would recover more than its operating costs fromrevenues (operating ratio at 73%), would be able to contribute from internal funds to its constructionprogram, and while its after tax return on total assets would drop, to 9%, it would be near its cost ofcapital.

Financial covenants. Because of the start-up nature of the new company and the uncertain baseline data,other than the standard general conditions applicable under the TCFA, no specific financial covenants areproposed. However, no disbursements would take place until and unless HEPCo has submitted for reviewby the project donors, and they deem acceptable, a corporate business plan which would, inter alia, detailoperating and revenue budgets, investment plans, and an initial audited set of financial statements for thenew company. Annual disbursements under the credit would likewise be reviewed and measured againstthe agreed benchmarks in the business plan.

3. Fiscal Impact Assessment.

The sale of electricity is currently a main source of income for most municipalities. Because incomesfrom electricity are being used for other purposes, the power distribution systems are not beingadequately maintained, and have deteriorated inexorably. This situation is unsustainable and could leadto the distribution system's inability to serve utility demand in the future. In addition, it is recognizedthat municipalities will not be able, on their own and in the near future, to undertake the investmentsrequired to maintain and expand the electric distribution system to meet the growing demand forreliable electricity supplies. A main goal of the project is to provide for a technically efficient andfinancially sustainable sector to meet demand in an economic manner which will also bring additionalresources to the municipalities, and to the national government through taxes on utility income.However, it will take time for the new distribution utilities to reach a level of operations which willpermit the payment of dividends sufficient to meet the needs of the owning municipalities, withoutharming the financial viability of the company. Thus, in the short- to medium-term, the municipalitieswill suffer short-falls in income from their former electric operations.

In order to mitigate such financial stress, a number of alternatives were discussed, bearing in mind thatthe municipalities at present have limited flexibility with respect to raising revenues from other sources.The ongoing Public Expenditure Review examines, in its chapter on Local Government and UtilityReform, a number of alternative instruments which could, over time, compensate for reduced revenuesfiom utilities, e.g.: develop the currently underutilized property tax; building licenses (cum developmenttaxes); a utility tax; a centrally-funded equalization fund; a temporary utility surcharge; municipalfranchise fees; taxes; rents levied on utilities; temporary support from the national govemnment. Many ofthese actions, however, cannot be undertaken unilaterally by the municipalities, requiring action by thecentral government and, in some cases, the legislature. Donors, including IDA, are working closely withthe PA to support such changes. As an example, the proposed Financial Sector Development Projectwill, inter alia, help strengthen land registration and titling, which are prerequisites for significantlyincreasing revenues from the property tax. In addition, IDA is assisting the municipalities to improvetheir financial management via its involvement in the Municipal Infrastructure and Development Projects(TF 43339 and TF 58683).

Thus, since many of these revenue options cannot be implemented in the short term, tangible short-termmeasures need to be developed. The project design has provided for a number of measures to improvethe cash generation capability of the new operating utilities, among which: highly concessionary costsof finance; funding for initial start-up and operating expenditures; and funding for consultancyservices needed during startup. While this helps the liquidity position of the new utilities in their start-

Project Appraisal Document Page 17Country: West Bank and Gaza Electrc Sector Investment and Management Project (ESIMP)

up phase, it does not deal specifically with the loss of revenues by the municipalities themselves.During project preparation one option examined to relieve financial pressures on the municipalities,would have allowed both SELCo and HEPCo to declare and make dividend payments to their municipalshareholders in anticipation of earnings; this was rejected because it would not be consistent withmanaging these companies on a sound financial basis. Therefore other means of revenue generationneed to be devised for the southern West Bank municipalities.

A number of avenues may be open to the municipalities to relieve the cash gap, and it is proposed thatthese be explored, by the municipalities in consultation with the PA, in the process of developing therespective strategies and business plans for SELCo and HEPCo. Both the HEPCo business plan and theSELCo management contract (which will reflect SELCo's business plan), which are to be submitted toIDA for review and approval prior to disbursements under the credit for these companies, shall reflectthe funding option(s) retained by the municipalities in agreement with the PA.

4. Technical Assessment.'

The rehabilitation component of the project has been carefully prepared under a consultancy servicecontract (funded under the TATF) with Rust, Kennedy and Donkin (RKD, United Kingdom), which wascompleted end-1995 (see Documents in Project File (Annex 13), Generation, Transmission andDistribution Master Plan and Emergency Assistance Project for WBG - Volumes I to VII). Under thecontract, a detailed analysis was made of existing WBG system load characteristics, in order to establishthe basis for developing projections of demand growth under low, base, and high-case economicconditions.

A full diagnosis of the state of repair of the various municipal power systems was conducted and trainingwas provided to counterparts with the full participation of the PEA, including operator/owners of affectedelectric distribution systems-many of whom seconded experienced local staff to participate with RKDengineers. Local engineers participated in both the field data-gathering phase of the consultancy as well asin subsequent design of the system master plan. The resulting master plan is technically sound, is basedon the rationalization of various equipment standards that have historically been in use in WBG, andequally importantly, is broadly supported by stakeholders as being appropriate for the future developmentof the power system. The master plan deals with: (a) the fact that the individual distribution systems arenot yet interconnected, pending agreement with the IEC; (b) selection of uniform technical standards atthe medium voltage distribution level; e.g., it provides for the rationalization/phaseout of the various 3:3-kV, 22-kV, and 11 -kV voltage levels used in different localities; (c) least-cost means of improving qualityof supply to consumers while reducing technical and non-technical losses. Economic parameters used inthe least-cost analysis are detailed in Volume II of the RKD report (discount rate, exchange rate, shadowwage rates, long-run marginal costs, cost of unserved energy, consumer surplus); (d) identification of bothnew and additions to existing bulk supply transmission delivery points to optimize expansion of thedistribution and transmission system; and (e) preliminary assessment of the economics of installation ofnew power plants in Gaza and/or the West Bank. The master plan has identified investment requirementsover the next ten years (exclusive of generation and new transmission facilities) totalling more thanUS$600 million.

The Gaza component of the RKD least-cost master plan has already been implemented. Therehabilitation of the municipal utilities in the northern region of the West Bank (Nablus area) is currentlybeing implemented-work in both Gaza and the Nablus region has been funded by NORAD. A projectcompletion report conducted by NORAD indicated that the Gaza works were satisfactorily executed andproceeded without significant technical difficulties.

Project Appraisal Document Page 18Country: West Bank and Gaza Electnc Sector Investment and Management Project (ESIMP)

S. Institutional Assessment:

(a) Overall sector institutional framework. The power sector in the WBG is characterized bydozens of small municipal electric systems which, with the notable exception of JDECo,have been providing only limited electric utility service. (JDECo is a Palestinian-owned-primarily private capital-utility with relatively good managerial and technical capacity. Itcould form a Palestinian core from which to develop the sectors). The municipalities havebeen using revenues generated from their electric departments as one of their main fundingsources for other social and utility services provided by them. Thus the power sector in theWBG has been inexorably run down. Considerable unmet demand exists, and there is littleor no financial capacity to meet the development needs identified for the sector (see para. 4above). The municipalities have recently been subject to a loose form of oversight by theMinistry of Local Government. Beyond the MOLG, the PEA and an Energy Council wereintroduced under the organic law passed in early 1995 as key players in the sector. Theplethora of sector institutions, and the unclear sector structure and legal framework, have ledto chaotic decisionmaking and have acted as severe constraints to effective development ofthe sector. To jump start the economy, there is a clear and pressing need to proceed withrehabilitation on an emergency basis and to rationalize the institutional framework.

Institutional capacity building is generally more complex than technical rehabilitation, andwill be particularly so in the WBG context: (i) final status arrangements for the sector haveyet to be decided under the peace negotiations, which means that key components of thesector, namely the takeover of bulk power supplies and transmission facilities from the IEC,remain outside the purview of the PA; (ii) while the PEA law has been passed (see above),the concomitant regulatory framework (Electricity Law) has not yet been defined, let alonelegislated; (iii) it will be difficult to remove the municipalities' main funding sources withouta clear source of new replacement revenue and efforts to consolidate the power sector couldbe slowed down. The strategic challenge, therefore, is how to rapidly develop and rationalizethe sector, taking into consideration the many weak institutions and untrained andinexperienced staff, within the above-described local environment.

To address these institutional issues within the project, a comprehensive technical assistanceconsultancy service contract was let under the TATF. This led to the development andadoption by the PA of a cohesive sector development strategy and associated action program(see Attachment), which are to be supported under the proposed project. Institution buildingwould be implemented hand-in-hand with rehabilitation. Key elements of the strategyinclude: (i) definition of the role of the PEA; (ii) establishment of a single buyer model forthe acquisition, transmission, and resale of new bulk power supplies; (iii) merger of themunicipal electric departments into shareholder-owned distribution utility companies-thesenew companies would replace, not be in addition to, the existing departments; (iv) use ofperformance-based management contracts to establish, operate, rehabilitate, and train stafffor the new utilities; (v) implementation of the strategy using, where possible, existing localPalestinian management capacity; and (vi) building competence in public relations andconsumer affairs into the distribution utilities' management, and into PEA's mandate to actas a safeguard for consumer interest and social protection (including lifeline tariffs for thepoorest and most vulnerable).

(b) Beneficiaries. JDECo, which would bear the main responsibility for project execution,would be supported by targeted technical assistance. Implementation of the SELCocomponents would proceed under a management contract. The HEPCo components wouldbe supported by TA, while PEA's would be implemented under consultancy servicecontracts (see Institutional and implementation arrangements under sections C4a and 4babove).


(c) Project management. Support for JDECo's restructuring and project management needs isto be provided through a contract with an internationally experienced consultant, whichwould also take responsibility for the training for Palestinian counterparts.

6. Social and Stakeholder Aspects (supported by Annex 9):

In addition to the socioeconomic background study conducted in 1996 (see Annex 13, item 9) a morerecent diagnostic survey was undertaken by a team of Palestinian sociologists in mid 1999. Conclusionsare that the project is expected to bring measurable direct benefits to consumers, the majority of whom arehouseholds, through improved quality and reliability of supply at little or no increase in tariffs, and with apossible future decrease in real terns as consumers share in efficiency gains.

(a) Social benefits. The great majority of households have electricity connections andappliances, the cost is within their means, and many would be willing to pay more forimproved service. However, to secure these socioeconomic benefits, the project would needto ensure that: (i) lifeline rates for the poorest and most vulnerable are implemented; (ii)distribution companies develop management capacity to handle consumer affairs; (iii) PEAdevelops the professional capacity and the mandate to monitor and evaluate social impactsand safeguard consumer interests as an integral part of its regulatory role; and (iv) the projectand institutions concerned make provision for consumer education and consumer voice.Other expected indirect benefits are: (i) a strengthened basis for economic growth, whichshould indirectly benefit the poor2; (ii) improved environmental and physical conditions,including reduced hazards, noise, and pollution from private generators and from unsafeinstallations, and (iii) a sound financial and institutional base to extend future public networkconnections to unserved areas. Social aspects would be monitored through appropriate TAat the PIU and assessed by the PEA, whose mandate shall include oversight of thesocioeconomic impacts of sector reform.

(b) Tariff issues. More effective sector regulation has the potential to reduce electric bills by atleast 10 percent. Under the project, a tariff study is to be conducted and results implemented.The study shall include the following issues:

* Refocusing of subsidies. Once refocused, subsidies are often more affordable (thoughnot necessarily desirable).

* Linkages of energy to basic social needs. Energy subsidies compete with many, oftenhigher priority social needs. Basic energy needs include space heating in the winter,fuel for cooking, and electricity for lighting. Where access is already available,subsidies should go to reducing the bill through increased energy efficiency. (Notethat this is done in only a few OECD countries.) A US$2.25 million UNDP (GEF)program was recently approved to focus on energy efficiency and energy conservationmeasures across Gaza and the West Bank.

* Access to service. Opening up access in the Hebron governorate is an objective of theproject and should, by itself, reduce the need for subsidies in this region. But reformsbeing supported under the project are needed to achieve this development objective.

(c) Labor impacts. Limited labor force reduction (50 to 75 positions) is expected at JDECo. Aseverance package shall be provided and funded by JDECo under the project to cover early

2 Research has shown that growth almost always reduces poverty and that energy promotes growth. The resultinggainful employment of the poor usually is, in turn, enhanced through increases in labor productivity.

P'roject Appraisal Document Page 20C(ountry: West Bank and Gaza Electric Sector Investment and Management Project (ESIMP)

retirements and assistance to staff who leave as a result of the restructuring, to help themfind good jobs or to retire comfortably. Appropriate records shall be kept and impactsmonitored during supervision and evaluated at midterm. These job losses would becounterbalanced by: (i) improved training, career opportunities, and remuneration, includingperformance incentives at JDECo; (ii) an increase in employment opportunities at SELCoand HEPCo, together with retraining of existing municipal electric department staff; and (iii)an increase in commercial and industrial employment where improved power supply enablesexpansion (see example in Annex 9).

(d) Financing of social services. The cost of social services is presently financed by municipalovercharging for electricity and is dealt with under risks below.

(e) Stakeholder aspects. The potentially strong stakeholder interests and possible conflictsrevolve around: (i) the vested interests of municipalities; (ii) the tradition of non-payment forsupply as a form of political resistance; (iii) the considerable differences among areas interms of wealth, employment, infrastructure, income, and supply needs; (iv) the competitionbetween the needs of commercial and industrial consumers as against those of householdconsumers; (v) the potential conflict of roles between PEA and the distribution companies;and (vi) the differences of interest, approach, and experience among JDECo, HEPCo, andSELCo. The project would need to make considerable efforts to ensure that stakeholders areappropriately integrated and involved in the project and have sufficient common interest inits successful outcome.

7. Environmental Assessment - supported by Annex IO: Environmental Category [ ]A [x]B [IC

Overall, the proposed project should have a positive impact on the environment by increasing safety andreducing line losses, which would reduce environmental impact at the power generation points. Theemergency upgrading of existing distribution voltage level facilities would have major environmentalbenefits by reducing the dangers that exist in many parts of the power system. Overhead line design willbe implemented to provide safety to people, animal, and birds. The project is well defined from anenvironmental viewpoint and the design criteria incorporate appropriate standards (British standards asadapted by the Israel Electric Company) which address environmental issues such as clearance ofelectrical lines. In accordance with Operational Directive 4.01 on environmental assessment, the proposedproject is classified as a category B project, and an environmental management plan has been preparedand included in the project implementation plan (PIP).

The main part of the project concerns upgrading of existing 33 kV and lower-voltage facilities. Therewould be no works associated with power stations, transmission lines, or greenfield sites, and no rights-of-way issues. Electromagnetic radiation from extra-high voltage is therefore not an issue. Distributionsabstations included in the project are within existing locations in urban areas and should have no effecton vegetation. It was confirmed, through a series of random tests and insulating oil manufacturers'specifications, that polychlorinated biphenyls (PCBs) have not been used in the transformers that arebeing replaced.3 During appraisal, a random sample of insulating oil from six of these transformers waschecked for PCBs, with negative results. In addition, the maintenance log of all transformers to bereplaced was checked. All use Shell Diala-A insulating oil, manufactured to ANSI/ASTM standardD3487, an oil that does not contain PCBs, a factor that was re-confirmed with the manufacturer.Nonetheless, to be even more sure that no PCBs are present upon removal and before disposal of the oldtransformers, all will be tested before final disposal. In the unlikely event that PCBs are found present,then these will be disposed of in accordance with the IFC Environmental, Health and Safety Guidelinesfor PCBs, as issued July 1, 1998-see environmental management plan at Annex 10 for details.

3 Overall, some 84 low voltage distribution transformers rated from 250 kVA to 630 kVA are to be replaced, allfinded under the Italian and EIB cofmancing.


A focused environmental monitoring plan (details at Annex 10) has been agreed upon with the PEA andJDECO, and would proceed as follows: removal and proper disposal (according to internationalstandards) of any substances considered environmentally unacceptable is mandatory; responsibility forimplementation would rest with the PIU, which would also report on any other environmental issues thatmay emerge during project execution. Rehabilitation contracts shall provide for the disposal of anytransformer oils, using duly licensed and internationally certified toxic waste disposal firms. Certificatesstating that such disposal has proceeded according to international standards shall be submitted by thecontractors prior to receiving progress payments. If any transformer oil leaks are found to havecontaminated the soil in the vicinity, then such soil shall also remedied in accordance with internationalstandards.

Environmental regulation. A diagnostic assessment has been done by the international consulting firmIVO International Ltd (see Annex 13). Based on this preliminary work, PEA, in coordination with theMinistry of Environmental Affairs (MEA), would develop the policy guidelines and regulations for thepower sector. Training would be provided to the PEA in the use of these guidelines and regulations. Thiswork would be done with the assistance of international consultants (US$200,000 has been allocated forthis purpose).

8. Participatory Approach:

(a) Primary beneficiaries and other affected groups. Preparation was undertaken with closecollaboration with West Bank municipalities, including through power sector workshops inNablus (October 1996) and Hebron (December 1996). Hebron governorate municipalitiesplayed a key role in the steering committee for the creation of SELCo-as did northernmunicipalities in the parallel creation of a northern utility, outside the purview of this project(see Section D4c, Indications of borrower commitment and ownership). A key projectpreparation activity, the WBG power system master plan, was developed with the fullparticipation of the affected municipalities, JDECo, and the PEA (see para. E4).

(b) Other key stakeholders:

* Consultations with the Israeli Electricity Authority, and the Israeli Ministry ofEnergy and National Infrastructure;

* Consultations and collaboration with other power sector donors;

- Ministry of Local Government, through consultations and involvement in theSteering Committee for the Creation of SELCo;

* Both the Ministry of Finance and the PEA have been closely involved with thepreparation of all aspects of the project.

* Stakeholder consultations, including household survey, conducted mid 1999--see Annex 9 for details.

F: Sustainability and Risks

1. Sustainability:

Relatively weak municipal management has led to lack of accountability, poor collections, deteriorationin service, and tariff structures that fail to respond to market signals, and provide inadequate incentivesfor efficient energy use. All investment requirements for the sector cannot be met from public resourcesalone. Given this environment, project sustainability is critically dependent on: (a) political commitmentto undertake reforms; (b) preparation and implementation of an unambiguous legal and regulatoryframework that would facilitate the introduction of the private sector in the delivery of utility services;

F'roject Appraisal Document Page 22Country: West Bank and Gaza Electric Sector Investment and Management Project (ESIMP)

gand (c) clear definition of an impartial and competitive regulatory structure. Related actions to provideincentives to the various stakeholders to implement the project successfully would therefore beundertaken in the context of the proposed project, through, inter alia, decrees and regulations under thenew Electricity Law; the regulation of electricity enterprises, including the formulation and enforcementof policies; and the use of operational contracting for distribution and commercial functions.

Flexibility in the application and timing of the institutional reforms is called for, rather than a more classicatpproach with relatively tight scheduling, buttressed by legal covenants. This choice of approach reflectsriot only experience in other countries (see Section D3 above), but, more importantly, the central role thatthe electricity business has played in maintaining the ability of city mayors in the WBG to deliver otherinfrastructure services to their population; and the large number of such municipal stakeholders involvedin the proposed operation. On the other hand, implementation of the rehabilitation work presents nounusual challenge. Linking reforms to rehabilitation permits early successes in rehabilitation (includingimprovements in commercial performance), which would set the stage for needed public support for thereforms. Given the non-blueprint nature of the proposed operation, close (monthly) oversight by theResident Mission, coupled with a fll midterm review of implementation, would be provided for.

Plroject sustainability depends on the financial viability of JDECo, HEPCo, and SELCo to mobilize(internally, or through debt) the working capital needed to sustain ongoing activities for system operationand maintenance (cost recovery), and on their capacity to self-finance a portion of the capital needed forexpansion. Development of a modem system of financial management and the gradual introduction ofthe private