Document of

The World Bank

Report No: 24719

IMPLEMENTATION COMPLETION REPORT(IDA-32660)

ONA

CREDIT

IN THE AMOUNT OF SDR 18.1 MILLION (US$25 MILLION EQUIVALENT)

TO

GEORGIA

FOR AN

ENERGY SECTOR ADJUSTMENT CREDIT

August 30, 2002

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CURRENCY EQUIVALENTS

(Exchange Rate Effective August 2002)

Currency Unit = LariLari 2.2 = US$ US$1

US$ 0.45 = Lari I

FISCAL YEARJanuary 1 December 31

ABBREVIATIONS AND ACRONYMS

AES Applied Energy ServicesBCM Billion Cubic MetersCAS Country Assistance StrategyCHP Combined Heat and PowerEBRD European Bank for Reconstruction and DevelopmentEMSP Electricity Market Support ProjectESAC Energy Sector Adjustment CreditESAF Enhanced Structural Adjustment FacilityETIB Energy Transit Institution BuildingFSU Former Soviet UnionGDP Gross Domestic ProductGGIC Georgia Gas Intemational CorporationGNERC Georgian National Energy Regulatory CommissionGTC Gas Transportation CompanyGUDC Georgian United Distribution CompanyIDA International Development AssociationIFC Intemational Finance CorporationIMF International Monetary FundJBIC Japan Bank for International CooperationKfW Kreditanstalt fur Wiederaufbau (Reconstruction Loan Corporation)kWh Kilowatt HourMW Mega WattsOECF Overseas Economic Cooperation FundSAC Structural Adjustment CreditSDR Special Drawing RightsSRS Structural Reform SupportUSAID United States Agency for International DevelopmentUSD Unted States DollarsUSSR Union of Soviet Socialist RepublicsWEM Wholesale Electricity Market

Vice President: Johannes Linn, ECAActing Country Director: Peter Nicholas, ECCU3

Sector Director: Hossein Razavi, ECSIETask Team Leader: Vladislav Vucetic, ECSIE

GEORGIAENERGY SECTOR ADJUSTMENT CREDIT

CONTENTS

Page No.1. Project Data 12. Principal Performance Ratings 13. Assessment of Development Objective and Design, and of Quality at Entry 24. Achievement of Objective and Outputs 85. Major Factors Affecting Implementation and Outcome 186. Sustainability 207. Bank and Borrower Performance 218. Lessons Learned 239. Partner Comments 2510. Additional Information 28Annex 1. Key Performance Indicators/Log Frame Matrix 29Annex 2. Project Costs and Financing 30Annex 3. Economic Costs and Benefits 31Annex 4. Bank Inputs 32Annex 5. Ratings for Achievement of Objectives/Outputs of Components 34Annex 6. Ratings of Bank and Borrower Performance 35Annex 7. List of Supporting Documents 36

Pr-oject ID- P064094 Project Name: ENERGY SECAC

Team Leader: Vladislav Vucetic TL Unit. ECSIE

ICR Type: Core ICR Report Date: August 30, 2002

1. Project Data

Name: ENERGY SECAC L/C/TFNumber. IDA-32660

Counn-y/Department: GEORGIA Region Europe and CentralAsia Region

Sector/subsector: Power (39%); Oil & gas (32%); Central governmentadministration (18%); Other social services (7%);Telecommunications (4%)

KEY DATESOriginal Revised/Actual

PCD: 11/16/1998 Effective. 08/02/1999 08/02/1999Appraisal: 11/10/1998 MTR

Approval: 06/29/1999 Closing: 06/30/2000 03/01/2002

Borrower/Implementing Agency Georgia/Government of Georgia

Other Partners. N/A

STAFF Current At Appraisal

Vice President. Johannes F. Linn Johannes F. LinnCountry Manager: Peter Nicholas Judy M. O'ConnorSector Manager. Hossein Razavi Hossein RazaviTeam Leader at ICR: Vladislav Vucetic Jonathan D. Walters

ICR Primary Author. Vladislav Vucetic; Jonathan D.Walters

2. Principal Performance Ratings

(HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=HighlyUnlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible)

Outcome: S

Sustainability L

Institutional Development Impact M

Bank Performance: HS

Borrower Performance: S

QAG (if available) ICR

Quality at Entrv. SProject at Risk at Any Time: No

3. Assessment of Development Objective and Design, and of Quality at Entry

3.1 Original Objective:The Georgian economy has been experiencing serious fiscal, quasi-fiscal, and extemal imbalances. A majorsource of these imbalances has been the use of the power sector for quasi-fiscal financing of subsidies tothe population and economy through low tariffs, low collection of paymnents, and tolerance of highcommercial losses. As in many other energy-poor FSU countries, the Georgian energy sector absorbed thebulk of the terms of trade loss consequent on the break-up of the USSR. The consequent quasi-fiscalsubsidies to energy customers, amounting to approximately 5 percent of GDP annually have severelydecapitalized the energy sector and diminished its ability to provide services, exacerbating the economicdowntum. The problem has been compounded by inefficient economic management and widespreadcorruption, both inside and outside the sector, resulting in economic waste and large scale misallocation ofresources.

The weak fiscal management and the weak management of state companies, combined with insufficientstructural reforms and widespread governance problems have made it difficult to abandon this quasi-fiscalrole of the sector and to fight off its increasing capture by vested interests and corrupt groups. The abuseand mismanagement of the sector resulted in poor collection of billed revenues, and large billing and othercommercial and technical losses, completing the self-perpetuating vicious circle of the sector's diminishingability to service its customers and the decreasing ability of the customers to afford the services.

The combination of softening the budget constraints of poorly-performing enterprises in an energy-intensiveeconomy and failure to provide reliable energy services to all enterprises as a result of the consequentfinancial crisis in the energy sector, has been economically devastating in Georgia. The impact on povertyhas been considerable, which has in turn hampered sector reform. In particular, the inability of the sectorto provide reliable electricity supplies in the winter created enormous hardship, caused significantenvironmental degradation, and posed considerable political risk to the Government's overall reforrnprogram. As in many other FSU countries, the quasi-fiscal deficit in the energy sector allowed increasedcontrol of the fiscal deficit itself (at least on a cash basis), which greatly facilitated monetary stabilizationand the all-important fight against inflation. However, eventually the cost of using quasi-fiscal energysubsidies to substitute for monetary expansion became unsustainable. Nonetheless, considerable vestedinterests had coalesced around the quasi-fiscal policy.

The Energy Sector Adjustment Credit (ESAC) was designed to help break out of these vicious circles bysupporting structural, policy, legal, and institutional reforms in the energy sector, in conjunction withbroader economic reforms pursued by IDA's adjustment lending (Structural Adjustment Credit III) and theIMF-supported program (Poverty Reduction and Growth Facility). The reform program supported by theESAC was well integrated into the Country Assistance Strategy (17000-GE). The ESAC was conceived asa significant step forward on a long process of economy-wide reform and adjustment in post-SovietGeorgia; it was not expected that all the major distortions in the energy sector would have been resolved bythe end of the ESAC period.

In parallel to the reform of the domestic energy sector, Georgia faced an opportunity to capitalize on itspipeline transit potential for landlocked Caspian oil and gas resources (as well as in exploiting Georgia'sown, albeit limited, hydrocarbon resources). The ESAC-supported reforms focused on maximizing the netbenefits to Georgia from private investment in transit pipelines, in both fiscal and environmental terms.Although this component was secondary in the ESAC program to power sector reform, it was neverthelessan important part of promoting private infrastructure investment in Georgia.

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It should be emphasized that Georgia's reform program took place against the background of the territorialdisintegration of Georgia, the aftermath of civil war, and complex relations with neighboring countries in aconflict-ridden region. The extreme challenge this posed to state-building in a newly-independent Georgia,and the central role that the energy sector played in regional political dynamics, are critical to anunderstanding of Georgia's energy reform program.

The weakness of the Georgian state both constrained the pace of reform and conditioned its design; thispoint cannot be overemphasized. Most importantly, this represented the joint perception of governmentofficials (from the President downwards) and IDA staff. The ESAC reform program reflected a strongintemal and external consensus.

The main elements of sector reform supported by the ESAC included strategic privatization in theelectricity sector, creation of an enabling environment for private sector participation in the oil and gasindustries, and improved environmental regulation and social protection.

The objectives of the credit were to help:

* maintain momentum of energy sector reform and help mitigate its social costs;* enhance financial management and combat corruption;* increase the availability of energy on a sustainable basis;* catalyze private investment;* realize Georgia's pipeline transit potential; and* upgrade environmental management.

The objectives reflected well the priorities of the sector at the time of the program's inception.

3.2 Revised Objective:There were no revisions to the original objectives.

3.3 Original Components:The reform program supported by the IDA Credit included the following components, measures andactivities:

A. The power sector

* Privatization of distribution and generation companies: the program called for completing the sale ofTelasi, the electricity distribution company serving the capital Tbilisi; offering all remainingdistribution and generation companies (outside Abkhazia) for privatization to strategic investors;successful sale or long-term concession for at least about 130 MW of hydropower plants; and closingbids for the Gardabani thermal plant.

* Adoption of electricity market rules, and stakeholders' management of the wholesale electricitymarket (as opposed to managing the market through a single buyer model, with Sakenergo, thetransmission and dispatch company, being the single buyer);

* Maintaining cost reflective tariffs: an initial increase by an average of 45% was necessary, after whichthe Georgian National Energy Regulatory Commission (GNERC) would maintain tariffs per tariffmethodology, privatization contracts, and license conditions;

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* GNERC to adopt dispute resolution procedures for companies operating in the electricity market;

* Adoption of a Chart ofAccounts according to International Accounting Standards for Sakenergo,Electrodispetcerizatsia, Electrogadatsema, Sakenergogeneratsia, and Tbilsresi. The first fourenterprises played a central role in sector operation and were envisaged to remain under statemanagement; Tbilsresi's privatization timetable - and indeed the very feasibility of privatization - wasunclear at the time of program design, hence its inclusion under this policy action;

* Auditing the 1999 financial statements of Sakenergo, Electrodispetcerizatsia, Electrogadatsema,Sakenergogeneratsia, and Tbilsresi by international auditors (see bullet point above);

* Introducing budgetary compensation for electricity delivered to Abkhazia: the power system wasdelivering a significant amount of electricity (10-15% of total generation and imports) to Abkhaziawithout any compensation. Since disconnection of Abkhazia was not possible for political reasons, itwas necessary that the budget compensate the power system for at least part of the cost of thiselectricity;

* Increasing poverty benefits to poor single pensioners: the Consolidated Budget was to include benefitsto single pensioners, as the most vulnerable group, in an amount sufficient to bring the beneficiaries tothe Bank-estimated poverty line (total amount to be included in the 1999 Consolidated Budget was Lari14.3 million); and

* Abolishing direct transfers from budget to Sakenergo on behalf of pensioners, civil servants, andrefugees (i.e. amounts withheld by Government from salaries and pensions and paid to Sakenergo) inprivatized distribution areas and disbursing them directly to the beneficiaries.

B. Natural gas transmission and distribution

* GNERC to regulate domestic gas supply: Parliament was to adopt amendments to the Electricity Lawto authorize GNERC to regulate gas marketing, distribution, and transmission;

* GNERC to adopt a transparent gas tariff methodology and issue.commercial licenses to thecompanies operating in the gas market;

* GNERC to adopt dispute resolution procedures for companies operating in the gas market;

* Pursue privatization of gas distribution and supply companies; and

* Adoption of a Chart ofAccounts according to Intemational Accounting Standards forSaktransgasmretsvi, the gas transmission operating company (envisaged to remain under statemanagement).

C. Oil and gas exploration and production

* Adoption of Oil and Gas Law, goveming exploration and production of oil and gas; and

* Separation of regulatory and commercial activities in state agencies.

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D. Oil and gas transit pipelines

* Attracting private investment in oil and gas transit;

* Adoption of legislation on eminent domain;

* Legislating tax stabilization and concluding double-taxation agreements;

* Adopting operational standards and permitting procedures for oil and gas pipelines to enhancesafety; and

* Ratifying international conventions on marine oil pollution damage.

E. Environment

* Clarifying environmental liability through adoption of legislation on environmental liability;

* Ratifying international conventions on marine oil pollution damage; and

* Amending the Privatization Law to include environmental due diligence.

To help implement the program, the Government contracted a number of advisors and consultants, financedby IDA credits (Structural Adjustment Technical Assistance Credit, Oil Institution Building Credit,Structural Reform Support Credit) and bilateral technical assistance from USAID. IDA Credits financed acontract with Merrill Lynch to advise on electricity privatization, negotiation advisors for oil and gaspipelines, and support to GNERC. USAID financed services of PA Consulting for regulation, marketadministration, and gas privatization; Deloitte Touche Tohmatsu for upgrading accounting, auditing, andfinancial controls of energy sector enterprises; advisors for capacity-building for the Competent Authorityunder the Oil and Gas Law; and advisors for development of legislation on environmental liability andeminent domain.

The main thrust of the program was to build on Government's strong commitment to privatization tostrategic investors, which had been demonstrated through previous operations (Structural AdjustmentCredit II) and during preparation of the ESAC. Strategic investors were seen as the principal source ofinvestment finance and technological and managerial know-how, and an essential force to enhance financialmanagement of the sector and combat corruption, thus improving the supply of energy on a sustainablebasis.

The Credit was divided into two equal tranches, the first to be disbursed upon Board approval and Crediteffectiveness (the tranche was released on July 27, 1999). Release of the second tranche was contingent oncompletion of a number of prior actions, on satisfactory progress with respect to the Energy Sector ReformProgram laid out in the Letter of Energy Sector Policy, and on maintaining a satisfactory macroeconomicframework, as defined by the Third Structural Adjustment Credit, and the International Monetary Fund'sthree-year Poverty Reduction and Growth Facility.

The set of actions taken before presentation of the proposed credit to the Board included:

* sale of Telasi;

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* offering for privatization of all remaining electricity distribution companies and generation plants(outside Abkhazia);

* increase in electricity tariffs (by an average of 45%);

* inclusion in the 1999 Consolidated Budget of 14.3 million lari for the poverty benefit targeted to poorsingle pensioners, and approval of an increase in the benefit to 18 lari for an individual recipient and 29lari for two recipients in the same household (from 9 and 14.4 lari (respectively, calculated to bring thebeneficiaries just up to the Bank-estimated poverty line);

* inclusion in the 1999 Consolidated Budget of 10 million lari to compensate for unpaid electricitysupplied by Inguri Hydro Power Plant (to Abkhazia);

* adoption of detailed electricity market rules;

* parliamentary adoption of Oil and Gas Law (governing exploration and production); and

* parliamentary adoption of amendments to the Electricity Law to authorize GNERC to regulate gasmarketing, distribution and transmission.

A satisfactory macroeconomic framework (ESAF and SAC programs on track) was an effectivenesscondition.

Actions completed before the release of the second tranche included:

* satisfactory progress on power privatization: bids for the Gardabani thermal plant closed; at least 130MW of state-owned generation, other than at the Gardabani plant, privatized through a competitiveprocess (sold or given for concession for at least 25 years); offers for distribution companies evaluatedand, if no eligible offers received, the packages reconfigured and offered for sale again;

* actual expenditures on the poverty benefit for poor single pensioners to fully reflect the 14.3 millionlari total budgetary allocation (i.e., no arrears) and individual benefit levels specified, and abolish directtransfers to Sakenergo in respect of pensioners, civil servants, and refugees in privatized distributionareas;

* actual expenditures in compensation for electricity supplied by Inguri Hydro Power Plant to fullyreflect the budgetary allocation;

* continued implementation of the electricity tariff methodology adopted by GNERC on July 1, 1998;

* adoption of a gas tariff methodology by GNERC and licenses to have been issued to all privatized gasdistribution companies, the gas transmission company, and all gas purchasers/resellers;

* Parliamentary adoption of legislation on eminent domain;

* Parliamentary adoption of legislation on environmental liability;

* Sakenergo, Energotransmission, Sakenergogeneratsia, Tbilsresi and Saktransgasmretsvi to adopt aChart of Accounts according to International Accounting Standards, and appointment of intemational

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auditors to audit the 1999 financial statements of those enterprises;

* satisfactory overall performance on ihe Government's energy reform program as stated in the Letter ofEnergy Sector Policy; and

* satisfactory macroeconomic framework (ESAF and SAC programs on track).

3.4 Revised Components:There were no revisions to the components of the program supported by the Credit.

3.5 Quality at Entry:Given the enormous problems facing the Georgian energy sector - mismanagement, corruption, physicaldecay, financial problems -- the main design issue was to select priorities which would have the largestimpact on these problems and be feasible to implement in the context of Government's limitedimplementation capacity and the domestic and external political and economic environment. During the1995-1998 period, the Government focused on physical rehabilitation of the energy system (using donorfinancing), development of legal and regulatory framework, and on sector restructuring which wouldfacilitate commercialization and privatization. During that period, cost recovery improved somewhat in thepower sector, with increases in both tariffs and collections, but still staying well below the levels needed forsustained operation of the sector (collection had been reported at the level of about 60-70%, although thesefigures had not been audited and could have been subject to significant accounting manipulations). Therewere clear signs that further improvements in increasing collections and reducing commercial losses werestalling (indeed, in some areas progress was beginning to reverse). In any case, electricity supply was notimproving and supply disruptions were having a serious impact on growth and poverty reduction. Gassupply was reduced to a minimum in the face of mounting extemal arrears. The investment climate wasunfavorable and the investment necessary to restore supply to paying customers remained limited. The oilsector had attracted significant foreign investment, but development was retarded by an uncertain legal andregulatory framework. Oil and gas pipeline transit had also attracted considerable attention and someinvestment, but much needed to be done to mitigate investor risk and enhance environmental management.Corruption, already extensive, was becoming rampant and the quasi-fiscal deficit unsustainable.

The main design dilemma for the reform program, especially in the power sector, was: to what extent topush for improving financial performance of state-owned companies prior to their privatization(accompanied possibly with horizontal re-aggregation of unbundled sector) vs. pursuing privatization of thesector under the existing conditions. Although these two strategic options were not completely mutuallyexclusive, they did imply a significant degree of focus on one option at the expense of the other in terms ofinstruments, degree of restructuring, sequencing, pacing, and, perhaps most importantly, allocation oflimited financial, human and institutional resources.

The balance of the arguments between the two strategic choices favored privatization, in spite of the risks itimplied and which were recognized. The most important among these arguments were: extremely poorrecord in management and performance of state-owned energy companies and low probability that thiswould change, given the near-universal weakness of state institutions in Georgia; the need to mobilizeinvestments quickly; Govemment's demonstrated commitment to privatization; demonstrated willingness ofprivate sector, including foreign strategic investors, to invest in Georgia and expectation that thiswillingness would continue, given Government's willingness to accept the responsibility for historic debts,relatively low cash prices for the privatized assets, and tolerate higher tariffs. Above all, the Governmentexpected that strategic investors would be effective in commercializing the sector, improving its efficiencyand financial performance, and weeding out corruption; the state had already demonstrated its inability to

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do so.

Thus, both intemal and extemal conditions created a window of opportunity to attempt privatization tostrategic investors. It is difficult to argue that seizing that window was incorrect, even if, in retrospect,some assumptions - e.g., on the buoyancy of extemal investment environment - were perhaps toooptimistic. It is possible that some elements of the program could have been handled differently andperhaps with somewhat better outcome in terms of financial performance of the sector. For example,municipal distribution companies - about 70 of them at the time - could have been merged into larger ones,which could have possibly both enhanced their attractiveness to investors and made this key segment of thepower sector more manageable under the state-ownership (although this proposal met with considerableresistance at the local level). This measure, in combination with more emphasis on financial performanceindicators of state-owned distribution companies, especially if leveraged explicitly by IDA's otheradjustment operations and IMF lending, may have induced the Government to focus its attention moreforcefully on improving financial performance of state-owned electricity distribution companies. However,these are counterfactual suppositions and it is difficult to prove that they indeed would have led to asignificantly different or better outcome. Indeed, the Govemment's track record suggested very limitedability to control state enterprises, and previous adjustment lending had not proved effective in improvingfinancial performance on a sustained basis (although some temporary modest successes had been recorded).

The proposed program was fully consistent with the CAS, supporting all four CAS objectives: (i)strengthening public finances (by reducing the continued threat to the Govemment budget, posed by theunsustainable deficits in the electricity sector, by complementing public investment with private capital, andby transforming the energy sector into a major taxpayer); (ii) deepening and diversifying sources of growth,as opportunities for private participation in the energy sector develops and the energy supply improves; (iii)contributing to poverty reduction (directly, through poverty benefits introduced under the program, andindirectly, through enhanced growth); and improving environmental protection.

The reform program was prepared collaboratively by the Government, Parliament, and IDA staff. Themajority of those involved had worked together on energy reform for a period of years prior to ESACnegotiations. The ESAC was negotiated in Tbilisi (the only adjustment credit to Georgia to be so), and allrelevant ministries and agencies participated throughout negotiations (Finance, Economy, Fuel and Energy,State Property, Environment, Justice, Georgia Intemational Oil Company, GNERC). As a result, theESAC was built on strong consensus, and any unresolved differences of perspective were fully transparent.

The ESAC was well coordinated with other IDA-financed activities in Georgia. Structural adjustmentlending and the associated technical assistance credits directly supported energy sector reform and served toimprove social safety net provision, underpin fiscal adjustment, and create hard budget constraints forenterprises - all of which should have improved payments discipline amongst customers of the energysector. The ESAC also complemented investment lending by IDA (the Power Rehabilitation Credit (Credit2958-GE)), EBRD, KFW, OECF/JBIC, the Government of Switzerland, the Government of Georgia, andsector enterprises. Also, the ESAC operationalized the strategy for privatization outlined in the PowerPrivatization Report (No. 17152-GE). In the oil and gas sector, the measures under the ESAC wereintegrated with the technical assistance provided to the sector by the Oil Institution Building Credit (Credit2944-GE) and the structural adjustment technical assistance credits. There was close coordination withIDA's environmental activities in Georgia, particularly in coastal zone management.

4. Achievement of Objective and Outputs

4.1 OLiztcome/achievernent of objective:

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Outcomes and achievements of the program supported by the ESAC against individual components ofprogram objectives are as follows:

* Maintain momentum of energy sector reform and help mitigate its social costs: satisfactory

The credit definitely helped maintain the momentum of energy sector reform on a broad set of issues in theenergy sector: privatization, restructuring, regulation, legal environment, and social protection. Overall, theachievements met expectations. Major progress was achieved in electricity privatization, putting Georgiaat the forefront among the FSU states. Significant segments of the electricity distribution market andgeneration assets were privatized to AES, a strategic investor with worldwide experience in operatingelectricity companies. Some distribution companies were privatized to local investors, giving theopportunity to the domestic private sector to contribute to recovery of the industry. A number of investorshad a chance to acquaint themselves with Georgia and its potential. Although these contacts did not resultin additional privatization, they helped put Georgia on investors' maps, making it easier to pursueopportunities later. As a result, Georgia became known as a country genuinely interested in working withprivate investors, albeit having a very difficult operating environment. Success in privatization ofdistribution and generation catalyzed Government plans to privatize management of transmission, dispatchand WEM;.this had not even been under discussion at the time of ESAC design. A number of legal actions,described elsewhere in this report, were undertaken to improve this environment in the electricity, oil andgas industries.

The credit helped improve mitigation of the social costs of reform. A poverty benefits program wasestablished as part of the program supported by the credit. The program was designed to help single poorpensioners and orphans, as the most vulnerable groups, deal with increasing costs of electricity supply. TheGovernment, faced with difficulties in maintaining overall budgetary conmuitments especially in thepost-crisis years after the 1998 financial crisis, was slow to start paying the stipulated poverty benefits.However, the accumulated arrears were repaid and the payments became more regular in 2001. TheGovernment continued to disburse poverty benefits in 2002, after the ESAC closed, and it appears thatthese payments are likely to be sustained. The consolidated budget disbursed about 12.9 million lari for1999, 11.45 million lari for 2000, and 13.3 million lari for 2001. About 8 million lari was disbursed for thefirst six months of 2002. The program covered about 45,000 families.

The ESAC prompted USAID to initiate a major social assistance program (the "Winter Heat" program),now in place for several years, to help poor families and some social institutions pay for electricityconsumption. Between 100,000 and 200,000 households and several hundred social institutions wereincluded. The "Winter Heat" program was supported by donations from private companies (BritishPetroleum). The Program disbursed $2.7 million during the 1998/1999 winter (all from USAID), $5million during the 1999/2000 (all from USAID), $5.5 million during the 2000/2001 winter ($5 million fromUSAID, $0.5 million from British Petroleum), and $10.1 million during the 2001/2002 winter ($9.1 millionfrom USAID, $1 million from British Petroleum).

* Increase the availability of energy on a sustainable basis: satisfactory (achieved in privatizedareas).

Before the privatization of Telasi and other distribution companies, Georgia had a reasonably reliableelectricity supply only in summer. Winter supply was terrible - blackouts were very long andunpredictable. Now, Tbilisi, which represents 35-45% of electricity demand, has significant supplyreliability year-round. Although winter supply is not yet 24 hours a day, blackouts are much shorter andconsiderably more predictable. This is an achievement of major importance for macroeconomic

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stabilization, structural adjustment, and poverty reduction. Indeed, it is one of the few major successes ofGeorgian reform since inflation was brought under control in the late 1 990s. Of course, much still dependson the private investors earning a return on investment sufficient to ensure they remain involved.

In the rest of Georgia, the electricity supply has not improved. Privatization has not been possible due tolack of investor interest in distribution companies in rural areas and secondary cities (a common problem indeveloping and transition countries); state management of those companies has gone from bad to worse.

In short, the reform program has worked only where private investors have been attracted. Economically,that represents almost half the country. Where the private sector has feared to tread, state management hasfailed and reform has not proved effective. The resulting inequalities pose a political risk to the reformprogram nationally, and have substantial economic costs. This is highly unfortunate, but not unexpected atthe time of ESAC design. Success in Tbilisi was itself very uncertain; success outside of Tbilisi wasalways seen as highly ambitious within the ESAC period. It can only be hoped that success in Tbilisi haslaid the basis for subsequent distribution privatization elsewhere.

* Enhance financial management and combat corruption: marginally satisfactory (partiallyachieved as AES-owned companies improved financial management and are actively fightingcorruption, but serious problems persist in the rest of the sector)

The outcome of the program relative to this objective was mixed. AES brought in better financialmanagement of the companies it bought (Tbilisi's distribution company Telasi, the Gardabani thermalplant, and the Krami I and Krami II hydropower plants). Gardabani and Telasi had previously been majorsources of financial leakage in the sector. AES contributed a disproportionately high share of cashpayments to the electricity market between 1999 and 2001 (in comparison with other companies in themarket), injecting more than US$200 million into the sector to finance investments and operating expenses.Most importantly, AES improved supply of electricity to Tbilisi beginning in early 2001. One of the mostimportant benefits of AES's involvement, was the anti-corruption effect: directly - by decreasingcorruption in the companies which it took over (it may take still a few more years to root it out, though),and indirectly - by adding its strong and influential voice to the national anti-corruption debate and actions.These effects demonstrate the central benefits of privatization to strategic investors:

* improved customer services and corporate performance, as a result of better alignment of incentiveswithin the company among the staff, management, and shareholders based on a shared objective ofsustaining, improving and expanding the business (vs. a mismanaged and corrupt state-ownedcompany, in which the staff and management are motivated by short-term personal gains, includingthrough illegal actions); and

* better alignment of private (corporate) and public interests based on a shared objective of efficient andsustained provision of good quality service.

Both of these types of alignments of interests and incentives - within a state-owned company and betweenthe company, and its environment - had fractured in the Georgian environment, where accountability andpenalties for mismanagement had been weak. Management's short-term interest is to maximize theirincome and other benefits, in alliance with influential politicians and public officials with whom they sharethe gains, even if it means damaging the interests of the company and the public. This goes deep in thecompanies such as electricity distribution, where a large number of employees are in a position to*"privatize" the company's production (electricity) and/or cash. Such behavior, owing to weakaccountability and corruption in public services, is protected by the officials who, one way or the other,benefit from the situation. The result is widespread corruption and high financial losses in the sector which

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are ultimately transferred to the budget, undermining both the sector and public financing in general.

AES was on the verge of leaving Georgia in late 2001 and early 2002, after coming under strong marketpressure at the corporate level, which reduced the company's appetite for tolerating financial losses andforced it to take a hard look at all poorly performing investments worldwide. (The serious intentions ofAES to consider leaving Georgia, announced at that time, and the difficulties in electricity supply at theoutset of the 2001/2002 winter, explain a more pessimistic outlook by IDA on achievements andsustainability of ESAC's objectives at that time.) However, by about April 2002, AES was reported tohave succeeded in improving its financial performance in Georgia, after managing to provide decentelectricity service during the winter.

There has been, however, no improvement in financial performance nor in the level of corruption in thestate-owned companies (with the arguable exception of some of the hydropower plants benefiting fromAES demand for wholesale power through bilateral contracts). Payment collections by state-ownedcompanies even deteriorated to about 35% overall (only about'10% in cash in 2001). Some structuralchanges in the state sector were introduced later: in year 2000 more than 70 municipal distributioncompanies were merged into eight regional companies and subsequently, in 2002, into one company;trading arrangements in the wholesale electricity market were relaxed to allow bilateral contracts. However,these changes have not yet resulted in appreciable improvement of the performance of the state-ownedcompanies. Since the state companies dominate the sector, the net outcome for the sector as a whole hasbeen continuing poor financial performance and still widespread corruption.

The only exception to this rather gloomy picture of the public side of the electricity (and gas distribution)sector has been the performance of the Georgia National Energy Regulatory Commission (GNERC), whoserole was strengthened and extended beyond the regulation of the electricity industry to cover regulation ofgas transport and distribution. The Commission has been able to maintain both its credibility andindependence, despite strong opposition, thanks to its strong legal underpinning and the competence andcredibility of its directors. This has helped maintain proper tariffs and their adjustments on a timely basis.

Another major institutional and structural initiative -- the establishment of the Georgian WholesaleElectricity Market (WEM) -- has not been successful. The purpose of creating the WEM was to replaceSakenergo as a single buyer, prone to mismanagement, corruption, and waste, with a more transparenttrading arrangement, which consisted of a regulated pool ("market" was something of a misnomer). TheWEM was supposed to issuer bills to the wholesale consumers (distribution companies and direct customers- large consumers which were members of the wholesale market), collect and enforce payments (i.e., issuedisconnection orders for nonpaying market members), and forward the payments to generators and thetransmission and dispatch companies. Bilateral contracts for imports and between wholesale consumers andgenerators were also allowed (at the pool prices). The transmission company was supposed to providetransmission services and implement disconnection orders issued by the WEM and cleared by the dispatchcompany (to ensure security of the system). This "market" organization was supposed to be a transitionalarrangement between the single-buyer model and a more competitive trading arrangement.

However, the WEM proved to be almost equally prone to mismanagement and corruption as the formersingle-buyer Sakenergo, unable and unwilling to enforce payments, improperly allocating collectedamounts, and engaging in activities beyond its terms of reference (signing long-term power purchaseagreements with investors on behalf of market members, taking commercial loans, etc.). The trading wasbased on market rules as a form of a collective contract between sellers/producers (power plants andimporters) and buyers/consumers (distribution companies, direct customers), which made all consumersparty to the "contract" with all producers. The Government, the owner of most of the market members onboth sides of the market (the producing and the consuming) and of the companies operating the market

(transmission and dispatch), appeared not to be very interested in inducing the market to operatecommercially; rather, political pressures at various levels were exerted on the companies to supplycustomers, even if they were in serious payment defaults.

The WEM's management did not succeed, nor did they try, in resisting political and other vested interestpressures for allocating electricity deliveries and payments. The WEM borrowed from commercial banksand engaged in signing long-term power purchase contracts with investors in generation, in clear violationof its mandate. As a result, the WEM failed to enforce payments, allowing consumers to' accumulate largedebts at a rate comparable to the pre-WEM situation. This record of failure is mitigated slightly in thatleakages from the WEM were more transparent than from its predecessor, Sakenergo: It was perhapsmitigated more strongly, but unintentionally, by the fact that a bilaterally-contracted competitive marketemerged because of the failure of the WEM to operate according to agreed rules. .Although this was atransitional phenomenon, it accelerated the efforts to reform the WEM, which is now under way under theEMSP program. Ii essence, the WEM represented a failure of state management, which resulted in aspontaneous emergence of more genuine market mechanisms.

* -Catalyze private investment: satisfactory

The program supported by ESAC led to privatization of significant parts of the electricity sector.Privatization accomplished during 1998-2000 in the electricity sector has not yet been followed byadditional sales due to a number of reasons, of which most important are probably general retrenchment ofintemational investments and difficulties experienced by AES in attaining profitability of its investments inGeorgia and fighting vested interests. However, the privatization strengthened Government's resolve tocontinue along the same reform path. ESAC, through the work on strengthening the legal, regulatory andinstitutional framework for oil and gas exploration, production, transport, supply, and distribution, alsocontributed to the successful conclusion of negotiations of oil and gas transit agreements and to theexpansion of private investment in oil and gas exploration and production (in July 2002, Georgia invitedproposals for new oil and gas concessions).

* Realize Georgia's pipeline transit potential: satisfactory

As mentioned above,' Georgia has worked successfully and effectively with other govemments (notablyAzerbaijan and Turkey) and with the private sector, to negotiate what it considers to be a fair share ofpotential revenues from oil and gas pipeline transit, at the same time improving security of its energysupply, especially in gas. It has also facilitated the application of international best practice inenvironmental management and land acquisition for pipeline development.

* Upgrade environmental management: satisfactory

The legal framework for environmental management in the energy sector has been strengthened throughadoption of a number of environmental,meas s (see Sections 4.2. D and E), particularly relating to newtransit pipelines, although enforcement will only be tested once operation commences. Especially importantwas the establishment of the legal framework for dealing with oil spills from pipelines through the lawimposing strict liability on pipeline operators, ard Georgia's ratification of the various marine oil spilltreaties.

The achievements under the ESAC generally mret expectations. The specific measures envisaged under theprogram were largely implemented, as described above, and the Government generally followed the policies

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which it had committed to. The situation in the power sector before and after the ESAC differsfundamentally in several aspects. Most importantly, the ownership structure changed: a major strategicinvestor has acquired significant stakes, which should have significant and lasting positive effects which areyet to be fully felt. This has led to improved electricity supply in the capital Tbilisi, politically andeconomically the most important region in the country. It has also led to a significant injection of cash inthe system and, now, to a better financial performance of distribution business in the capital. AES alsotook over some of the assets which were a major source of corruption: electricity distribution in Tbilisi andthe productive assets at the Gardabani thermal plant, where procurement of fuel was an attractive target forcorrupt groups and individuals. Social policies in the energy sector were transformed from a system ofsubsidies based on Soviet-era type of privileges, poorly related to income and unaffordable, to a systemwith a narrower and better targeted base, but affordable to the budget. The strengthening of the legal andregulatory framework in oil and gas industries, including environmental liabilities and land acquisitionrules, created a better environment for the private sector and contributed to the successful conclusion oftransit oil and gas pipeline deals. Macroeconomic benefits of these achievements are potentially very large:reduced quasi-fiscal and external deficits, increased public income from oil and gas transit, lower publicand publicly-guaranteed external debt (as the responsibility for energy imports is shifted to private sector),etc.

Of course, significant-problems remain: corruption is still rampant, and financial performance and thequality of service by the state-owned companies remain dismal, both in the electricity and gas sectors.However, Georgia is in a better position after the ESAC to continue solving these problems. The ESACwas just a stage in sector reforms: it was not realistic to expect, nor was it expected, that it would endsector problems. Thus, the most relevant question for judging the success of the ESAC - is the energysector of Georgia in a better shape after the ESAC than before - should be answered with "yes", assumingthat the benefits of the ESAC program will be sustained, as expected.

4.2 Ouitputs by coinponents:A. The power sector

* Privatization of distribution and generation companies: Telasi, the electricity distribution companyserving the capital Tbilisi and taking 3545% share of Georgia's 7+ TWh annual electricityconsumption, was sold to AES at the end of 1998. The remaining distribution companies were initiallygrouped into two packages ("East" and "West") and offered for sale, but received no preliminaryexpressions of interest. Subsequently, all distribution companies were offered for privatization withinvestors having the right to buy them in any configuration. As result, only eight small companies (lessthan 5% of the market in total) in the Kaheti region (out of about 70 offered) were sold to a localinvestor. The Government recently (in April 2002) consolidated all remaining distribution companies,outside the autonomous republic of Adjara, the autonomous region of South Ossetia, and the disputedregion of Abkhazia, into a single, state-owned (vs. previously muiucipally-owned) distributioncompany ("The Georgian United Distribution Company" -- GUD2) in order to facilitate improving itsmanagement and performance and make it more attractive to pri'riMe investors. The Govermnent is inthe process of hiring private management for the GUDC.

On the generation side, two newer units at the Tbilsresi (Gardabani) thermal power plant, 300-MWeach, were also sold to AES in April 2000, after protracted negotiations. These units represent the bulkof Georgia's thermal capacity; the remaining thermal capacity includes a small (15-MW) CHP plant inTbilisi, and eight 150-160 MW old units at the Tbilsresi plant, most of which have beendecommissioned except for 2 units maintained for emergency services. No offers to buy the oldTbilsresi units (Units I through 8) were received. Hydroelectric plants at Krami I and Krami II, with

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combined capacity of about 230 MW, were given to AES under a 25-year concession. There were acouple of bids for a number of hydro plants in Western Georgia, from a French and a Chinese investor.However, negotiations with these investors failed due to lack of required experience in the case of theFrench investor, and over high tariffs required in the case of the Chinese investor.

In early 2001, the Government signed a contract with EFC for advisory services for privatization of allstate-owned distribution and generation enterprises.

* Adoption of electricity market rules, and stakeholders' management of the wholesale electricitymarket: The Wholesale Electricity Market (WEM) was established in July 1999, to facilitate trading ofelectricity among the wholesale market participants. The WEM replaced Sakenergo, the single buyer incharge of buying electricity from domestic and foreign generators and selling it to distributioncompanies. The WEM was not allowed to enter into any commercial deals, its sole purpose was toissue payment invoices for the consuming market members, collect payments, distribute them togenerators, importers, and transmission and dispatch service providers, and issue disconnection ordersfor nonpaying consumers. Although physical and financial flows in the system became moretransparent, the expectation that the WEM would lead to improved payment discipline has notmaterialized. Technical problems, political pressures, social concerns and corruption have outweighedthe market operator's legal right to impose dispatch of electricity to customers only against payment.In late 2001, the Government hired a foreign contractor (Iberdrola, a Spanish utility) to manage theWEM for five years, as part of the program agreed under the Electricity Market Support Project (IDACredit 3502 GE). This management contract will be complemented by a management contract fortransmission and dispatch, awarded to ESBI, the Irish utility, under the sane program.

* Maintaining cost reflective tariff: GNERC adopted an electricity tariff methodology by Resolution No.3 dated July 1, 1998, and regularly adjusted tariffs based on that methodology. Recently, GNERCestablished tariffs of 13.7 tetri per kWh for AES-Telasi's consumers and 8.5 tetri per kWh for otherretail consumers, to be effective on September 1, 2002 (up from 12.4 tetri per kWh and 8.1 tetri perkWh, respectively). The tariffs should be adequate to compensate generators, distributors and thetransmission and dispatch companies for prudently incurred costs of service. AES's tariffs aresignificantly higher than for the state owned distributors on account of the much higher level ofinvestment and higher rate of returns required by the private operator. In addition, the Commission hasadhered to the contractual increases for AES Telasi as laid out in the privatization agreement, and tothe tariff levels for the Inguri hydropower plant which were agreed with EBRD to ensure repayment ofthe EBRD Loan for rehabilitation of the plant.

* GNERC to adopt dispute resolution procedures for companies operating in the electricity market:GNERC approved Resolution #4 on Prbcedural Rules for Resolution of Disputes Between Licensees orLicensees and Customers on April 6, 2000.

* Adoption of a Chart ofAccounts according to Intemational Accounting Standards for Sakenergo,Electrodispetcerizatsia, Electrogadatsema, Sakenergogeneratsia, and Tbilsresi. The companies adoptedtheir respective Charts of Accounts consistent with the accounting standards in 1999.

* Auditing the 1999 financial statements of Sakenergo, Electrodispetcerizatsia, Electrogadatsema,Sakenergogeneratsia, and Tbilsresi by international auditors. Deloitte Touche Tohmatsu carried outaudits of the 1999 financial statements of the enterprises.

* Introducing budgetary compensation for electricity delivered to Abkhazia: the Government of Georgiapaid to the electricity sector 33.3 million lari for the 1999-2001 period (i.e., more than 10 million lari

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annually) to compensate for unpaid electricity supplied by the Inguri Hydro Power Plant to customersin Abkhazia.

* Increasing poverty benefits to poor single pensioners: The consolidated budget and USAID's "WinterHeat" program provided significant social assistance to vulnerable groups to help pay electricity bills(see Section 4.1 for data).

* Abolishing direct transfers from budget to Sakenergo on behalf ofpensioners, civil servants, andrefugees in privatized distribution areas and disbursing them directly to the beneficiaries:Presidential Decree of December 19, 1999 abolished direct budgetary transfers for the country as awhole (effective from May 1, 2000).

B. Natural gas transmission and distribution

* GNERC to regulate domestic gas supply: Parliament adopted amendments to the Electricity Law in1999 to authorize GNERC to regulate gas marketing, distribution, and transmission, which establishedindependent regulation of this segment of the energy sector.

* GNERC to adopt a transparent gas tariff methodology and issue commercial licenses to thecompanies operating in the gas market: In September 1999, GNERC adopted a gas tariff methodologythat meets the requirements of transparency, cost recovery, and the promotion of efficiency in gassupply and consumption. GNERC started introducing tariffs based on this methodology in November1999. Licenses have been issued to all privatized gas distribution companies, the gas transmissioncompany, and all gas purchasers/resellers, in accordance with the Energy Law of May 1999.

* GNERC to adopt dispute resolution procedures for companies operating in the gas market: GNERCapproved Resolution #4 on Procedural Rules for Resolution of Disputes Between Licensees orLicensees and Customers on April 6, 2000.

* Pursue privatization of gas distribution and supply companies. Several efforts were made sincemid-1999 to privatize the Tbilisi gas distribution company (Thilgazi), but the Government was unableto reach satisfactory terms with potential investors. USAID provided funding for a team ofmanagement consultants to take over key aspects of the company's operations in an attempt to improveits operations and facilitate continuing efforts to find a suitable strategic investor. The Government hasalso indicated its intention to privatize the remaining gas distribution assets. The assets of thehigh-pressure transmission network have been consolidated under the control of the Georgia GasIntemational Corporation (GGIC). GGIC has established a Gas Transportation Company (GTC)which is contracted to provide operations and maintenance services. The clarification of ownership andoperating responsibility represents a significant step forward, and will facilitate GGIC's negotiations,on behalf of the Government, for gas transit through Georgia either from Russia or from gas-producingareas to the east.

* Adoption of a Chart ofAccounts according to Intemational Accounting Standards forSaktransgasmretsvi, gas transmission operating company. The company adopted a Chart of Accountsconsistent with the accounting standards in 1999.

C. Oil and gas exploration and production

* Adoption of Oil and Gas Law. The new Oil and Gas Law, goveming exploration and production of oil

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and gas, was adopted in May 1999. The law established a one-stop regulatory authority for theupstream regulation of oil and gas exploration and production (State Agency for Oil and GasRegulation). The law consolidated the legal foundation for operations which had started before the lawwas adopted and which were governed by presidential decrees. The law should catalyze investment inexploration and production of oil and natural gas and facilitate pipeline access for Georgian oil and gas(where access is not constrained by international agreement). The Government recently invited offersfor the rights to explore and produce oil and gas in several fields.

* Adoption of legislation on eminent domain. Parliamnent approved the Law on Rules of Expropriationof Property for Public Purposes on July 23, 1999, which established the legal framework for theexpropriation of, including provision of fair compensation for, land needed for a public good such as anoil or natural gas pipeline, and easement rights needed for the servicing and maintenance of such publicgood. Pipeline transit agreements reflect the provisions of this law (in neighboring countries therespective transit agreements impose greater financial risk on government to act as an intermediary inland acquisition, because of the lack of adequate legal provision for eminent domain).

* Separation of regulatory and commercial activities. In July, 1999, the Government established theGeorgian Oil Company, Saknaftobi, as a joint stock company, with 100 percent of the shares held bythe State. The company no longer acts as the principal regulatory authority in the oil and gas industry,although it does provide support to the regulatory agency established under the Oil and Gas Law (StateAgency for Oil and Gas Regulation), and endorses all petroleum agreements. Its primary function is toserve as a commercial and operating enterprise.

D. Oil and gas transit pipelines

* Attracting private investment in oil and gas transit. Georgia negotiated arrangements for the transit ofboth oil and gas from Azerbaijan. The Early Oil pipeline from Baku to Supsa is already in operation.Contractual agreements have been reached for the Baku-Thilisi-Ceyhan oil pipeline, which is expectedto be completed in 2004, significantly raising oil transit revenues over the next 10 years. The SouthCaucasus Gas pipeline from Azerbaijan through Georgia to Turkey is also expected to be completed in2005. Gas deliveries from Turkey will be phased up from 2 BCM in the first year to a plateau level of6.6 BCM in the fourth year of operation (i.e., about 2009), further increasing transit revenues toGeorgia. While the two transit arrangements provide the potential for attractive revenues to Georgia inthe medium-to-long term time frame, they also incorporate significant contingent liability risk forGeorgia, particularly with regard to Georgia's obligations to provide security (at Georgia's expense) forthe two lines. The South Caucasus Gas Pipeline Host Government Agreement also includes provisionsfor the sale of the Azeri gas to Georgia. This, ostensibly, will reduce Georgia's dependence on Russiafor its gas supplies, although the terms of the proposed arrangement leave all the swing supplyresponsibility with Russia, which still leaves Georgia with considerable exposure on the issue ofsecurity of gas supplies.

* Adoption of legislation on eminent domain. (See Section 4.2.C. above.)

* Legislating tax stabilization and concluding double-taxation agreements. With respect to reform ofthe tax regimes pertaining to foreign investments in oil, gas and pipeline developments, clarificationand stabilization of the tax regime was essentially handled in the inter-governmental agreement and inthe Host Govemment Agreement on new oil transit pipelines, which established a benchmark that canbe applied to anticipated negotiations on gas transit. Double taxation agreements have been concludedwith a number of countries (Azerbaijan, Armenia, Belgium, Bulgaria, Germany, Greece, Iran, Italy,

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Kazakhstan, Poland, Romania, Russia, Turkmnenistan, Ukraine, and Uzbekistan). The pipeline transitagreements incorporate fiscal terms, which preclude the risk of double taxation, without penalizingGeorgian revenue in consequence.

* Adopting operational standards and permitting procedures for oil and gas pipelines. Thedevelopment of operational and pernitting standards for pipelines is a part of the Energy TransitInstitution Building Credit (ETIB), approved by IDA in 2001. Pipeline transit agreements containpermitting procedures, which reflect best intemational practice.

E. Environment

* Ratifying international conventions on marine oilpollution damage. The Government has alsoratified all intemational oil spill conventions and has developed a draft National Contingency Plandefining arrangements which have been or should be put in place by the Maritime Administration andthird parties to mitigate the effects of an oil spill in the harbors or offshore areas of Georgia. Additionalsupport for this initiative is also to be provided under the proposed ETIB project.

* Clarifying environmental liability. Parliament adopted the Law on Compensation of Damages Causedby Harmful Substances on July 23, 1999, which govems liabilities for damages and pollution, causedfrom production, processing, transportation and distribution of liquid and gaseous hydrocarbons onland. The law imposes strict liability on companies for environmental damage, and requires fullcompensation to affected parties. The provisions of the law were reflected in the Georgian pipelinetransit agreements (in contrast to the respective agreements in neighboring countries which are lessdemanding).

* Amending Privatization Law to include environmental due diligence. An amendment to the law hasbeen drafted, but not adopted by Parliament yet.

4.3 Net Present Value/Economic rate of return:NA

4.4 Financial rate of return:NA

4.5 Institutional development impact:The ESAC helped further advance the concept of separating the ownership, policy, regulatory, andcommercial activities, strengthen the institution of independent regulation, and promote transparency incommercial operations, through the following measures:

* introduction of independent regulation of domestic gas transmission, distribution, and supply, andstrengthening the regulatory framework through adoption of transparent tariff methodologies anddispute resolution procedures in the electricity and gas markets;

* establishment of the Wholesale Electricity Market (WEM) as an association of market members, incharge of transaction accounting and payment collections, but not responsible for purchase and sale ofelectricity; and

* separating commercial activities in oil exploration and production from regulatory functions(establishment of State Agency for Oil and Gas Regulation).

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The initial success of the new institutions differs. GNERC has managed to establish itself as a reputableagency, both in the electricity and gas industries. The WEM, however, has not met expectations, asdescribed in Section 4.1. The abuse of the institution and its mismanagement prompted the Government tohire an independent firm ([berdrola) to manage the WEM for five years. This management contract, as wellas a similar management contract for transmission and dispatch, are supported by the IDA-financedElec ricity Market Support Project. The State Agency for Oil and Gas Regulation is a young institutionwith short track record, which has been satisfactory so far.

5. Major Factors Affecting Implementation and Outcome

5.1 Factors outside the control of government or implementing agency:The main factors largely outside Government control which adversely affected the program were: (i)regional political risks; (ii) general attitude of investors; and (iii) performance of private companies.

The Caucasus region is one of the most complex in terms of the local and regional political situation andwider geopolitical interests. The civil war in Azerbaijan between the Armenian and Azeri populations andthe unresolved status of Nagomo-Karabakh, the problems with the Georgian breakaway region ofAbkhazia, the civil war in neighboring Chechnya and its direct impact on Georgia through the Pankisigorge, made the political situation volatile and the investment environment risky. Occasional discormectionsof Georgian electricity and gas networks from Russian networks, as much as ostensibly related tononpayments, did not help reduce concerns with Georgian vulnerability to possible political use of thesedependencies.

The private sector became more risk averse sooner than anticipated, resulting in a tepid response toinvestment in the Georgian energy sector. There were few credible bids for the remaining properties to beprivatized, despite the Government's engagement of expert international advisors, and its willingness torestructure companies and historic debts in order to create more attractive packages. It appears that the"window of opportunity" started closing already in 2000, when major intemational energy investmentfirms, which were active in the region, such as AES, Enron, Union Fenosa, may have started feelingfinancial pressures at the corporate level. The investment retrenchment became very clear in 2001, whichsaw the collapse of Enron and decimation of market values of many energy companies, including AES.Thus, although the minimum privatization targets set under the ESAC program were met, these deals werenot followed by additional sales.

AES -- the private owner/operator of the Tbilisi electricity distribution network, the 600-MW of thermalcapacity at the Gardabani thermal plant, and the Krami I and Krami II hydropower plants - had to climb asteeper and longer learning curve than anticipated to address serious financial and operational problems inboth distribution and generation during the 1999-2001 period. The re-metering and re-wiring program inTbilisi has not yet been completed (about 75-80% of consumers were covered as of mid-2002), and internalcorruption and theft in the company, while reduced, is still strong, in spite of the major effort to reduce it(significant portion of the original work force in the company has been replaced). The company operated ata financial loss until Spring 2002, when it appeared to break even. AES also had its share of difficulties atthe Gardabani thermal plant: a mishap during the start-up of one of the units at the plant in December 2001daraged its boiler, taking the unit out of operation. Whether the result of poor Government support inaddressing some of the key problems (corruption, theft, system dispatch, etc.) or possibly company'ssub-optimal approach in addressing some of the problems in the Georgian environment, the net result hasbeen still high losses in the distribution network (mostly theft) and reduced power supply from the thermalplant (mitigated by increased imports). In addition, significantly higher tariffs for consumers supplied byAES-Telasi distribution company (about 60%: 13.7 tetrilkWh vs. 8.5 tetri/kWh for low-voltage customers,

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to be introduced as of September 1, 2002) on the one side, customer theft and the large debt by the WEMto AES for electricity supplied to the market by the AES-owned power plants (more than $20 million inmid-2002) on the other, have complicated the relationships between the company, the Government, and thepublic. The significant improvements in electricity supply made by AES, its large contribution to thesector's cash flow, and generally the important constructive role which AES is playing both in the sectorand beyond, helped the company manage these difficulties.

5.2 Factors generally subject to government control:The Government has contributed substantially to a successful outcome of many of the program measuresthrough its positive attitude towards privatization and restructuring, constructive negotiation of oil and gastransit agreements, support for a suitable legal and institutional framework for sector regulation andenvironmental protection, support for the social protection measures, and proactive approach in elicitingdonor assistance for social program related to commercialization and privatization of the energy sector. Onthe other hand, the Government failed to address forcefully some of the most serious problems:

* pervasive corruption and mismanagement in state companies (which has undoubtedly contributed to thefailure of the Wholesale Electricity Market and the ongoing financial problems in both state-owned andprivate sector enterprises);

* inadequate support to AES in their fight against theft, corruption, for better performance ofstate-owned companies and better management of the sector,

* poor enforcement of payment discipline in the electricity and gas markets;

* poor enforcement of laws and contracts; and

* weak general security in the country (illustrated, e.g., by abductions of high-profile businessmen).

The Government is aware of these failures and is trying to address them through the follow-up programs inthe sector and broader program. The sector program is supported by donors, including the IDA, KfW andEBRD-financed Electricity Market Support project which focuses on management and financialperformance of state-owned electricity companies.

The long delay between the first and second tranches is also attributable to Government's performance.Owing to a number of populist measures taken during the run-up to national elections in late 1999, thegovernment failed to meet agreed macro-economic targets, and the IMF suspended its program. It tookseveral months before the IMF and the Government were able to agree on a revised program. During thattime the Government was unable to meet some key conditions for the second tranche release -- satisfactorymacro-economic performance, and timely disbursement of poverty benefits, although all the energy-specificconditions were satisfied on schedule. As a result, the closing date for ESAC had to be extended to March1, 2002.

5.3 Factors generally siubject to implementing agency control:N/A

5.4 Costs andfinancing:The total cost of the project was SDR 18.1 million, equivalent to USD 25 million at the time of approval.The Credit was disbursed in two equal tranches. The first tranche was disbursed after declaration ofeffectiveness (in July 1999). Disbursement of the second tranche was delayed because of problems withGovernment's macroeconomic performance in 2000 and early 2001, which led to suspension of the IMF

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program and extension of ESAC's closing date to March 1, 2002. During the second half of 2001, IMFprogram was reinstated. ESAC's second tranche was disbursed in December 2001.

6. Sustainability

6.1 Rationale for sustainability rating:Sustainability of the reforms implemented or initiated under the ESAC depends dn a number of intemal andexternal factors: regional and domestic political stability; external economic and investment environment;domestic economic growth and fiscal discipline; and political will to fight corruption, strengthenenforcement of laws and contracts, enforce fmancial discipline, and further commercialize and privatize theenergy sector.

AES had a difficult experience in Georgia, very much frustrated by the adverse business environment andthe resulting sustained financial losses it experienced between 1999 and early 2002. While in late 2001 andearly 2002 AES was on the verge of leaving Georgia, the company now appears determined to stay,recently encouraged by better financial results of its distribution business in Tbilisi. In late 2001 andthroughout 2002, the Government took several steps to create a better environment for AES and the sectorin general, including elimination of some excessive tax obligations. AES's electricity tariffs are about thehighest in the region, mainly because of the significant investments made and the higher rate of returnsrequired relative to state-owned companies. Its main difficulties at this stage - apart from fighting theft inits network - come from the pressure by non-perforning state-owned transmission and dispatch companies(which have been, e.g., tolerating diversion of electricity procured by AES for its own customers), and theWEM, which has accumulated large debts toward AES-owned generation as result of its tolerance ofnon-payments by other distribution companies and other weaknesses described elsewhere.

These difficulties are being addressed in part by the Government through the Electricity Market SupportProject (EMSP), which envisages 5-year private management contracts for the transmission and dispatch,the WEM, and the consolidated state-owned distribution company (GUDC). The program is supported byIDA, EBRD, and KfW. USAID has stepped up its already significant social assistance to the sector, whichbenefits AES (as well as other distribution companies). The IMF has also included performance of theelectricity sector in its program, increasing Government's incentives to continue with sector reforms. Thesuccess (or failure) of the program under the EMSP will have significant impact on the sustainability ofAES's business in Georgia and on the sustainability of the reform in the electricity sector supported by theESAC. In this context, the ESAC should be viewed as a stage in the long-term effort to reform the energysector, supported by a series of IDA's operations (and of other donors), which had started before the ESACand are continuing after it.

Many of the changes effected under the ESAC are enshrined either in law or in the form of legal contracts.For this reason, it is considered unlikely that the Government and Parliament would reverse these measures.More of a question is implementation and enforcement of the laws and contracts, where Government'sperformance has been weaker. However, if the presence of private investors keeps increasing as expected -through management contracts in the electricity sector followed by privatization, operation of the oil andgas transit pipelines, privatization of domestic gas supply, and domestic oil and gas exploration - there willbe increasing pressure for better enforcement of laws and contracts which should translate into animproving legal and commercial environment for businesses.

Georgia is becoming increasingly integrated into international markets in electricity and, especially, into oiland gas markets through oil and gas transit pipelines and oil and gas explorations on its own territory.These international projects are financed by major international companies, which should bode well for

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sustainability of the reforms. Major international donor organizations, multilateral and bilateral, includingIDA, also remain actively involved in the energy sector, and will continue their effort to sustain andadvance the reform process.

Performance of GNERC has been generally good, but remains vulnerable to political and personnelchanges. GNERC derives much of its strength from the Government's support and the personal attributesof the current regulators. While an ideological shift in the government or a change in personnel at theGNERC's top management level could weaken the regulatory institution, GNERC has established a goodtrack record and its institutional reputation to build on and to resist political and other pressures.

Sustainability of social benefits will depend on macroeconomic performance. It is encouraging that thesebenefits have been preserved in 2002, i.e., after the ESAC was closed, indicating the likelihood that thesebenefits will be sustained.

Overall, the main benefits of the ESAC program, while under considerable risks, are still more likely to bepreserved in the medium to long-term, although the progress may not be uniform and some setbacks alongthe way are quite possible. The benefits from the increased involvement of the private sector in electricity,oil and gas, take time to materialize. Much will depend on the progress in other areas domestically(corruption, sustained economic growth), as well as on the external political and economic environment,which contains many risks, but, encouragingly, economic growth has returned to the region during the lastfew years.

6.2 Transition arrangement to regiular operations:N/A

7. Bank and Borrower Performance

Bank7.1 Lending:The ESAC was prepared rather efficiently. Many of the problems that were addressed under the credit hadbeen identified as part of the ongoing dialogue with the government and preparation of other projects. Assuch, IDA was in a situation to respond quickly to the request for the Credit and agree on the priorities tobe included in the program. As argued elsewhere in this report, the selection of the priorities was generallyappropriate, even if ambitious and with high risks, especially with respect to privatization in the electricitysector.

7.2 Supervision:IDA supervised the project very actively, both directly and through the work on preparation andsupervision of other operations (Electricity Market Support Project (EMSP), Energy Transit InstitutionBuilding (ETIB), Structural Reform Support (SRS)). The missions were frequent, especially during the1999-2000 period, when most of the program was implemented. The delay in disbursement of the secondtranche was caused by Government's fiscal (macroeconomic) performance going off track, due to whichthe IMF program was suspended and SAC HI tranche delayed. This caused a temporary accumulation ofarrears in disbursement of poverty benefits, another violation of ESAC's second tranche disbursementconditions. These issues were actively pursued by the IMF and IDA's SAC III teams in late 2000 andthroughout 2001. During that period, IDA's energy team focused on preparation of follow-up operations inthe energy sector - EMSP and ETIB - which are designed to sustain and further advance the reformsundertaken under ESAC. Activities on preparation and supervision of EMSP and ETIB, given the nature ofthese operations, were also used to supervise the ESAC program, especially during 2001 and 2002.

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7.3 Overall Bankperformance:

Highly satisfactory.

Borrower7.4 Preparation:Government's ownership of the program was very strong. The Government was frank and explicit inrealizing its limitations and weaknesses in managing the energy sector and in fighting corruption. Thus, theGovernment was very eager to privatize the energy industry to strategic investors in order to elicit theirassistance in reducing corruption and improving performance, even if it meant higher prices and initialincrease in social costs, aware that in the medium term it should lead to significant economic and socialbenefits. The Govermnent was very active in preparing the reform program, although it was not able tofully deliver on all initial commitments, (such as, e.g., to include the Zhinvali hydropower plant intoprivatization packages due to unclear contractual relationships with plant's management and some foreigninvestors). The ESAC was built on a strong consensus between the Government, Parliament and IDA aboutthe objectives and the content of the reform program.

7.5 Goveniment implementation performance:The Government implemented the ESAC program eagerly. It did its best to privatize as much of the sectoras possible, repeatedly trying to privatize electricity distribution and generation which remained unsoldafter AES bought the assets it wanted. The Government negotiated hard and was willing to accommodatethe private sector on a number of important issues to get a strategic investor in and keep it in. The'Government, e.g., was willing to accept rather low prices for the assets it offered for privatization, awarethat price was the main risk-mitigating measure for the private sector. The Govermment was also willing totake over almost the entire historical debts, tolerate significant increases in tariffs, and ease the tax burdenfor investors. The Government also expended great effort to sell Thilgazi, the gas distribution company inTbilisi, with assistance of USAID; it has not succeeded, though, as the market interest was insufficient. TheGovemment was prepared to accommodate investor's concems as much as possible, through, e.g.,accepting the responsibility for the historical debts, allowing GNERC to operate rather independently andset tariffs on an economic basis, allowing investors to pick and group assets offered for sale, etc. Afterrealizing that further privatization was not forthcoming, the Govemment continued with efforts to introduceprivate management contracts in the sector which previously had been in the exclusive domain of the state(electricity transmission and dispatch), as well as for the non-privatized distribution assets (under theEMSP). After some initial delays in disbursing poverty benefits due to fiscal difficulties, the Governmentrepaid the arrears and continues to disburse the benefits.

The Govemment exhibited weaknesses in the areas of the program dealing with the performance of statecompanies (distribution, generation, transmission, dispatch, WEM) - their financial performance remainsextremely weak. This is not surprising, however, as these weaknesses (payment collections, corruption)were the very reasons for launching the ESAC program in the first place. It would not be realistic to expectthat the Government would somehow have more success in these areas before other ESAC measures -privatization, strengthening of the legal framework - and measures in other areas, such as judicial reforms,public sector reforms, and general privatization, had time to make their impact. The Govemment also hasnot succeeded in curbing corruption, neither in state-owned companies, nor did it do particularly well inactively helping AES fight corruption in the companies it acquired. This is obviously a problem whichneeds to be addressed. However, even in this respect, while more should be expected from and done by theGovemment, the Govermment had not extended unrealistic promises and implicitly admitted that it neededthe private sector's assistance. Given the success in attracting the private sector, however vulnerable thatsuccess is, the Government is now in a better position to fight corruption than before the ESAC.

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7.6 Implementing Agency:

N/A

7.7 Overall Borro+t'erperfornzance:

Satisfactory.

8. Lessons Learned

Energy sectors in FSU countries (particularly those which are poor in primary energy like Georgia) carryan enormous macroeconomic burden, probably not experienced anywhere else in the world on such scale,as the combination of such energy-intensive economies, fragile states, near-universal connection to networkenergy, and cold winters is unique to this region. Low collections, high commercial losses, and low tariffs --resulting from combined effects of mismanagement at the sector and enterprise levels, corruption,inappropriate tariff policies (often justified by social concems), tolerance of non-payments (typicallyordered by politicians), and low affordability -- produce significant quasi-fiscal deficits which the sector isforced to carry. The key issue -- often not recognized or addressed explicitly by the governments orinternational financing institutions - is how to manage and eventually eliminate this deficit. The Georgiancase illustrates the difficulties of a strategy which deals with the problem through privatization, where theprivate sector is asked to take over bankrupt companies with large upfront investment and working capitalneeds, with limited government support and with expectations that tariff increase will be within the"affordability range". The risk is that the cost to the private sector during the first several years -- evenassuming its most efficient performance, low purchase price, and Government's taking over the historicdebts -- may still be too large. It is very likely that this cost was higher than the private sector had expectedin Georgia (although they may also have had broader strategic reasons for making that investment). Whilethe subsequent measures taken by the Government of Georgia, the donors (especially the US Government),and the regulator in the form of social programs, Abkhazia subsidy, tax policies and tariff increases couldcreate conditions for AES to sustain its business, it would be difficult to replicate such privatization undersimilar conditions (some examples to the contrary notwithstanding, such as in Moldova and Ukraine, whichshare similar problems with Georgia but where some privatization of electricity companies happened afterthe privatization in Georgia). The governments should improve performance of the companies and reduceor eliminate their financial deficit before privatization (in countries where this is possible, unlike Georgia),or should have an explicit program of assistance to private investors in dealing with the financial deficit fora certain period. The first option requires good public governance, and the second requires a fiscal supportto investors (either directly or through support to consumers). This in turn requires a higher level ofcoordination between governments, the IMF and the World Bank Group than is usually necessary forenergy system reforms. This last point cannot be overemphasized.

The ESAC confirned that reforms in the energy sector are complex and, thus, inherently difficult to designand implement, because of the sector's political, economic and social implications which transcend thesector, and because the very same weaknesses which the reforms are trying to address are limitingimplementation of the reforms. Thus, sector reform is difficult and slow, depending to a great extent onprogress in other areas of reforms outside the energy sector, and most importantly in the pace of actualadjustments in response to those reforms. Expectations should be realistic, and success measured againstthose expectations.

Energy sector reforms need to be designed in coordination with overall economic reforms and need to beleveraged with instruments whose scope and impact are correspondingly broad and include Government

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agencies and other interest groups beyond those dealing with the energy sector directly.

In some cases, even the substantial amounts of financing available from the World Bank and the IMF maybe unable to counter-balance the potential profits from corruption. At best in such an environment,conditionalities that affect vested interests will only be met with great difficulty.

Commercialization of the sector, especially if accompanied with privatization, hardens budget constraintsand, in the short-term, is likely to increase the cost of electricity, even substantially. This increase should becompensated for vulnerable households through appropriate social programs, to make the cost of reformsmore equitable and socially acceptable.

Weak states cannot manage energy sector recovery and restructuring effectively, but that very weaknessdeters many private investors. Postponing privatization will only make matters worse; therefore,privatization should proceed urgently when feasible, but the terms must reflect high levels of risk.

Privatization may be possible even under adverse'conditions (poor financial performance, high corruption,weak state), although at the cost of low privatization proceeds, higher tariffs, and even worseningperformance of state companies before and during privatization. While it may look attractive - andcertainly desirable - to try to improve performance of the state companies before privatization to increaseprivatization proceeds and reduce the risks for investors (thus reducing the returns and tariffs they mayrequire, i.e., reducing the cost to consumers), this may be a very costly and elusive option in cases wherethe governments are too weak to bring about such improvements within a reasonable timeframe. Whetherthe net benefits of this option are higher than the 'net benefits of proceeding with privatization even underadverse conditions (to accelerate sector improvements), should be the main criteria for deciding which wayto go (provided there are interested qualified investors to make privatization a feasible option). Thejudgment depends on a number of considerations and does not lend itself to easy generalizations andprescriptions.

Structuring properly assets to be privatized is a key element for both attracting investors and makingprivatization sustainable. Important considerations include the degree of leverage which the rest of thesector - if publicly owned and poorly managed - may have over the privatized companies afierprivatization, and vice versa: the degree to which the privatized companies may induce change withinthemselves and within the sector. The more independent the privatized company is from the rest of thesector, the more attractive and resistant to public sector mismanagement it becomes. The leverage of theprivatized companies, however, also need to be balanced in order to control market power, guard againstmonopolistic or monopsonistic behavior and protect public interest.

Privatization to strategic investors does'bring benefits: improved supply, access to investments andtechnology, reduced corruption, better management and financial discipline, improved governance practiceswhich should spill out into the rest of the sector and the economy, and more competent debate on sector andeconomic reforms.

Government's support to private investors after privatization is very important, especially in helping fightvested interests and corruption and provide adequate fiscal policies. The ability of the government to carryout this responsibility is a key factor affecting the sustainability of privatization. Similarly important isregulatory support through, e.g., tolerance for higher losses inherited from state companies, during the firstfew years after privatization.

Post-privatization support by international financing institutions plays an important role as well. IFC and

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EBRD are almost the only financial institutions capable of providing investment funds to private investorsduring the first post-privatization years, as commercial banks may be reluctant or too expensive. Continuedattention of international financing institutions to sector reforms and broader economic reforms are oftencritical to ensure sustainability of reforms and enabling environment for private sector. Bilateralorganizations, as well as private sector, could play an importanit role in mitigating social costs.

The private sector has a steep leaming curve to climb in the FSU environment. Time is needed for privateinvestors to hone their managerial, technological, and cultural skills to the specifics of the region.

9. Partner Comments

(a) Borrower/impleinenting agency:The purpose of this document is to provide contribution by the Government of Georgia to theImplementation Completion Report (ICR) for the Energy Sector Adjustment credit (ESAC) and it formsan integral part of the said ICR. Notwithstanding the minor discrepancies, the assessments by theGovermment of Georgia mainly coincide with the World Bank's estimations with regard to theimplementation of the above Project.

BACKGROUND

Reform-of the Georgian energy sector has faced the twin challenges of a Soviet heritage of negligibleprices for energy services and a collapse of the economy since the dissolution of the Soviet Union andcivil war in Georgia. Therefore Georgia urgently needed adjustment financing to restructure theeconomy.

The Energy Sector Adjustment Credit (ESAC) is a key element of IDA's country assistance Strategyand had therefore been designed in parallel with stabilization and structural reform programs supportedby the IMF's ESAF and by the Bank's structural adjustment lending. The credit intended to allow theimplementation of the energy sector referm program, with adequate funding of social sectorexpenditures to mitigate the impact of the program on the most vulnierable groups.

Credit was made to Georgia, represented by the ministry of finance, which was responsible for creditadministration. Credit budget was 18.1 million SDR (US$ 25 million equivalent). The credit was onstandard IDA terms with a maturity of 35 years, including a grace period of 10 years. The first tranchedisbursed immediately upon credit effectiveness; the second tranche disbursement was made to anaccount (the "Deposit Account) of the Ministry of Finance established at the Georgian National Bank.

The ESAC was designed to help break the vicious circle of sector's inability to provide services andcollect payments and improve its performance by supporting structural, policy, legal, and institutionalreforms in the energy sector, cormpounded by the associated broader economic reforms pursued by theBank's adjustment lending. The main elements of reforms supported by the ESAC including strategicprivatization in the, electricity sector and creation of enabling environment for private sectorparticipation in the oil and gas industries, and improved environmental regulation and social protection.

The objectives of the credit were to help:

(i) Maintain momentum of energy sector reform and help mitigate its social costs;(ii) Enhance financial management and combat corruption;

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(iii) Increase the availability of energy on a sustainable basis;(iv) Catalyze private investments;(v) Realize Georgia's pipeline transit potential;(vi) Upgrade environmental management.

THE PROJECT AND GOVERNMENT STRATEGY

A. The power sector

Privatization: The Government privatized Telasi - Tbilisi electricity distribution company (sold inDecember 1998 to AES). #9 and #10 units of Gardabani Thermal Power Plant privatized (capacity 600MW, sold AES). At least about 230 MW of hydro plants privatized/leased competitively (Krami I andII leased for 25 years to AES). State own regional electricity distribution companies consolidated(Georgian United electricity Distribution Company Established). The Government has decided to offerfor privatization or long-term concession of Georgian United Electricity Distribution Company and resthydro power plants. International financial Corporation (IFC) helps to Georgian Government in theprivatization transactions.

Direct Transfers to Sakenergo: Direct transfers to Sakenergo on behalf of pensioners, civil servantsand refugees in privatized areas were abolished in December 1999.

Compensation'for Abkhazia: 10 million GEL included in the 1999-2001 budget to compensation costof electricity needs in Abkhazia. No compensation in the 2002 budget though, but planned to be includedin the 2003 budget.

Introduction of International Accounting Standards in Sakenergo, Energotransmission,Sakenergogeneratsia, Tbilsresi and Saktransgasmretsvi: International accounting/auditing standardswere inserted in July 1999 in order to upgrade financial management.

Increase poverty benefits to poor single pensioners: The Government has decided to increase thepoverty benefit targeted to poor single pensioners, which has been identified as a particularly vulnerablegroup. It was inclused 14.3 million GEL in the 1999 Consolidated Budget, to bring the beneficiaries tothe world Bank-estimated poverty line. Poverty benefits paid in 1999, 2000, 2001 and 2002.

Adoption of electricity market rules and stakeholders management of the market: As a key elementof the power sector reform program, the foundations of a competitive wholesale electricity market werelaid. It was established Georgian electricity wholesale market (GWEM) in June 1999. A major benefitof the firsi phase is that stakeholders were represented in market management (in contrast to thesituation in Sakenergo, which played a dominant role).

Cost reflective tariffs: Georgian National Energy Regulatory Commission (GNERC) maintains propertariffs.

Dispute resolution procedures to be adopted: According to the resolution -On approving theprocedural rules for reviewing the dispute issues between licensees, licensees and customers- ofGeorgian national Energy Regulatory Commission (April 6, 2000, resolution #4) Dispute resolutionprocedures adopted.

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B. Natural gas transmission and distribution

GNERC to regulate tariffs and issue licenses: Parliament of Georgia adopted amendments to theElectricity Law to authorize GNERC to regulate gas marketing, distribution and transmission.

Adoption of gas tariff methodologies and issuance of licenses: The Georgian national EnergyRegulatory Commission adopted a transparent methodology for setting tariffs for monopoly services,including gas purchase/resale (until competitive market can be established), transmission anddistribution. The tariff-setting procedures ensured that regulated enterprises can recover prudentlyincurred costs of service, while at the same time promoting efficiency in gas supply and energyconsumption, and protecting consumers from monopolistic pricing practices.

Maintaining cost reflective tariffs: Georgian National Energy Regulatory Commission (GNERC)maintains proper tariffs.

Licenses to be issued: The Georgian National Energy Regulatory Commission developed terms andconditions-for commercial licenses which address the rights and responsibilities of sector enterprises,and issued licenses to participants in the supply chain. The amended electricity Law gives theCommission the authority to prevent a given participant in the gas from holding more than one license.

Privatization: Six gas distribution companies were privatized during 1998. However, the privatizationprocess was conducted in a less than fully competitive manner. Repeat attempts to privatize Thilgaziwere unsuccessful, but still going on.

C. Oil and gas exploration and production

Parliamentary adoption oil and gas Law: The new Oil and Gas Law adopted in may 1999, is expectedto catalyze investment in exploration and production of oil and natural gas establishing a one-stopregulatory authority for the sector, and by consolidating the legal foundation for existing operations.

Parliamentary adoption of legislation on eminent domain: According of the resolution of Georgianparliament (July, 23, 1999) the Law on Rules of Expropriation of Property for public Purposes wasadopted.

Separation of regulation and commercial activities: Saknavtobi established as a commercialenterprise, State Agency for Oil and Gas regulation established for regulation.

Catalyze private investments in exploration and production: Private investments in.explorations andproductions successfully implemented. a number of private investors involved.

D. Oil and Gas transit pipelines

Legislating tax stabilization: As is known pipelines involve large infrastructure investments of longgestation and payback periods, with very limited alternative uses once constructed. They will thereforerequire long-term predictability in the tax regime. Tax stabilization legislating handled in theintergovernmental agreements on oil transit pipelines.

Conclusion of double-taxation agreements: The attractiveness of the investrnent climate for pipelineswill also be enhanced by the conclusion of double taxation agreements with major home country

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governments. Such agreements Georgia already concluded with 15 countries.

E. Energy and environmentThe energy privatization due diligence process include appropriate environmental audits to ensure thatthe responsibility for environmental mitigation can be clearly assigned post privatization and theprivatization Law to.be amended. The parliament of Georgia adopted Legislations to clarifyenvironmental liability in the energy sector (the Lae on Compensation of damages Caused by HarmfulSubstances was adopted on July, 23, 1999).

BANK'S ROLE IN PROJECT IMPLEMENTATIONThroughout the entire project implementation as well as during the Project preparation, the Bank and itsstaff offered appropriate and relevant assistance.

The Bank support provided was qualified and adequately due and was therefore critical to success infulfilling the Project objectives.As far as disbursements are concemed, the Banks operations were performed in a smooth and timelymanner.The Bank's contributi6ii in the Project implementation is rated as highly satisfactory.

SUMMARYProceeds of credit have been used in accordance with conditions under the Development CreditAgreement. In addition, this credit have carried out the two most important functions: Budget deficit ofthe State of Georgia for years 1999 and 2001 have been financed and credit funds have been used by theState for ensuring the right accomplishment of the obligations under the Loan Agreement.

On the whole, the Government of Georgia estimates as satisfactory the objective achieved through theProject implementation and agrees to the assessments provided in the Implementation CompletionReport by World Bank.

(7') Cofinanciers:Not applicable.

(c) Other partners (NGOs/private sector):Not applicable.

10. Additional Information

Not applicable.

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Annex 1. Key Performance Indicators/Log Frame Matrix

Outcome / Impact Indicators:lndicitdtIIato r '-- _ _ lfl__ _ _ _ _ _SR. ____________________

Improved social protection measures No arrears in disbursement of poverty No arrears in disbursement of povertybenefits from the central and local budget. benefits from the central and local budget

Adoption of legislaton to clarify environmental Legislation adopted. Legislation adopted.liability in the energy sector andenvironmental auditsSatisfactory overall performance on the Satisfactory. Satisfactory.Govemmenfs energy reform program asstated in the Letter of Energy Sector PolicyMacroeconomic framework (ESAF and SAC Sustained satisfactory macroeconomic Satisfactoryprograms on track) performance

Output Indicators:

_- ..' AIdicator/ir!M txPet'q aate R,i1;gA-*AiUa mt . -

(1) Actual expenditures for elecricity On target. Not Included in the 2002 budget; will besupplied by Inguri Hydro Power Plant to fully Included in the 2003 budgetreflect the budget allocation.(2) Continued implementation of electdricity On target. Satisfactory implementatlon.tariff methodology adopted by GNERC onJuly 1, 1998.(3) Adoption of a gas tariff methodology by Completed. Completed.GNERC and licenses to have been issued toall privatized gas distribution companies, thegas transmission company and all gaspurchasers/resellers(4) Parliamentary adoption of legislation on Legislation adopted. Legislation adopted.eminent domain.(5) Adoption of chart of accounts according Charts of accounts adopted. Charts of accounts adopted.to IAS, and appointment of intemationalauditors to audit the 1999 accounts of majorelectricity companies

End of project

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Annex 2. Project Costs and Financing

The total cost of the project was SDR 18.1 million, equivalent to USD 25 million at the time of approval.The Credit was disbursed in two equal tranches. The first tranche was disbursed after declaration ofeffectiveness (in July 1999), and second tranche in December 2001.

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Annex 3. Economic Costs and Benefits

Not applicable.

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Annex 4. Bank Inputs

(a) Missions:Stage of Project Cycle No. of Persons and Specialty Performance Rating

(e.g. 2 Economists, I FMS, etc.) Implementation DevelopmentMontWfYear Count Specialty Progress Objective

Identification/PreparationJune 1998 2 Economists

1 Pipeline SpecilistI Environmental Specialist1 PSD SpecialistI Financial Analyst

October 1998 2 EconomistsI Pipeline Specilist1 Financial Analyst

Appraisal/NegotationDecember 1998 2 Economists

I Financial Analyst

SupervisionApril 1999 2 Economists S S

I Financial Analyst1 Environmental Specialist

August 1999 2 Economists S SI Financial Analyst

September 1999 1 Economistt S SI Financial Analyst

October /November 2 Economist S S1999 1 Financial AnalystFebruary 2000 1 Economist S S

1 Financial AnalystJuly 2000 1 Energy Specialist S S

I Financial Analyst2 Economists

September 2000 1 EconomistI Financial Analyst

November 2000 1 EconomistI Financial Analyst

May 2001 1 Energy Specialist S SI Financial Analyst

October 2001 1 Economist U s1 Financial Analyst

May 2002 1 Energy Specialist1 Financial Analyst

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(b) Staff

Stage of Project Cycle Actual/Latest EstimateNo. Staff weeks US$ ('000)

Identification/Preparation NA 64,084Appraisal/Negotiation 3.5 22,000Supervision 57.8. 204,603Total 61.3 290,687

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Annex 5. Ratings for Achievement of Objectives/Outputs of Components

(H=High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable)Rating

O Macro policies O H * SU O M O N O NAEl Sector Policies O H *SUOM O N O NAO Physical O H OSUOM O N * NAL Financial OH OSUOM ON ONAO Institutional Development 0 H O SU *M 0 N 0 NAO Environmental O H *SUOM O N O NA

SocialEl Poverty Reduction O H OSU*M O N O NAEl Gender OH OSUOM ON *NAO Other (Please specify) -O H OSUOM O N * NA

El Private sector development 0 H * SU O M 0 N 0 NAEl Public sector management 0 H O SU O M * N 0 NAO Other (Please specify) O H OSUOM O N * NA

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Annex 6. Ratings of Bank and Borrower Performance

(HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HU=Highly Unsatisfactory)

6.1 Bank performance Rating

II Lending *HS OS OU OHUOI Supervision *HS OS OU OHUOI Overall OHS OS O U O HU

6.2 Borrower performance Rating

L Preparation OHS OS O U O HUL Government implementation performance O HS O S 0 U 0 HULI Implementation agency performance OHS *@S O U O HULI Overall OHS OS O U O HU

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Annex 7. List of Supporting Documents

Not applicable.

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