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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY IMPLEMENTATION COMPLETION REPORT Energy, Environment, and Transport Division Central Europe Department Europe and Central Asia Region HUNGARY POWER PROJECT (Loan No HU) November 7, 1996 Report No This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EOUIVALENTS (as of December 31, 1995) Currency Unit=Forint Ft =US$1.00 AVERAGE EXCHANGE RATES Forint per US$ WEIGHTS AND MEASURES 1 kilowatt-hour (kwh) = 1,000 watt hours 1 Megawatt-hour (MWh) = 1,000 kilowatt-hours 1 Gigawatt-hour (GWh) = 1,000,000 kilowatt-hours 1 Terawatt-hour (TWh) = 1,000,000,000 kilowatt-hours 1 Megawatt (MW) = 1,000 kilowatts FISCAL YEAR OF BORROWER January 1 - December 31 ABBREVIATIONS AND ACRONYMS LRMC - Long-run marginal cost MIS - Management Information System MRS - Management Reporting System MVM - Hungarian Power Companies Ltd Trust before December 31, 1991) (the MVM MW" - Megawatt of electric power MW, - Megawatt of thermal power NO, - Nitrogen oxide UCPTE - Union for the Coordinated Production of Electricity WASP III - Wien Automatic System Package, Version III Johannes F. Linn, Vice President, ECAVP Jean-Michel Severino, Director, EC2DR Hans J. Apitz, Division Chief, EC2ET Richard Hamilton, Sr. Energy Economist, EC2ET

3 FOR OFFICIAL USE ONLY IMPLEMENTATION COMPLETION REPORT HUNGARY POWER PROJECT (Loan 2697-HU) TABLE OF CONTENTS PREFACE PAGE EVALUATION SUMMARY PART I: PROJECT IMPLEMENTATION ASSESSMENT A. STATEMENT AND EVALUATION OF OBJECTIVES 1 Project Objectives 1 Evaluation of Objectives 2 B. ACHIEVEMENT OF OBJECTIVES 2 Physical Objectives 2 Institution Building 4 Financial Performance Objectives 6 C. MAJOR FACTORS AFFECTING THE PROJECT 6 D. PROJECT SUSTAINABILITY 6 E. BANK PERFORMANCE 7 F. BORROWER PERFORMANCE 7 G. ASSESSMENT OF OUTCOME 8 H. FUTURE OPERATION 8 I. KEY LESSONS LEARNED 8 Ths document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

4 PART II: STATISTICAL ANNEXES Table 1: Table 2: Table 3: Table 4: Table 5: Table 6: Table 7: Table 8: Table 9: Table 10: Table 11: Summary of Assessments Related Bank Loans Project Time Table Loan Disbursements Key Indicators for Project Implementation Key Indicators for Project Operation Studies included in the Project Project Costs, Project Financing Status of Legal Covenants Bank Resources - Staff Inputs Bank Resources - Missions APPENDICES BORROWER'S CONTRIBUTION (Summary)

5 IMPLEMENTATION COMPLETION REPORT HUNGARY POWER PROJECT (Loan 2697-HU) PREFACE This is the Implementation Completion Report (ICR) for the Hungary Power Project (Loan No HU, US$64.0 million equivalent) approved on May 20, The Republic of Hungary was the Borrower. The Beneficiary was the former Hungarian Electric Power Trust (MVMT), reorganized effective January 1, 1992 as the Hungarian Power Companies Ltd. (MVM Rt). The project was the Bank's first with the Beneficiary. Its implementation period coincided with the fall of communism in Central Europe and the restructuring of the company. It was successfully completed in spite of these circumstances. The loan was closed on March 31, 1995, two years after the original loan closing date. The delay was due mainly to the modification of an important project component from supply and installation of a 60 MW turbogenerator at the existing coal-fired Borsod power plant to supply and installation of a 150 MW gas-fired combined-cycle cogenerating unit at the existing Kelenfold power and district heating plant at Budapest. This required an amendment to the Loan Agreement and a change of project description, both of which were made in July It also required negotiation of a 35 million ECU loan from the European Investment Bank (EIB) to cover the increased foreign costs of about US$43 million. The Bank loan amount was unchanged and it was fully disbursed by end March The project was completed when the gas-fired combined cycle unit at Kelenfold plant was commissioned on December 23, The ICR was prepared by Messrs. Richard Hamilton, Wiegong Cao (Consultant) and C. K. Chandran (Consultant), Energy and Environment Division, Central Europe Department. The work began during February/March It is based on the Staff Appraisal Report, the Loan and Project Agreements, Supervision Reports, correspondence between the Bank and the Borrower/Beneficiary, internal Bank memoranda and a Completion Report prepared by MVM Rt in March The report was reviewed by Mr. Franz Kaps, Project Advisor (EC2DR).

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7 EVALUATION SUMMARY Project Objectives 1. The project was one of the earliest Bank-financed projects in Hungary and the first in the power sector. It was originally intended to: (a) increase utilization of domestic coal in primary energy generation in accordance with Government policy at that time; (b) reconstruct and rehabilitate 8 coal power stations (with some marginal expansion) belonging to Hungarian Power Companies Limited (MVM 1 ) and upgrade other MVM power stations, transmission and distribution systems; and (c) improve MVM 's operational efficiency and management. In 1990 the worsening financial situation in the coal mining industry led the Government to establish the Center for Restructuring of Coal Mining, which then began closing unviable mines. In consultation with the Bank the project was modified in July 1991 to drop the coal-fired 60 MW component at Borsod plus various small items and construct instead a gas-fired 150 MW gas turbine generator and heat recovery boiler at Kelenfold in Budapest to provide both electricity and heat. The rest of the project was unaffected. Implementation Experience and Results 2. The original project was defined as a time-slice of MVM's investment program from About 81 % of the US$620 million program was intended for reconstruction, rehabilitation, upgrading and marginal expansion of 8 coal power stations. The actual program amounted to US$591 million, of which 61 % consisted of expenditures at coal power stations. The US$64 million Bank loan financed a diverse set of goods plus a small amount of technical assistance. A summary breakdown is as follows: Kelenfold (US$25 million), coal power stations (US$13.7 million), other power stations (US$5 million), transmission and distribution systems (US$17.7 million), technical assistance (US$2.6 million). 3. The expenditures at the 8 coal power stations increased availability of capacity, improved thermal efficiency, reduced outages and greatly reduced emissions of particulates and nitrogen oxides. The combined-cycle co-generation unit at Kelenfold entered service at the end of 1995 with satisfactory efficiency and cost results. 4. Technology transfer through the project was impressive. In least-cost investment planning, Hungarians were able not only to successfully adapt Western models but to improve them. Up to date management information systems were also introduced. 1/ On December 31, 1991, the MVM Trust (MVMT) - the Beneficiary at Loan Signing - was incorporated as MVM Rt. Throughout this report, the Beneficiary will be referred to as MVM.

8 A factor which cast a shadow on the project was the trend of demand for electricity which, for socio-economic reasons linked to the political upheavals in and around Hungary from 1989, declined instead of increasing. This was mainly due to decreased demand by industry. Gross electricity consumption (including station use and losses) was 36.6 TWh in At appraisal this figure was expected to increase to about 48.2 TWh at a minimum in 1995 and to 56.5 TWh by the year The actual consumption in 1995 was only 36.4 TWh. MVM's 1995 minimum demand forecast for the year 2000 was only 37.0 TWh. Hungarian experts and Bank staff were aware of the large potential for energy conservation in Hungary at the time of appraisal, and the possibility of a lower than forecast demand was also considered, but not the large reduction which occurred. Fortunately the project was fairly robust with respect to changes in demand since it involved mainly rehabilitation. Nevertheless, the ex post rate of return was only 6% as compared to 12% envisaged in the SAR. 6. Another problem was that coal-generated electricity turned out to be less competitive than expected at the time of appraisal. This led to the change in project scope described in paragraph 1, and contributed to the lower than expected project rate of return. 7. The project was completed in its entirety but with a delay of two years on Bank financed project components. The delay was due to the change in project scope (para. 1) and to the Hungarian institutions' unfamiliarity with the Bank's procurement regulations and procedures. 8. The self-financing and debt service coverage targets were met through 1994 (the last year for which data were available on a consolidated basis). In 1994, MVM's operating costs exceeded revenue, but no target had been fixed for these indicators. The other covenants under the Project Agreement were met. 9. The covenants under the Loan Agreement were mostly met. The agreement (Section 4.03 (a) (iii)) to bring producer energy prices in line with economic costs was met for most energy products but there were a few gas and electricity price exceptions. 10. On December 31, 1991, MVM was reorganized as a Joint Stock Limited Company with a rationalized group of fifteen subsidiaries - eight generating companies, a transmission grid operating company, and six distribution companies. The first revaluation of assets in three decades was carried out in In 1994, the Act (XLVIII of 1994) on the Production, Transport and Supply of Electric Energy was approved by Parliament. By the end of 1995, the State Privatization and Holding Company had sold minority shares in two generation and six distribution companies to foreign strategic investors, thus starting the program of privatization of the power sector. Key Lessons Learned 11. The key lessons learned are:

9 -iii- (i) (ii) (iii) (iv) more attention should have been given at appraisal to cost comparisons between indigenous coal and alternative energy options, including environmental costs; it is important to take account of the risks of actual demand turning out to be different from forecasts, and to adjust investment programs promptly to changed demand information; to avoid procurement delays under international competitive bidding the Bank should provide to new borrowers and beneficiaries detailed information on its procurement guidelines during project preparation (the Borrower found the subsequent preparation by the Bank of standard bidding documents helpful); and financial covenants should be flexible enough to ensure financial soundness of the enterprises through periods of falling as well as increasing demand.

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11 PART I - PROJECT IMPLEMENTATION ASSESSMENT A. STATEMENT AND EVALUATION OF OBJECTIVES The Project Objectives 1.1 The project was a 7-year ( ) time slice of MVM's program for reconstruction, rehabilitation, upgrading and marginal expansion of its facilities. It included the following three components: (a) (b) (c) Reconstruction of coal-fired thermal power stations at Gagarin (later renamed as Matra), Ajka, Borsod, Pecs, Tiszapalkonya, Oroszlany, November 7 (later renamed as Inota), and Tatabanya, and installation of a 60 MW turbogenerator at Borsod (Part A of Schedule 2 of Loan Agreement); Rehabilitation of other generating plants and rehabilitation and upgrading of the transmission and distribution systems (Part B of Schedule 2 of Loan Agreement); and A program to improve MVM's capabilities in planning, management and operations (Part C of Schedule 2 of Loan Agreement). The increases in generating capacity and electricity generation expected from the project were 266 MW and 2,300 GWh respectively. 1.2 The Loan Agreement Amendment of 1991 introduced the following changes in the project due to a Government decision at the end of 1989 to shut down the uneconomic coal mine at Borsod. They were to: (a) (b) Omit the 60 MW steam turbogenerator at Borsod and the retrofitting of the boilers at Ajka power station to fluidized-bed combustors from Part A of the project; and Add construction of a gas-fired co-generation plant, capable of combined cycle operation at the existing Kelenfold district heating power plant at Budapest. It involved replacement of oil-fired boilers supplying steam to six existing backpressure turbines by a 150 MW gas turbine and a heat recovery steam generator capable of producing 196 MW of heat. 1.3 The objectives of the project at appraisal were to: (a) Support the Government's strategy to increase the share of indigenous coal in Hungary's primary energy consumption, thus saving imported oil and gas (expected to be more expensive than indigenous coal);

12 -2- (b) (c) (d) (e) Assist MVM in conserving scarce investment capital through delaying major new nuclear and lignite investments; Strengthen MVM's institution building efforts; Reduce atmospheric pollution; and Assist in the transfer of modem technology. Evaluation of Objectives 1.4 All the objectives except (a) were sound. The strategy of increasing the share of indigenous coal would have been reasonable if indigenous coal had been less costly than imported energy and if environmental pollution from coal could be kept to acceptable levels. However, by 1989 all 8 coal companies in Hungary were in serious financial difficulties despite government subsidies, and it was recognized that some coal mines were economically uncompetitive. The Government then modified its coal development policy and began to restructure the coal mining sector and shut down some uneconomic coal mines. Coal's share in total national energy supply fell from 27.5 percent in 1985 to 16 percent in Physical Objectives B. ACHIEVEMENT OF OBJECTIVES 1.5 The original project was defined as a time-slice of MVM's investment program from About 81% of the US$620 million program was intended for reconstruction, rehabilitation, upgrading and marginal expansion of 8 coal power stations. The actual program amounted to US$591 million, of which 61 % consisted of expenditures at coal power stations. The US$64 million Bank loan financed a diverse set of goods plus a small amount of technical assistance. A summary breakdown is as follows: Kelenfold (US$25 million), coal power stations (US$13.7 million), other power stations (US$5 million), transmission and distribution systems (US$17.7 million), technical assistance (US$2.6 million). 1.6 The effect of the project on available generating capacity and electricity generation is difficult to evaluate because of the problem of determining what would have been the performance of the coal power stations in the absence of rehabilitation and because declining electricity demand after 1989 resulted in a reduction in load at coal power stations. Rehabilitation increased available power capacity at Gagarin and Orozlany (which absorbed the bulk of the rehabilitation expenditures) by 268 MW and electricity generation by 1,525 GWh in compared to the years just before rehabilitation. However, available capacity fell over the same period at the other coal power stations; generation also fell but mainly because of lower demand for electricity from these units rather than insufficient availability. The impact of Kelenfold is clear - an increase of 150 MW in available electric power capacity and an increase in electricity generation estimated at 720 GWh in In addition to increasing

13 -3- capacity, the project contributed to improved efficiency and reduced forced outages at the 8 coal power stations. The average increase in thermal efficiency was about three percentage points, which is considered to be substantial. 1.7 A major objective of the coal power station reconstruction/rehabilitation program was to reduce the levels of NO, and particulate emissions mainly through replacement of electrostatic precipitators and conversion to fluidized bed combustors (not financed by the Bank). NOI levels were reduced by 30 percent. Dust levels before and after rehabilitation at three power plants are given in the table below. Power Plant Prior to Rehabilitation Emission Levels (mg/nm3) Post Rehabilitation Gagarin 1, Ajka 1,900-6, Pecs 530-1, The Staff Appraisal Report estimated the rate of return on the time slice of MVM's investment program at 12%. The benefits were expected to come from increased revenue due to additional demand relative to the supply capability that would have been achieved in the absence of rehabilitation. An ex-post estimate of the rate of return yielded a rate of return of only 6%, mainly because of falling electricity demand from Despite this unfavorable result, the decision to proceed with the project at the time of appraisal may still be considered to have been largely justified based on the information available then. The timing and severity of the fall in demand which occurred after 1989 in the wake of the fundamental political and social changes could not have been reasonably expected at the time of project appraisal. Moreover the original project was mainly for rehabilitation of existing capacity and pollution control rather than construction of new capacity. However, the appraisal decision may be faulted for overestimating the competitiveness of indigenous coal.' In addition, MVM may have erred after 1989 in not cutting back enough on its overall investment program when it became clear that electricity demand was falling and the cost of electricity production at some coal power stations was high. Further, continued operation of uncompetitive coal power stations also contributed to the unfavorable ex-post economic rate of return. In 1991, the fuel and operating costs (excluding investments) were about US$0.044 per kwh at Gagarin, Oroszlany. Pecs and Tatabanya, US$0.053 at Ajka and Borsod, US$0.065 at Tiszapalkonya and US$0.127 at November 7. Since the electricity import price in 1991 was US$0.051 per kwh, 1/ Admittedly, the evaluation was difficult since international oil prices fell sharply towards the end of project preparation, and their future evolution was not yet clear. The Staff Appraisal Report's analysis was based on the new lower prices. I

14 -4- and prices in subsequent years have been as low as US $0.025 per kwh, it was less costly to import electricity than to operate the most costly coal power stations. Despite this situation MVM was required to use more coal than would be indicated on cost grounds in order to alleviate the painful adjustments associated with downsizing the domestic coal industry. In the early 1990's it negotiated annual coal purchase contracts with the miners' union and the Ministry of Industry and Trade. In 1993 and 1994 some coal mines were integrated with MVM's coal power station companies, but MVM was still obliged to purchase some coal from independent mines at higher prices than it paid to the integrated mines. 1.9 A separate economic analysis was made of the Kelenfold investment. The original investment decision was justified on the grounds (i) of the urgent need to replace aged heat supply equipment; and (ii) that the electricity component was estimated to be in the least-cost power generation investment program as a replacement for power stations needing early retirement. The electricity component was also considered to be economic as a means to displace more expensive imported electricity. An ex post calculation, using actual data for the first four months of 1996 together with actual investment costs, yielded an estimate of the cost of incremental electricity generation at Kelenfold of 7.3 forints per kwh (US$0.052). The operating cost (excluding investment) was estimated to be 3.4 forints per kwh (US$0.024). The cost including investment is higher than the US$0.045 per kwh originally estimated, mainly since the actual investment cost was 36% higher than the original estimate, but it is still acceptable. This analysis does not take account of the benefits at Kelenfold of prolonging the lifetime of the heat supply facilities. Institution Building 1.10 The program to strengthen MVM's institution building efforts in planning, management and system operations included: (a) (b) (c) (d) (e) a long-run marginal cost (LRMC) pricing study; a study to develop a detailed management information system (MIS) and data collection, recording and reporting systems (MRS); a study to identify the major causes of quality fluctuations in coal supplies at MVM's power stations and to ensure boiler flame stability at such power stations; a study to develop a least cost investment strategy for further development of power generation facilities; and staff training, computer hardware and software and a mobile pollution monitoring unit In addition, the Government agreed to complete a comprehensive study of energy prices by January 31, 1987 and thereafter keep producer prices of fuel in line with economic costs, as

15 -5- defined. This study was carried out. During the disbursement period of the project, the Government implemented several important price reforms including freeing oil and coal prices from controls and establishing a regulatory agency, the Hungarian Energy Office (HEO). Most energy prices (exceptions as of June 1996 included some gas, electricity and district heat prices) have been raised to cover economic as well as financial costs, but the process has not yet been completed because of social considerations and concerns over inflation LRMC calculations were not used in the power sector in Hungary before During 1988, MVM experts, in cooperation with the Argonne National Laboratories (USA) initiated the first LRMC study using the WASP (III) planning model. It was completed in summer A second study was completed by MVM in February 1991, with assistance from Electricite de France, as part of a UNDP/World Bank program of studies for European and Arab countries. The LRMC study was updated in 1992 and in About 20 Hungarian specialists took part in the various modelling training programs arranged by the Bank. Not only were models suggested by the World Bank and the International Atomic Energy Agency - WASP III - taken over successfully by MVM, they were also adapted to suit Hungarian conditions, for example through alterations to permit evaluation of electricity imports and combined-cycle co-generation power stations as candidates. Besides taking part in the improvement of WASP III, MVM experts participated in development of several other LRMC calculation and generation expansion software packages. They are now being used routinely by MVM in its decision making. This aspect of technology transfer was particularly impressive MVM selected Ontario Hydro and Price Waterhouse in 1987 for its study to develop appropriate management information and reporting systems. Foreign consulting firms working with MVM experts set out the fundamental basis by 1989 and thereafter introduced a working management reporting system (MRS). During , the MRS was improved and modernized. It is now being used by MVM and its subsidiaries for technical information, stock control, energy invoicing etc. It was able to cope with the major institutional reorganization of The study to identify the causes of flame instability at coal-fired power stations and to eliminate them was carried out during by MVM's local consulting engineers. Some foreign experts were also utilized for specialized services at a few important stations such as Gagarin. The study was completed and necessary corrective steps taken Regarding item 1.10 (d), the WASP III model, adapted by MVM, was used for development of a least cost investment strategy commencing in The experiences are described in paras and 1.13 above Most of the staff training and acquisition of necessary computer hardware and software (item 1.10 (e)) took place under the parts of the program described in paras and 1.13 above.

16 -6- Financial Performance Objectives 1.18 The Project Agreement required MVM to (a) produce funds from internal sources equivalent to not less than 35 percent of defined investment needs and (b) to obtain concurrence of the Bank before incurring debt whenever its internal cash generation was not sufficient to cover its debt service on a yearly basis at least 1.5 times in any future year. MVM met the selffinancing and debt service coverage targets through 1994 (consolidated accounts for 1995 were not available when the ICR was prepared). However, in 1994, MVM's operating costs exceeded revenues, and the consolidated loss after interest payments and taxes was about HUF 11.7 billion. These unfavorable results were partly due to high coal costs and a delayed adjustment of electricity prices to inflation between 1993 and The financial covenants under the Power Project were superseded by those of the Energy and Environment Project (Loan HU), which became effective on April 15, Under this project the self-financing target was increased to 55 % and an operating ratio covenant was added. Because of continued reform and privatization of the power sector, new financial covenants are expected to be introduced under the proposed Quick Start Gas Turbine Project, which will replace those under the Energy and Environment Project. C. MAJOR FACTORS AFFECTING THE PROJECT The major factors which affected the project were: (i) the major political and social changes in Central Europe in the late 1980s; (ii) the associated decline in the demand for electricity after 1989; and (iii) Government's decision in 1990 to reduce coal mining - a radical modification of its previous policy of increasing the role of coal in the country's energy consumption. The election of a non-communist government in Hungary in 1990 was followed by the preparation of a new energy policy, restructuring of the energy sector, including MVM, and a major initiative to privatize the energy sector companies. MVM's decision to request a reallocation of funds under the Power Project to finance the Kelenfold combined-cycle unit was due to the changed policy environment. D. PROJECT SUSTAINABILITY 1.20 The rehabilitated coal power generating units, except Matra, are expected to be retired by soon after the year 2000, in line with expectations at the time of appraisal. Matra's lifetime is expected to be longer: the attractiveness of this plant is evidenced by its sale to a foreign strategic investor in Kelenfold's sustainability is probably assured by its high thermal efficiency, low operating costs and secure supply of natural gas. Since the project was defined as a time-slice of MVM's investment program, the question of sustainability really applies to the whole power system. The power system's prospects are favorable due to the restructuring and continuing privatization of the power sector and establishment of a new regulatory framework. Membership in the Union for the Coordinated Production of Electricity (UCPTE) will also help to ensure a continued high quality and reliability of electricity supply.

17 -7- E. BANK PERFORMANCE 1.21 Bank performance can be considered satisfactory. The Bank maintained good working relations with the Borrower, the Beneficiary and its consultants throughout. The Bank displayed flexibility in resolving problems that arose on redefining the scope of the project when earlier assumptions on coal availability, quality and costs were found to be wrong and required a change in Government energy policy Delays occurred in the early years of the project in procurement of major equipment through ICB - such as procurement of the 60 MW turbogenerator at Borsod. It took almost three years for preparation of satisfactory bidding documents - too late to be issued! The delays were primarily due to the unfamiliarity of the implementing agencies and their local consultants with ICB procedures, but also to the inadequate efforts by the Bank staff to anticipate and overcome the problems efficiently. In retrospect, it would have been better to familiarize the Borrower and the Beneficiary in detail with the procurement procedures of the Bank during project preparation. F. BORROWER PERFORMANCE The project components were implemented by MVM and in the later stage by enterprises separated from MVM proper. Their performance was commendable since they successfully carried out the project during a period of major political and economic transition. Since this was the first Bank-financed power project, the implementation agencies were not familiar with Bank practice, particularly on procurement. However, through the project implementation, the implementing agencies gained substantial experience in international procurement. The credit for the successful execution of the project as a whole is due to the organizational skill and commitment of MVM's Directorate of Development. Through the project, MVM absorbed not only modern construction and operation techniques for thermal power units, but also greatly strengthened its organization. During project implementation MVM established in-house capacity to develop the least-cost investment plans for power generation on a regular basis. The unit was also active internationally, and contributed to improvements in the WASP III model, which were accepted by the International Atomic Energy Agency (IAEA). The efforts towards increasing internal efficiency in all parts of MVM were successful. MVM needs to be commended for its role in the implementation of the reconstruction/rehabilitation program. MVM has also made an important contribution by altering the project to fit new circumstances through successfully introducing combined cycle co-generation technology into the Hungarian energy system The performance of the Borrower was also satisfactory. It was highly commendable in major policy matters such as the shutting down of uneconomic domestic coal mines, initiation of privatization of the electricity subsector, and establishment of a regulatory framework. The Borrower permitted sufficient electricity price increases to allow MVM to meet the financial covenants under the project; however, these did not prevent MVM from incurring a financial loss in 1994.

18 -8- G. ASSESSMENT OF OUTCOME 1.25 The physical objectives were achieved and the power stations and systems are operating satisfactorily. The technical assistance component of the project contributed to acquiring modern means of system planning and economic pricing, improving the firing conditions of boilers using poor quality domestic coal, and improving environmental monitoring. The institutional capacity building effort was particularly effective. However, largely because of a steep fall in electricity demand that could not have been reasonably expected at the time of appraisal, the project economic rate of return was only 6 %. In addition some of the rehabilitated coal power stations have high operating costs because of low thermal efficiency and high coal costs. Overall, the project outcome is rated as satisfactory. H. FUTURE OPERATIONS 1.26 The Project was followed in 1994 by the Energy and Environment Project (Loan HU), which provides for a major expansion of the combined cycle co-generation program, started under the first power project. It involves: (a) construction of a 235 MWe and 240 MWt cogeneration unit at Dunamenti, (b) upgrading of MVM's existing Energy Management System (EMS), (c) technical assistance aimed at reinforcing the environment management and monitoring capabilities of MVM, and (d) upgrading MVM's training and institutional-building capacity in the power sector. The Quick Start Gas Turbine Project is expected to be negotiated in late 1996 or early It would involve the construction of 2xO10 MW gas turbines to provide secondary reserve for the power system. Continued Bank assistance will help MVM to develop an effective approach to pollution control in the electricity subsector and strengthen its institutional capabilities to address environmental issues. The power generating and distributing companies which benefited from the investments under the project have been separated from MVM and are being privatized. The Hungarian Energy Office has been established to provide regulatory supervision. These actions are considered to be sufficient to provide for satisfactory future operations The key lessons learned are: I. KEY LESSONS LEARNED (i) (ii) (iii) more attention should have been given at appraisal to cost comparisons between indigenous coal and alternative energy options, including environmental costs; it is important to take account of the risks of actual demand turning out to be different from forecasts, and to adjust investment programs promptly to changed demand information; to avoid procurement delays under international competitive bidding the Bank should provide to new borrowers and beneficiaries detailed information on it sprocurement

19 -9- guidelines during project preparation (the Borrower found the subsequent preparation by the Bank of standard bidding documents helpful); and (iv) financial covenants shoule be flexible enough to ensure financial soundness of the enterprises through periods of falling as well as increasing demand.

20 HUNGARY - POWER PROJECT LOAN 2697-HU Table 1: Summary of Assessments [A. Achievement of Objectives Substantial Partial Negligible Not Applicable Macro Policies x Sector Policies X Financial Objectives Institutional Development Physical Objectives X X X Poverty Reduction Gender Issues Other Social Issues X X x Environmental Issues X Public Sector Management X Private Sector Management Other X x B. Project Sustainability Likely Unlikely Uncertain C. Highly Satisfactory I Satisfactory I Deficient Identification Preparation Assistance Appraisal Supervision [D. Borrower Performance J _ X x x x Preparation T T x Implementation X Covenant Compliance X E. Assessment of Outcome Highly Satisfactory Satisfactory Unsatisfactory Highly Unsatisfactory i ''i j ~~~~~~Xji

21 HUNGARY - POWER PROJECT LOAN 2697-HU Table 2: Related Bank Loans Since this is the first power sector loan to Hungary, there are no Bank loans that fall into this category. In the larger Energy Sector, the Industrial Energy Diversification and Conservation Project (Loan 2317-HU of 1983), which aimed at economic substitution of domestic energy resources through a switch from oil towards domestic coal, was a related loan. Table 3: Project Timetable Steps in Project Cycle Planned Date [ Actual Date Initiating Project Brief Ident. Reconn. Mission 02/16/1983 Appraisal 07/17/ /17/1985 Completion of Negotiations 03/24/ /24/1986 Board Approval 05/20/ /20/1986 Effectiveness 08/22/1986 Project Completion 09/30/1995 Loan Closing Date 03/31/ /31/1995

22 HUNGARY - POWER PROJECT LOAN 2697-HU Table 4: Loan Disbursements (US$ million) [ Appraisal Estimate Actual Actual as a % of Estimate Date of Final April 26 Disbursement Table 5: Key Indicators for Project Implementation (From the Tmplementation Schedule - Annex 4.4 SAR) No Key Indicators were listed in the SAR/MOP Table 6: Key Indicators for Project Operation No Key Indicators were listed in the SAR/MOP

23 HUNGARY - POWER PROJECT LOAN 2697-HU Table 7: Studies Included in the Project [ Study Purpose as Defined at Appraisal Status Impact 1. Energy Price To study impact on national Study carried out Most energy prices budget, balance of payments, cover economic costs. energy demand, and investments Electricity prices and incomes of consumers to permitted MVM to enable Government to keep its meet the financial agreement with the Bank to keep covenants, but it producer energy prices of fuel incurred some (and electricity) in line with financial losses after economic costs Long Run Marginal To enable Government to keep Study carried out. The electricity tariff Cost electricity prices of consumers in structure partly line with economic costs. relfects marginal costs. Investment Study for For MVM to develop least cost First study completed. Power Generation further development of development options and enable it Studies being expansion planning Power Generation to meet its Loan obligations to continuously updated uses the tools Facilities recommend to Government for since with very developed by the approval only such options. beneficial results to the study country. On causes of coal To recommend measures to ensure Satisfactorily The problem has been quality fluctuations at boiler flame stability - a serious completed by resolved. MVM Rt power operational problem - at power providing coal mixing stations stations. facilities where necessary. 5. Management To develop modern management Satisfactorily Now operating Information System reporting system (MRS) at completed. effectively at system (MIS) MVM's headquarters and at its centers. Handled subsidiaries. major 1992 restructuring effectively.

24 HUNGARY - POWER PROJECT LOAN 2697-HU Table 8-A: Project Costs (US$ million) Appraisal Estimate Actual/Latest Estimate Item Local Foreign Total Local Foreign Total Costs I Costs Costs Costs Costs KELENFOLD PROJECT COMPONENT l Electromechanical Equipment Civil Works and Fuel Tanks Sub Transmission Line Gas Pipeline, etc, Spare Parts Contingencies Total TOTAL HUNGARY POWER PROJECT Reconstruction Precipitators and Desulphurization **,* Borsod Turbogenerator *** Other four generation plants Upgrading and Rehabilitation Technical Assistance * Base Cost Contingencies Total Interest During Construction J ** [ TOTAL FINANCING REQUIRED [ [ * from World Bank Loan only ** as of 29 February, according to the figures of the National Bank of Hungary it is included in the reconstruction data of the Power Plants Table 8-B: Project Financing (US$ million) Appraisal Estimate Actual/Latest Estimate Source Local Foreign Total Local Foreign Total MVM Rt Internally Generated IBRD Loan Process EIB Total Financing

25 HUNGARY - POWER PROJECT (LOAN 2697-HU) Table 9-A: Economic Costs and Benefits Rate of Return Calculation (Ft millions prices) Sales (GWh) 33,087 33,014 33,250 32,440 30,222 29,015 27,769 28,800 28,951 29,549 29,982 30,385 30,684 31,050 Incremental Sales (73) 163 (647) (2,865) (4,072) (5,318) (4,287) (4,136) (3,538) (3,105) (2,702) (2,403) (2,037) Industrial Price Index Nominal Elec. Price (FVkWh) Price (1985 prices) Incremental Revenue (164) 325 (1,321) (5,938) (7,868) (9,586) (6,989) (6,869) (7,132) (6,272) (5,458) (4,854) (4,115) Investments 13,174 15,304 11,009 13,634 15,727 12,771 18,480 1,198 3,899 6,019 2,426 (nominal prices) Investments (1985 prices) 12,903 14,479 9,954 10,677 10,094 6,185 8, ,373 1,644 / (100,000) e Fuel costs (nominal prices) 27,544 25,810 27,328 33,713 49,577 59,521 55,721 54,941 66,371 (1985 prices) 26,059 23,336 21,400 21,639 24,008 25,845 21,834 19,345 18,129 18,500 18,800 19,000 19,200 19,450 Incremental (1,936) (1,697) 672 2,509 (1,502) (3,991) (5,207) (4,836) (4,536) (4,336) (4,136) (3,886) O & M Costs (nominal prices) 19,930 22,061 25,866 31,089 34,814 36,843 38,518 44,212 (1985 prices) 18,855 19,947 20,255 19,954 16,859 15,998 15,093 15,568 15,900 16,100 16,350 16,500 16,700 16,900 Incremental 1,092 1,400 1,099 (1,996) (2,857) (3,762) (3,287) (2,955) (2,755) (2,505) (2,355) (2,155) (1,955) Elec. Imports (nominal prices) 9,206 9,264 10,370 9,857 24,438 9,895 6,784 6,868 (1985 prices) 8,710 8,376 8,121 6,327 11,834 4,297 2,658 2,418 2,430 2,480 2,520 2,550 2,570 2,600 Incremental (334) (589) (2,383) 3,124 (4,413) (6,052) (6,292) (6,280) (6,230) (6,190) (6,160) (6,140) (6,110) Total Costs 12,903 14,479 10,712 9,552 7,113 7,985 3,263 (10,846) (12,197) (12,798) (13,158) (13,231) (12,851) (12,431) (111,951) Net Benefits (12,903) (14,479) (10,875) (9,226) (8,434) (13,923) (11,131) 1,260 5,208 5,929 6,026 6,959 7,393 7, ,836 IRR= 6%

26 HUNGARY - POWER PROJECT (LOAN 2697-HU) Table 9-A (continued) Notes 1. All incremental revenue and cost estimates measure changes with respect to 1987 levels, except for fuel costs, for which the base year was taken as The year 1987 was the last year before rehabilitation had an impact. Ideally the increments should measure changes with respect to estimates with and without rehabilitation. However, estimates of what would happen in the absence of rehabilitation are very speculative. The without rehabilitation estimates made at the time of appraisal could not be used since the figures for available capacity and generation of coal power stations exceeded the actual results after rehabilitation. The year 1988 was chosen as the base year for fuel costs for two reasons. First, the improvements in thermal efficiency at the rehabilitated coal power stations came mostly after Second, since the Paks nuclear power station reached full operation during 1988, by selecting that year as base year it was possible to avoid including in the benefits of the project fuel cost reductions attributable to Paks. 2. The investment estimates for the years 1986 through 1992 are actuals. The estimates for the years 1993 through 1996 are the actuals for Kelenfold only. 3. Fuel costs, 0 & M costs and imports were assumed to grow from the 1995 level at the same rate as forecast sales. 4. The large negative number shown in the investment row for the year 2000 is a measure of the year 2000 value of the net benefits of the investments for the remainder of their lifetimes, assuming a 12% rate of return. In order to be consistent with the Staff Appraisal Report estimates, the same ratio of value to investments was selected as was estimated in that report. 5. The estimates are given in 1995 prices in order to facilitate comparison with the Staff Appraisal Report estimates. An interesting finding revealed by this approach is that actual average electricity prices throughout the disbursement period of the project turned out to be about equal to those forecast at appraisal - about 2 forints per kwh.

27 HUNGARY - POWER PROJECT (LOAN 2697-HU) Table 9-B: Calculation of the Economic Cost of Electricity at Kelenfold Costs of Additional Electricity Generation (Ft million) Backoround Data Investmen Fuel costs Other costs Total Equivalent/b Increment Fuel consumption: Gas (Gj) HFO (Gj) Fuel oil (Gj) fuel prices: lncr. costs Gas(forints/GJ) E HFO(forints/GJ) E Fuel oil(forints/gj) E Price Index Other costs (excl. depr.) forints 2.97E E Adjust to 1996 prices 4.63E E E Net power generation NPV at 12% 25,392 25,410 (GWh) a/ includes value of reduced heat sales in b/ 720 GWh at 7.28 forints per kwh gives the same present value as the stream of costs. Net heat sold (Tj) Heat revenue (forints) -3.2E+08 Investment (Ft million) In 1996 prices Page 1

28 HUNGARY - POWER PROJECT LOAN 2697-HU Table 10: Status of Legal Covenants Agreement Text Covenant 1 Status Original T Revised Description of Covenant Comments Reference Class Fulfill Fulfill Date Date Loan 4.03 (a) 12 C 01/31/87 Carry out a study of energy prices. Submit Study completed and submitted (i), (ii) the study to the Bank. to the Bank. Loan 4.03 (a) 12 PC Government to adjust producer energy Most energy prices cover (iii), and prices in line with economic costs and economic costs. Electricity 3.01 (a) adjust electricity prices to enable MVM to prices permitted MVM to meet meet the project obligations. project obligations, but it incurred some financial losses after x Project C 01/31/87 MVM to carry out a long run marginal cost Study completed. Pricing pricing study. Submit the study to the timetable was revised under Bank. SAL 2 and Loan No Project C 01/31/87 MVM to carry out a study on major causes Study satisfactory. of quality fluctuations in coal suppliers at Recommendationis made by study MVM Rt's power stations and to implemented. recommend measures to ensure boiler flame stability at such stations. Submit the study to the Bank. Project C 01/31/87 MVM to carry out Information System Study satisfactory. Study. Submit the study to the Bank. Recommendations implemented. Project C 01/31/87 MVM to carry out a study to develop a Revised study completed. least cost investmenit strategy for further developmenit of power generationi facilities. Submit study to the Bank.

29 Agreement Text Covenant Status Original Revised Description of Covenant Commenits Reference Class Fulfill Fulfill Date Date Project 3.04 (c) 10 C 12/31/87 Adopt program to cistire boiler flame Coal mixing facilitics have becin stability at power stations. constructed. Project 3.05 (c) 12 C 12/31/87 Prepare a least cost investment strategy. A least cost investment strategy up to year 2000 was completed after exchaniginig views with the nk. 1Ba Project C Six monthis after end of each fiscal year, First consolidated financial have accounts audited and submit audit statements covering 1993 report to the Bank. received in Project C 35% of Investimienit program to be financed from internally generated funds. In comilpliance Project C Annual net revenues to be at least 1.5 times In compliance. of annual debt service requirement as condition of new borrowing. Covenant Class: Status: I - Account/Audit C - Complied with 2 - Financial Performance NC - Not complied with 5 - Management Aspects 10 - Project Implementation 12 - Sector Policy

30 HUNGARY - POWER PROJECT LOAN 2697-HU Table 11: Bank Resources - Staff Inputs (staff weeks) Stage of Project Cycle Planned Actual Through Appraisal n.a Appraisal to Board n.a Board Effectiveness n. a. Supervision n. a Completion n. a. 8.0 Table 12: Bank Resources - Missions Performance Rating Stage of Month/ No. of Days in Special Implementation Development Problems Project Cycle Year Persons the Field Staff Status Objectives Skills Through 00/84 5 ECN None appraisal to EGR Reported 00/85 EGO Appraisal 00/85 4 ECN None through to EGR Reported Board 00/86 ECO FNA Board to 00/86 None Effectiveness to Reported 00/86 Supervision 00/86 4 to 11 ECN I S None to EGR (None or minor (Satisfactory) Reported 00/95 ECO problems) FA PA Completion 2 EGR None CON Reported

31 Magyar Villamos MGvek Reszvenytirsasag Hungarian Power Companies Ltd. APPEND IX Page 1 of 23 Implementation Completion Report (Short form) on the Power Project financed on the basis of Loan Agreement of HU-2697 between the (People's) Republic of Hungary and the Intemational Bank for Reconstruction and Development and implemented by MVM Rt. (former MVMT). Budapest, June 1996 Prepared by: MVM Rt. Development Directorate 1. INTRODUCTION The Hungarian Power Companies Ltd. was founded on 1 September 1963 on the basis of Resolution No /1963. (IV. 2.) of Economic Committee by Foundation Resolution No. 667/1963. (63. VIII. 28.) of the Minister of Heavy Industry. The monopoly of the Hungarian Electricity Trust was of nearly exclusive in the electricity industry as it had the right to direct 11 power plants accounting for the major part the electricity generation capacity, the 6 electricity supply companies distributing the power in their local districts, the National Power Grid Company operating the transmission grid, transmitting the high voltage electricity and providing intemational connections and the 4 service companieserving the whole power system, supporting the operation and development of the above mentioned companies and perfofming other services. Besides electricity supply, the district heat supply is also a significant activity, carried out in the region of certain power plants. The two-third of district heat supply in Hungary was provided by MVMTs power plants. Over the period with the trust organisation the following activities belonged to MVMT: (1) production - including all the activity connected to the generation units - (2) transmission on the basic network (grid), distibution - including the distribution network and all the associated activity and (3) the consumer services. MVMT (i) directed through its intemal regulatory system; (ii) provided for the continuos supply of electricity and (iii) managed the investment funds allocated for power plants and the network and made decisions (except constructing new generating capacities). The operation of MVMT was based on Act IV of 1962 on the Generation, Transmission and Distribution of Electricity and regarding economic aspects the direct state control was determinant. MVMT made every effort in its power to satisfy consumers' demands both in quantity and quality. The funds deemed necessary were provided by the govemmenthrough budgetary channels. These funds determined the possibilities of development (wages and salaries) and, occasionally, also the strategy of operation. In the 80s several power plants working under the management of MVMT became over-aged, the technical standard became obsolete, they were in need of reconstruction or replacement. Based on the investigations carried out according to different considerations, decisions were made on the reconstruction of the coal fired power plants to ensure an adequate and continuo supply of electricity at a satisfactory standard of service until new capacities were put into operation. Due to reduced development funds and the fact that the equipment, materials and parts could only be procured through imports from the industrialised countries there was a need for convertible financial funds. At that time Hungary joined to the World Bank. This made it possible to take out a World Bank loan for the partial financing from a reliable source of the up-to-date reconstruction of the power plants, called the Power Project. This was also supported by the decisions of the Hungarian Govemment Authorities.

32 APPEND IX Page 2 of PROJECT PRELIMINARIES The reconstruction of the coal fired power plants - the Power Project - mentioned in the Introduction was a chance of development in the power industry that was in line with the concepts of the World Bank. Using a World Bank loan for the reconstruction raised the funds still missing for the financing of the project, making it easier to buy modem parts and equipment from the industrialised countries. In addition to the reconstruction of the power plants the World Bank accepted the improvement of the technical level of the power sector and the rehabilitation of the old machinery a development subproject justified for being financed partly or in the whole from World Bank funds. After preparatory activities lasting about one and a half years, the Loan Agreement between the Hungarian People's Republic (Borrower)- and the Intemational Bank for Reconstruction and Development (the Bank) and simultaneously the 'Project Agreement" between the Bank and the Hungarian Electric Power Trust were signed on 17 June THE LOAN AND THE PROJECT 3.1 Characteristics of the Loan Agreement The Loan Agreement dated 17 June 1986 was concluded between the Hungarian People's Republic (Borrower) and the Intemational Bank for Reconstruction and Development (the Bank): Its title is: Power Project, No. HU The project was implemented by the Hungarian Electricity Trust (MVMT). On the same day the so called Project Agreement was concluded between the Bank and MVMT and on 31 July 1986 the so called Subsidiary Loan Agreement was concluded between the Hungarian People's Republic and the Hungarian Electricity Trust and that Agreement, or rather Contract, constitutes an inseparable part of the Loan Agreement. The characteristics of the three contracts are: a) A Loan Agreement between the Hungarian People's Republic and Intemational Bank for Reconstruction and Development; al) The sum of the Loan Agreement is USD 64,000,000,- (say sixty-four million US dollars); to be disbursed from quarter IV of 1986, with a term of 15 years and a grace period of three years within this term; a2) The commitment fee is 3/4 % per annum on the unused part of the principal amount of the Loan and the interest is to be calculated on basis of the principal amount of the Loan disbursed and still outstanding with an interest rate equal to the Costs of Qualified Borrowings +1/2 % per annum. a3) Closing Date: (originally 31 March 1993 then, after the modifications) 31 March 1995; a4) Repayment is done over the period from 15 February 1990 until 15 August 2001 cn the 15 February and 15 August of each year according to the Amortisation Schedule (Annex 1). b) A Project Agreement between the Intemational Bank for Reconstruction and Development and Hungarian Electricity Trust (MVM Rt.); b1) The date of this agreement corresponds to that of the Loan Agreement; b2) The agreement was concluded with the same terms and conditions as the Loan Agreement; b3) MVM Rt. assumed the obligation to realise the project with proper care and efficiency. c) A Subsidiary Loan Agreement between the Hungarian People's Republic and Hungarian Electricity Trust (MVM Rt.): c1) The Subsidiary Loan Agreement is an inseparable part of the Loan Agreement; c2) The Hungarian (People's) Republic re-lent in forints (HUF) the World Bank loan to MVMT within the framework of this Subsidiary Loan Agreement under the same terms and conditions as in the Loan Agreement:

33 APPENDIX Page 3 of 23 c3) The Hungarian (People's) Republic entered into commissioning contract on the whole (i) foreign completion of the project - with the Hungarian National Bank then (ii) domestic financial management with the Budapest Bank Rt. (The assignment of Budapest Bank as a commercial bank was concluded as a result of the introduction of the two-tier banking system.) 3.2 Sub-projects The project consist of the following parts that can be modified from time to time by agreement between the Bank and Borrower to meet the objectives of the Project: Part A: The reconstruction of eight coal fired power stations; Part B: Rehabilitation of MVM Rt's (MVMrs) other generating plants and upgrading MVM Rt's (MVMTs) transmission and distribution systems; Part C: The improvement of MVM Rt's (MVMT's) capability in planning, management and system operation. 3.3 The Allocation of the Loan The allocation of the loan amount according to each categories: (1) Turbogenerator for the Borsod Power Plant USO 8,000,000 (2) Other goods and materials USD 50,400,000 (3) Technical assistance (consultant services and training) USO 1,000,000 (4) Unallocated USD 4,600,000 Total: USO 64,000,000 At the end of 1989 a decision was made to stop the Borsod Turbogenerator Project due to the uncertainty in the coal supply to Borsod Power Plant and the uneconomic generation of the condensation type power in the power plant; bids to be financed from the Loan could not be invited and further procurement- had to be stopped. The unused (undisbursed) part of the Loan was reallocated to the Kelenfdld Gas-turbine Project. After this reallocating, the categories were modified as follows: (1) Budapest Power Plant. Kelenfold Power Station USD 25,000,000 (2) Other goods and materials USD 35,660,000 (3) Consultant's services and training USO 2,834,000 (4) Unallocated uso 500,000 Total: USo 64,000, THE ECONOMIC ENVIRONMENT 4.1 Forecast of electricity demands Over the almost one decade passed since conclusion of the Loan Agreement the forecasts of demand trends on the development of Hungarian electricity system have been reviewed and revised several times. The demand trend forecasts prepared in 1986, 1989, 1989 and 1995 and sent to the

34 APPENDIX Page 4 of 23 World Bank' are highly different from each other and predict an increasingly moderate rise in the demand (Annex 3 - figures 1 and 2). The very big differences between the demand trend forecasts are basically due to the great economic-social transformation and changes of economy structure that started in and that have been in progress since then. The estimate of electricity demand included in the Staff Appraisal Report and serving as a basis for the taking out of the Loan was prepared by the Ministry of Industry in co-operation with the Central Planning Bureau. The forecast was reviewed by the World Bank (report no HU) and was considered as well based and acceptable. These forecasts predicted an annual increase of 3.3 % in gross electricity consumption for the period between 1985 and The forecasts in 1989 (least cost power plant investment project, June 1989) calculated with a much moderate rise in the overall demand. The long term forecast of electricity demand included in the study titled 'Preliminary system analysis of the extension of the Hungarian power plant system' sent to the World Bank already took into consideration the very significant drop of demand due to the economic changes commenced in A common characteristic of the estimates in 1992 was that they calculated with a rise in demand trend after 1995 and estimated a practically unchanged demand trend between 1992 and (Annex 3 - Figures 1 and 2 give a summary view of forecasts made in different times /in 1986, 1989, 1992 and 1995/ regarding the trend of gross electricity demands at system level and peak power demands at system level.) 4.2 Energy policy, energy strategy In the period between 1986 and 1995, due to the economic, social and political processes and changes that began in the country, the policy and partly even the objectives of the energy policy and energy strategy have significantly changed. At the time of the taking out of the Loan the main objectives of the energy policy and the means to achieve them were summarized in report No HU (Hungary Staff Appraisal Report - Power Project, 23 April 1986). A part of the changes in the Hungarian energy policy of the 90s can be related to the economic processes going on in the country and to the changes in the world economy. The most important change occurred in the demand trend. At the end of the 80s the decrease in energy demands began in each field resulting from the reduction of consumption and of industrial production determining energy consumption. The absolute and relative decrease of primary energy production and, as a result, the increased dependence on energy imports became a trend. Sirpultaneously with the decrease of energy demands also the forecasts of long term energy demand (energy consumption) became more and more moderate (see Annex 4). Within the Hungarian electricity consumption the rate and volume of the imported electricity dropped significantly. Whilst in 1986 the volume of the imported electricity was GWh accounting for 27.5 % of the total consumption, in 1994 these values were 2034 GWh and 5.7 %, respectively. Although system-level electricity demands dropped from 40 TWh to 35 TWh between 1989 and 1994, the electricity generation of the domestic power plants increased more than ever, in GWh, compared to the GWh produced in the year of the maximum demand. The increase in the domestic electricity production was a consequence of the major decrease of rate and absolute volume of the imported electricity. The economic recession and the gradual conversion of the price system of the energy carriers - going on even at present - resulted in a major price rise of the energy caniers and the changes of price ratios. By the early 90s it became clear, that the domestic brown coal mining and most of the mining companies were permanently producing losses, and the brown coal produced was not competitive 1 -STAFF APPRAISAL REPORT. HUNGARY. POWER PROJECT, 23 April 1986 (report no HU) - Power plant investment program of least cost, June 1989, Hungarian Electricity Trust - Preliminary system analysis of the extension of Hungarian power plant system, September 1992, Hungarian Electricity Trust - Power plant investment strategy of the Hungarian Power Companies Ltd.. October, Hungarian Power Companies Ltd.

35 APPENDIX Page 5 of 23 compared with the imported hard coal either in short term or in long term. In 1990 the govemment set up the Center for the Restructuring of Coal Mining (SZISZEK) with the task of gradually cut back coal mining in accordance with the long term objectives of the energy policy. Within the framework of this project a part of the domestic coal mines were closed down, some were integrated in power plant companies and others were allowed to continue their operations for a limited period. The cut back of electricity production on brown coal basis was justified by the stricter environment protection regulations, too. The comerstones of the development plan of the Hungarian power plant system in the mideighties were the improvement plans of the Paks nuclear power plant, the reconstruction of the coal based electricity production capacity and the expansion of the Dunamenti Power Plant with a combined cycle unit. In the long term power plant construction project of 1989, already based on the system-wide optimization program, the expansion of the Hungarian system with further nuclear power plant units and with lignite fired base load power plant units was - partly due to the modifications in demand forecasts - postponed, and the reconstruction project of coal fired power plants was stopped at this time. This power plant construction project of least total cost envisaged the commercial operation of the combined cycle power plant units to be constructed in the Dunamenti Power Plant by 1993 and the proposed gas turbine expansion in the Kelenfold Power plant by In the least cost power plant construction strategy prepared in 1992 the fluidized-bed firing power plant units planned to be installed at existing power plant sites (Borsod Power Plant 80 MW, Inota Power Plant 150 MW, Pecs Power Plant 80 MW, Matra Power Plant 150 MW) and to run on imported hard coal fuel were new elements as compared with the earlier strategies. The program also included the construction of a power plant unit for the firing of heavy residue fuel oil with greater unit capacity (450 MW) as part of the so called high demand scenario. The program assumed a highly reduced (300 MW, 1800 GWh) electricity import and counted upon the connection to the UCPTE. (For detail see MVM Rt's Implementation Completion Report.) 4.3 Energy Prices (Tariff Policy) General analysis In principle, the production and consumer prices of the energy carriers were in harmony up to the first oil price explosion in Subsequently, basically due to social policy considerations, the consumer prices lagged behind the level of production prices. From 1983,. in their letters of intent given to the World Bank, the successive Hungarian governments agreed to increase the consumer prices and asked for a postponement up to 1995 to complete these actions. The World Bank noted the delay but with the reservation that up to 1992 all state subsidiaries to consumer prices should be discontinued. This obligation was fulfilled. Since 1992 no state subsidiary is included in the household consumer prices. The ongoing devaluation of the forint after 1992 continued to increase the difference between the free market prices of the energy carriers and the fixed prices of the line-transported energy sources in such a way, that the production prices were always adjusted, while the consumer prices were not. Price adiustments ud to 1994 Global price adjustment was made in 1990 and only minor other price rises took place during the investigation period. Until to 31 December 1996 the determination of the highest official price (tariff) and the conditions of its application were regulated by Act LXXXVII of In 1993 a VAT of 10 % was introduced. The production and consumer prices of the now officially priced energy carriers and the price adjustments in the electricity sector carried out since 1 November 1990 are shown in Annex 5.

36 APPENDIX Page 6 of 23 Since 1992 the majority of the group companies makes losses and the high loss of HUF 10.8 billion in 1994 clearly shows the need for price rises. The mostly loss-making tariff groups are the household, the railway traction and the public lighting tariffs. The maximized official prices of heat production did not cover the costs of production and supply, not even at the time they came into effect. The corporation believes the main cause of loss-making operation is the failure to rise the prices and to restructure the tariffs. The Govemment increased the official price of the electricity several times since 1995 but these corrected the existing problems only marginally. The Govemment partially raised the price of electricity in September 1995 and in March 1996 to comply with its obligations towards the World Bank. According to Govemment Decree No. 1074/1995 (VIII. 4.) cost-based prices should be determined by October 1996 and should be maintained starting January (For details see MVM Rt's Implementation Completion Report.) 5. IMPLEMENTATION OF THE PROJECT 5.1 Procurements The funds for the most important imports from industrialised countries were provided by the World Bank Loan Agreement and the Project Agreement. Within the framework of the World Bank Loan Agreement and the Project Agreement supporting the reconstruction program of the power plants and the expansion of the lifetime of the power plants and the electrical networks the most important imports from the industrialised countries were allowed to be acquired exclusively by bid invitations according to the World Bank procurement rules. These regulations were significantly stricter than those used in the former traditional foreign trading practice. In addition to the more effective business management, a new way of thinking in technical and trading issues and a new practice of procurements was required by the bidding procedure. The general experience was the price level of the bids received for bid invitations issued according to the World Bank rules was far more advantageous than the contract price level achieved through the conventional foreign trade practice. Thus, nowadays this method is used more widely, consciously utilising the stimulating effect of consistent foreign trading operations with strict rules and of systemizing. After the initial difficulties, a period of about one and a half years, using the prepared and approved standardndocuments valid for the various types of procurement, the procurement process was used in a relatively quick. manner and the set deadlines were met. 5.2 Part A - Reconstruction of Coal Fired Power Plants Preliminaries, Introduction The objective of the reconstruction of the coal fired power plants financed from the World Bank loan was to increase the rate of coal within the use of domestic fuel to the detriment of gas and oil and to delay the major investments in power plants, due to lack of capital, by developing certain capacity surplus. Moreover, the reconstruction should result in a system of up-to-date, reliable and efficient components; the equipment and facilities to be reconstructed should meet the technical level prevailing at the time of their reconstruction. A major objective of the reconstruction was also that the main and auxiliary equipment of the power plant could reliably operate for another 15 to 20 years. The program made also great efforts - taking into consideration the financial possibilities of the given period of time, too - to decrease the adverse effects of the coal fired power plants to the environment. Regarding the power plants, the development projects based on the World Bank Loan mainly related to ongoing reconstruction projects and to those under preparation, as well as to upgrading and rehabilitation programs.

37 APPENDIX Page 7 of 23 At those times of foreign currency shortage it was a great chance for the power plants that in addition to replacing the main equipment stipulated in their reconstruction program, they could get the equipment for the auxiliary facilities, too, by the help of imports within a given technical limit. Supplementary equipment of power plant technology, control instruments, machinery and tools and also the necessary amount of spare parts enabling the continuous reliability have been purchased within the framework of this program. Procurement for the reconstruction of coal fired power plants The funds for the procurement for the reconstruction of MVMT's power stations of Gagarn, Ajka, Borsod, Pecs, Tiszapalkonya, Oroszlany, November 7 and Tatabanya including the reconstruction of boilers, the reconstruction and repowerng of turbines and generators, the installation of a 60 MW turbogenerator, the replacement of high pressure pipes, valves, pumps, insulation material and control equipment for boilers, turbines and generators, the rehabilitation and replacement of electrostatic precipitators, the installation of desulphurization units and the rehabilitation of heat exchangers, coal handling and auxiliary equipment were provided from categories 1 and 2 of the World Bank Loan. Due to a change of concept, the Borsod turbogenerator has fallen out. Thus, the categories were reallocated as described in Chapter 3 'The Loan and the Project". The allocation of the actual procurement items by companies and types of equipment is shown in Annex Part B - Procurement by the Electricity Supply Companies and other Companies Within the framework of sub project 'Modemisation and reconstruction' of Loan no HU, further to the power plants that had been reconstructed, the technical-technological modemisation and rehabilitation of two other power plants, the power generating, transmitting and distribution systems of the electricity supply companies of the Hungarian electricity system and other servicing companies have been effected. This included the overhaul and/or procurement of boilers, turbines and spare parts for generators, valves, instruments, auxiliary equipment, protection and remote control devices, machines and tools, laboratory equipment, computer components, insulators and switchgears. The World Bank loan was used to purchase machinery and tools for; increase the safety of; modemise the operation and maintenance technology of; and speed up the trouble shooting of the networks and equipment of the MVM Rt., the Dunamenti and the Budapesti Power Plants, the electricity supply, service, design and engineering companies DlDASZ, EMASZ, TITASZ, ERBE, EROKAR, OVIT, VERTESZ, i.e. of the Hungarian electricity system. This way these companies were able to increase the efficiency of their work, provide modem working conditions, meet the increased safety rules in the installation operations, as well as to procure spare parts for the imported equipment. Within the framework of the program the companies purchased universal construction machinery and tools, cranes, trucks, railway and road trailers, bulldozers, grabs, tools for work with live circuits, tools for electric cable installation, a measuring van for location of cable fault, an environmental measuring van, portable calibrating and control instruments, spare parts, etc. The purchases of the companies are shown in Annex 6.

38 APPENDIX Page 8 of Part C - Technical Assistance (Consultant and other services) The purpose of the technical assistance consisting of consultant services and computer hardware and software purchases is that the MVM should be able to expand its planning, controlling and operating activities and improve its environment protection activity. Twenty contracts have been concluded for implementing the sub-project, a part of which was of study character, another part aimed at elaboration of management and organisation systems through consulting. In addition, experts were instructed within the framework of training on site and in study tours abroad, as well as in the form of participating in intemational conferences. MVM Rt. has implemented the following in the framework of this sub-project: (i) a long run marginal cost (LRMC) pricing study; (ii) a study to develop a detailed management information system (MIS) and data collection, recording and reporting system (MRS); (iii) a study to develop a least cost investment strategy for further development of power generation facilities; (iv) a study to identify the major causes of quality fluctuation in coal supplies at MVM Rt's power stations and to ensure boiler flame stability at such power stations; (v) staff training, computer hardware and software and a mobile pollution monitoring unit; and (vi) an energy pricing study. The use of World Bank Loan for Technical Assistance (consultant and other services) is shown in Annex RECONSTRUCTION OF KELENFOLD POWER PLANT The preparation of the reconstruction of the Kelenfold Power Plant, a part of Budapest Power Plant, began in The Investment Program (for the reconstruction, a sub-project of Power Project) was approved by Budapest Power Plant Co. in The reconstruction was implemented on the basis of this Investment Program also accepted by the Worid Bank. The investment cost of the Program is the following: -1, PLANNED FINAL million USD I million HUF million USD million HUF FOREIGN 57 5, ,369 LOCAL 56 5, ,174 TOTAL , ,542 The distribution of the financing plan is the following: million USO million HUF World Bank Loan 25 2,364 EIB Loan 32 3,051 MVM Rt. Loan 40 3,795 Kelenfold's own funds 16 1,504 Total ,714 The detailed description of the Program implementation (a sub-project of Power Project) can be found in the Implementation Completion Report dated May 1996 of the Budapest Power Plant.

39 APPENDIX Page 9 of 23 Results of the reconstruction The following units have been installed during reconstruction: - PG 9171 type gas turbine of 137 MW capacity, manufactured by General Electric; - A TS type generator of 156,5 MVA capacity, manufactured by ELIN; - Heat recovery steam generator with a thermal capacity of 196,5 MW, manufactured by Austrian Energy Environment, together with a stack of 82 m height; - Main transformer of 180 MVA, 132/15,75 kv, manufactured by Ganz Ansaldo; Additionally other related elements to serve the above mentioned main parts such as buildings, high pressure (60 bar) natural gas pipeline between Szazhalombatta and the power plant for the fuel supply to the has turbine, natural gas receiving station, oil pipeline, 2 pcs of oil tanks, provided with double wall and floating cover and with a capacity of 2000 m 3 each, steam- and hot water pipelines of 40 bar, 120 kv cable between the unit and the network substation. The project was implemented according to the time schedule in The on-site erection works were finished by June 1995 and operational tests started. The planned commissioning of the gasturbine was delayed by the public protest against the construction of the high-pressure gas pipeline. The gas supply commenced on 19 October The trial run was completed on 23 December 1995 and the unit was commissioned. The contractors completed the service systems according to the time schedule. The Transelektro Company - who was responsible for the modemisation of the water treatment equipment - was in a six-months delay but this did not delay the commissioning of the unit. Environment-Drotection To get authority permits an audited laboratory had to be hired to measure the emission of air pollutants and noise level. The result of measurements in both cases confirmed that the gasturbine unit operates within the specified emission limits. Because of the lower emission of air pollutants the environmental condition of the Kelenfold Power Plant and its neighbourhood improved significantly. Operation The equipment running since 23 December 1995 are operated at a proper way by the operators. Summary The new section of the Power Plant implemented under the reconstruction program has taken over the production from the old plant, i.e. the major part of the of the production has been transferred to the new unit. Four steam boilers were shut down in the old power plant. The new power plant section works at a constant load during the heating season and on partial load during the off-heating season. 7. REVIEW OF FINANCIAL ISSUES The statements and the evaluation indicate current prices. 7.1 Financial situation over the loan period The assets of the company increased from HUF 153 thousand million in 1985 to HUF 682 thousand million by the end of An amount of HUF 413 thousand million of the increase of HUF 529 thousand million is due to the assets revaluation with effect of 1 January The increase in the assets was mainly financed from own funds. The debt ratio increased from 4 % in 1985 to 5 %.

40 APPES lix Page 10 of Business results The business results of MVM Rt. truly reflect the negative stagflation processes taking place in Hungary. - Over the perod between 1985 and 1990, MVM Rt. operated under a special income regulation; the state left every year a minimum profit for the company in case of the fulfilment of annually set indices and the rest was withheld by the state in the form of a differential tumover tax of producers (KUTEFA with Hungarian initials). - This special regulation was cancelled as from 1991 and MVM was governed by the general business regulations. - From 1989 the costs considerably increased due to the inflation, but these effects could not be recognised in the prices. Due to these changes the financial situation of the Companies began to deteriorate from Consequently, the financing of their operation required an increasing amount of loans. The interests caused by the high rate of inflation resulted in a further increase of costs, thus the balance sheet of the Company Group has indicated a loss since Available funds and their utilisation Over the years , funds totalling to HUF 352 thousand million were available to the Company Group. Out of this figure, the intemal funds represented HUF 227 thousand million (65 %); HUF 58.5 thousand million (16 %) resulted from funds received from the state and consumers' contributions, and HUF 66 thousand million (19 %) from loans. HUF 253 thousand million, i.e. 70 % of the funds were used for investments and for the increase of working capital. The fulfilment of obligations conceming the payment of taxes and dividends required HUF 42 thousand million (12 %), and the debt service needed HUF 47 thousand million (13 %). 7.4 Fulfilment of financial forecasts indicated in the loan assessment report of the World Bank A comparison with the financial forecasts is complicated by the significant changes in accountancy regulations implemented several times during the crediting period in the years 1988 and 1992), and also the assets were revaluated in In order to facilitate the comparison, certain adjustments were made. The profit according to the balance sheet of MVM company group, summarised for the period considered, is by HUF 34 thousand million lower than the amount indicated in the financial forecast. The main reasons for this lower figure are as follows: The Revenues exceed those indicated in the forecast by HUF 74 thousand million. - the electricity sold dropped by 24.8 TWh due to a setback in the consumption for production purposes, - although the average price of electricity was higher than the forecast value, nevertheless, it did not follow the rate of inflation; - the increase of incomes from other activities - mainly from heat sales - fell behind the rate of increase of expenditures.

41 APPENDDIX Page 11 of 23 The increase in Expenditures exceeded the planned figures by HUF 190 thousand million - higher than that in the revenues. The three main reasons are: - The rate of inflation was higher than expected. - Two unplanned cost components, i.e. the amount of HUF 33.2 thousand million of Paks capital allowance (repayment), and of HUF 60 thousand million of the Differential Tumover Tax of Producers; The costs of depreciation were by HUF 18 thousand million higher than the projected figure, mainly resulting from the assets revaluation that took place in The revaluation was mainly caused by settling the power plant reconstruction to the charge of production expenditures until 1986, and it was indicated in the books without vaflue. During the assets appraisal with effect of 1 January 1992, the value of this equipment was defined under consideration of the remaining period of service life and the reproduction costs. The deterioration of HUF 116 thousand million in Operating Profit was positively counterbalanced by the lower level of interests, taxes and dividends than that planned. It produced a profit increase of HUF 73 thousand million. Taking the above facts into consideration, the retained profit decreased by HUF 34 thousand million, as compared with the planned figure. The financial indices are shown in the Annex No.3 of MVM Rt's Implementation Completion Report (see Tables M3/10-M3/1 1). It should be noted that the value of all indices is within the range required by the World Bank. 8. EXPERIENCE DURING PROJECT IMPLEMENTATION MVM Rt. and its group companies proceeded according to the investment instructions strictly stipulated in the period of taking out the Wortd Bank Loan. The extraordinary limited extent of imports from the West and the limited capacity of the Hungarian manufacturing and installation companies did not allow the use of modem investment procurement methods. Consequently, neither MVM Rt. nor the other companies had such kind of experence. MVMT was put into a direct borrower position through the World Bank Loan, thus obtaining experience conceming effective decision making mechanisms used in market economy. The specialists of the branch had therefore the possibility: - to leam the techniques of investment assessments, - to get acquainted with bidding methods and to exercise them, - to get acquainted with modem planning methods. 8.1 Reconstruction of coal fired power stations The organisation and management of reconstruction in coal fired power stations took place in different ways at each plant, depending on the different character of technical objectives to be achieved. In spite of this fact, the single jobs were generally ordered by the power stations themselves, while the most significant orders were prepared and managed by ERBE (the investment company of MVMT). The investment activity of the entire reconstruction period practically followed the practice and common law applied in Hungary. This means that the various generat contracting methods were not applied, partly because the technical tasks fulfilled during reconstruction were excessively split and consisted of locally performed partial activities. The use of any new method would have been too risky given the lack of experience. Therefore, the jobs were implemented in a form used in the Hungarian practice, through a general co-ordination performed by the investor, with the involvement of general designers and general contractors.

42 APPENDIX Page 12 of 23 However, some general contracting agreements were concluded during this period for certain well-specified jobs, where the supplier assumed a performance responsibility and was accountable for guarantee and quality. Considering the above, the experience gained during the reconstruction program can be summarised as follows: - there was no power station construction during the reconstruction period - apart from the investment of Paks Nuclear Power Station -, thus the experience gained here can be utilised for the construction program of new power stations (in bidding, general contracting, etc.). Regarding the procurement of equipment, the knowledge related to contracting and bidding defined and collected according to World Bank guidelines can be utilised; - - it became obvious that the issues of required quality, time schedule of implementation, price and responsibility can only be satisfactorily ensured by a project approach and that project implementation works out only in the form of general contracting. 8.2 Procurement The experience gained during the procurement procedure performed by ERBE can be summarised as follows: * the experience gained during the management of intemational bidding procedure under Loan No HU can be used more favourably in the procurement procedures under the further loans; - the time necessary for the own work within the procurement process should be shortened, resulting in costs saving; - through the use of the World Bank recommendations taken over during the preparation of the contract conditions and the regular consultations canied out with World Bank experts, Bidding Documents are already prepared in a form which, combined with the winning bid, constitute contracts ready to be signed without significant changes after closing of the bidding procedure; thus further reducing the processing time and costs related to the procurement process; - the contracts concluded in the above way guarantee a smooth work during the implementation, fulfilment period, and a co-operation between the contracting parties as well as a correct observance of the terms and conditions of the contract, - the employees of the electricity branch got acquainted with the management and administration procedures of World Bank loans. This knowledge represents a safe financial foundation for the projects under implementation and also provides a guarantee in the contacts maintained with other financial instituttons. It has been proven that the objectives set by MVM conceming the energy program were, except for some minor revisions, correct, for the power sector has been able to meet the demands without the construction of new power stations, through the increase in the generation capacity achieved by the reconstruction and an appropriate maintenance of the coal fired power stations, taking naturally into consideration also the energy imported and produced outside the sector. The considerable reduction in the environment pollution caused by the power stations, resulting from the systematic support and observance of efforts taken in the protection of environment, represents a further result. 8.3 Technical assistance About 20 Hungarian specialists, mainly from the electricity sector, took part in various training and co-operation programs related to the modelling. Not only the models and methods suggested by the World Bank were taken over successfully, but also their constructive improvement and the sharing of experiences with the electricity specialists of other developing countries were also performned, for instance: - taking part in the improvement of the WASP-Ill program (WASP-IV); - development of the software package ENPEP (a new LDC module, integration of Icarus);

43 APPENDIX Page 13 of 23 - development of the LRMC calculation software package and the user documentation; - several experts of the sector have acted as specialists the training programs of the Intemational Nuclear Energy Agency. The specialists of MVM leamed how to adapt other calculation and planning models, e.g.: - application of ARIMA/SARIMA type models for the estimation of the medium term electricity demands; - application of artificial neural networks for estimating the medium and short term electricity demands, - application of the calculation software package prepared by Power Technologies Inc. (PTI) Schenectady, New York, USA for the simulation and calculation of transmission networks of electricity generation; - adaptation and use of the long term financial model prepared by Coopers and Lybrand; - Warme Schema Rechnung software for the calculation of the heatflow of power stations. All the above software and procedures are in permanent use or are about to be introduced, rendering assistance for the everyday decision making mechanisms. Note: A detailed Implementation Completion Report (herein referred to as MVM Rt's Implementation Completion Report) was prepared on the implementation of the Power Project which was forwarded to the World Bank by MVM Rt. in early March The Implementation Completion Report on the Kelenfold sub-project was also completed after the successful implementation of the Kelenfold subproject and was handed over to the Mission Leader of the World Bank Supervision Mission in May For other details relating to the Project refer to MVM Rt's Implementation Completion Report.

44 APPENDIX Page 14 of 23 ANNEXES Annex 1 Amortisation Schedule Date Payment Due Payment of Principal (USD) 15 February ,665, August 2,665, February ,665,000 :15 August 2,665,000 *15 February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665, February ,665, August 2,665,000

45 APPENDIX Page 15 of 23 Annex 2 Objectives of the Project Part A: "The reconstruction of MVM7s Power Stations of Gagarin, Ajka, Borsod, Pecs, Tiszapalkonya, Oroszlany, the 7 November and Tatabanya, including the reconstruction of boilers, the reconstruction and repowering of turbines and generators, the installation of a 60 MW turbogenerator, the replacement of high-pressure pipelines, valves, pumps, insulation material and boiler, turbine and generator control equipment, rehabilitabon and replacement of electrostatic precipitators, the installation of desulphurization units and the rehabilitation of heat exchangers, coal handling and auxiliary equipment." Part B: "Rehabilitation of MVMT's other generating plants, and upgrading MVMT's transmission and distribution systems, including the rehabilitation and replacement of boilers, turbine and generator components, valves, instrumentations, auxiliary equipment, protection and telecontrol systems, machinery and tools, laboratory equipment, computer parts, insulators and switchgears." Part C: "Carrying out a program to improve MVMT's capability in planning, management and system operation, including the provision of: (1) a long-run marginal cost pricing study, (2) study to develop a detailed informaton system and informaiton flow, data collection, recording and reporting systems, (3) a study to identify the major causes of quality fluctuations in coal supplies at MVMT's power stations and to recommend measures to ensure boiler flame stability at such stations, (4) a study to develop a least cost investment strategy for the further development of power generation facilities, and (5) staff training, computer hardware and software and a mobil pollution monitoring unit."

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