/S 32Z?2- /0 Reort No IND

Transcription

1 Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY /S 32Z?2- /0 Reort No IND Public Disclosure Authorized STAFF APPRAISAL REPORT INDONESIA Public Disclosure Authorized FERTILIZER RESTRUCTURING PROJECT NOVEMBER 26, 1990 Public Disclosure Authorized Industry aid Energy Operations Division Country Department V Asia Region lfhis domnent has a resrcted disribution and may be used by recipients only in the perfomanoe of their offlial duties. Its contents may not otherwise be disdosed whout World Bak aulhoulzioid

2 CURRENCY EQUIVALENTS (As of June 1, 1990) Currency Unit = Indonesian Rupiah (Rp) US$1.00 = Rp 1,830 Rp 1 billioni = US$0.546 iilllion WEIGHTS AND MEASURES 1 British Thermal Unit (Btu) = Kilocalories (Kcal) 1 Metric ton (t) = 1,000 kilograms (kg) 1 Metric ton (t) = 2,209 pounds (lb) 1 Cubic meter (m 3 ) = Cubic Feet (cuft) 1 Standard Cubic Foot (SCF) of Natural Gas = 1,000 Btu FISCAL YEAR Government of Indonesia - April 1 - March 31 Fertilizer Companies - January 1 - December 31 ABBREVIATIONS AND ACRONYMS AAF - P.T. ASEAN Aceh Fertilizer APPI - Indonesian Fertilizer Producers' Association AS - Ammonium sulfate ASEAN - Association of South-East Asian Nations BAPPENAS - National Development Planning Board BI - Bank Indonesia BPKP - Financial and Development Supervisory Board BNI - Bank Negara Indonesia 1946 EKUIN - Minister Coordinator for Economics, Financial and Industrial Affairs, and for the Supervision of Development GOI - Government of Indonesia Gresik - P.T. Petrokimia Gresik ICB - International competitive bidding IKPT - P.T. Inti Karya Persada Tehnik Kaltim - P.T. Pupuk Kalimantan Timur KC1 - Muriate of potash, or potash, or potassium chlloride KLH - Ministry of Population and the Environment KONEBA - P.T. Konservasi Energy Abadi Kujang - P.T. Pupuk Kujang Mr4SCFD - Million Standard Cubic Feet per day MMBtu - Million British Thermal Unit MOA - Ministry of Agriculture MOI - Ministry of Industry MOF - Ministry of Finance PERTAMINA - National Oil and Gas Company PFE - Participating fertilizer enterprises PIM - P.T. Pupuk Iskandar Muda PUSRI - P.T. Pupuk Sriwidjaja REPELITA V - Fifth Five-Year Development Plan, 1989/ SBI - Sertifikat Bank Indonesia (BI Domestic Money Market Certificate Rate) SCB - State Commercial Bank SLA - Subsidiary Loan Agreement tpd - Tons per day tpy - Tons per year TSP - Triple superphosphate

3 INDONESIA FERTILIZER RESTRUCTUIRING PROJECT Loan and Proiect Summary Borrower: Beneficiaries: Amountt Lending Terms: Onlending Terms: Project Description: Republic of Indonesia Five State-owned Fertilizer Manufacturing Companies: Gresik, PIM, Kaltim, Kujang and PUSRI. $221.7 million equivalent The proposed loan would be made at the Bank's standard variable interest rate for a term of 20 years including 5 years of grace. The proceeds of the loar would be onlent to the five fertilizer companies for periods of either 10 or 15 years, including respective grace periods of three and five years, at a variable interest rate reflecting the market rate for domestic term funds. The five fertilizer companies would also pay commitment fees equal to those payable by the Government to the Bank under the loan. The Government would bear the foreign exchange risk. The overall objectives of the Project would be to: (a) assist the Government in implementing an agreed Statement of Fertilizer Sector Policies; (b) support an industry-wide investment program; (c) identify the scope for improved efficiency in marketing and distribution; and (d) assess the industry's environmental impact and standards, and prepare an environmental management program. The Project's components would be: (a) building a new ammonia/urea facility at Gresik, with a capacity of 1,350 tons per day (tpd) of ammonia and 1,400 tpd of urea, to provide low-cost ammonia to existing operations and to supply low-cost urea in East Java, and modernization of Gresik's existing plants; (b) undertaking optimization investments in four fertilizer plants (Lskandar Muda, Kaltim, Kujang, and PUSRI) to realize productivity gains, energy savings, environmental improvements and product diversification; and (c) supporting preparation of a marketing and distribution study and of an overall fertilizer industry assessment of environmental impacts, including identification of long-term objectives for environmental improvement and an action program to ensure that the industry meets appropriate standards. 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.

4 - il - Benefits: Risks: Estimated Cost: The main project benefits would be an improvement in the industry's performance, a reduction of budget subsidies, and minimization of the adverse environmental impact of fertilizer production. The investments to be supported under the Project do not present significant risks. The timely availability of natural gas to the Gresik ammonia/urea plant is a potential risk. To account for this risk no disbursements would be made for expenditures under the Gresik Restructuring Component until a contract, satisfactory to the Bank, for the provision of the required natural gas to Gresik has been executed oni behalf of Gresik and PERTAMINA. The main sector-wide risks are that domestic ex-factory prices may not be increased to border prices as anticipated and that internatignal fertilizer prices may not be in line with Bank forecasts. The first risk is niinimized by the Government's stated objective in the Policy Statement to bring ex-factory prices to their economic levels. The latter risk is acceptable, since the industry has a relatively low variable cost structure and even at significantly lower prices it would remain financially viable. Local Foreign Total (US$ million) Gresik Restructurlng /a Optimiization Studies N Base Cost (June 1990) Physical contingencies Expected price increases Interest during construction Working capital Total Financing Required /a Includes iheuitifiable taxes oni services estimated at $4.0 million.

5 - iii- Financing Plan: Local Foreign Total (USS million) Enterprises' equity IBRD / Medium-term borrowing (BNI) /b Slhort-term borrowing (BNI) /b Total /a Includes retroactive financing of up to $22.2 million for eligible expenditures incurred by the fertilizer enterprises after January 15, 1990, to cover advanced procurement of imported equipment and services. /c Bank Negara Indonesia Estimated Disbursements: Bank FY $ million) Annual: Cumulative: Economic Rate of Return: Gresik anmonia/urea plant: 21 percent.

6 - iv. INDONESIA FERTILIZER RESTRUCTURING PROJECT Table of Contents Page No. I. THE FERTILIZER SECTOR A. Structure and Performance Structure and Organization Fertilizer Consumption Trends Distribution and Marketing Fertilizer Pricing... 5 Fertilizer Production... 6 Investment Program B. The Policy Framework... 9 C. The Sector and the Natural Environment II. THE BANK'S PAST LENDING, STRATEGY AND RATIONALE FOR INVOL'iEMENT IN THE SECTOR A. The Bank's Past Lending in the Fertilizer Sector B. The Bankle Strategy and Rationale for Involvement in the Sector ls III. THE PROJECT * A. Objectives and Description B. The P.T. Petrokimia Gresik Restructuring Component Gresik's New Ammonia/Urea Plant Modernization of Gresik's Existing Fertilizer Plants. 16 C. The Optimization Component D. The Studies Component E. Project Organization and Implementation IV. PROJECT COST, FINANCING PLAN AND LOAN FEATURES A. Project Cost B. Financing Plan C. Features of the Loan Onlending Arrangements Loan Administration.. 30 This report is based on the findings of an appraisal mission to Indonesia in March/April The mission consisted of J. Gamba (AS5IE), H. Murphy (AS5IE) and C. Escudero (LEGAS). D. Brown (ASTIF), K. Constant (ASTIF) and S. Venkataraman (Consultant) also participated in project preparation.

7 - v - V. FINANCIAL, ECONOMIC, AND ENVIRONMENTAL ANALYSIS, AND PROJECT RISKS., A. Financial Analysis B. Economic Analysis C. Environental Analysis.n.y.i.s D. Project Risks VI. UNDERSTANDINGS AND AGREEMENTS REACHED TABLES IN THE TEXT 1.1 Indonecia - Historical Growth in Fertilizer Consumpcion 1.2 Indonebia - Projected Fertilizer Consumption Estimated Fertilizer Economic Subsidies Fertilizer Production Capacity and Output in Bank Operations and Evaluation of Project Performance in the Fertilizer Sector Project Cost Summary P.T. Petrokimina Gresik Restructuring Component - Capital Cost Estimate Optimization Component - Capital Cost Estimate Studies Component - Cost Estimate Financing Plan Initial Allocation of Loan Proceeds to Participating Fertilizer Enterprises Procurement Arrangements Allocation of Bank Loan Gresik - Historical Financial Data Gresik - Projected Financial Data With Project P.T. Petrokimina Gresik Ammonia/Urea Plant - Summary of Financial Rates of Return P.T. Petrokimina Gresik Ammonia/Urea Plant - Summary of Economic Rates of Return ANNEXES 1. Government of Indonesia Statement of Policy 2. Fertilizer Sector - Statistical Data and Analysis 3. Terms of Reference A. Fertilizer Marketing and Distribution Studies B. Development of Fertilizer Industry Environmental Improvement Program 4. Project Cost and Financing Plan 5. Detailed Capital Cost Estimates 6. Estimated Disbursement Schedule for Bank Loan 7. Financial and Economic Analysis 8. Key Implementation Indicators and Supervision Plan 9. Selected Documents Available in the Project File MAP IBRD No R1

8 I. THE FERTILIZER SECTOR A. Structure and Performance Structure and Organization 1.1 During the past two decades, Indonesia has successfully developed and implemented a policy of promoting food self-sufficiency, particularly in rice, and including support for all agricultural inputs such as fert 4 lizers, extension, seeds, irrigation, and research. The major agricultural j.f.ograms for this purpose have been developed and managed by the Ministry of Agriculture (MOA). The fertilizer sector, in all aspects of production and marketing, has been managed by the Ministry of Industry (OI) as an important element contributing to the above programs. A large investment program has been planned and implemented in the public sector to produce and deliver fertilizers from domestic plants, which primarily produce urea based on domestic natural gas resources, to minimize risks that farmers may face from the uncertainties of imported fertilizer supplies and highly fluctuating international fertilizer prices. Large marketing and distribution infrastructure facilities have been built, mostly in the public sector, to ensure timely and adequate delivery of fertilizers to the farmers at affordable prices. The farmgate fertilizer prices have been maintainod at low and uniform levels country wide through a system of price subsidies managed directly by the Government. The Government is aware of the negative impacts of these subsidies and has taken steps and will continue to adopt measures to sustain a more economically efficient fertilizer industry (Annex 1). The current structure of the Indonesian fertilizer sector should be viewed in this broad context. 1.2 At present, the Indonesian fertilizer industry consists of six government-owned companies (PUSRI, Kujang, Gresik, Kaltim, Iskandar Muda, and Aceh--the last owned Jointly with the ASEAN partners) with a total installed capacity of 5.0 million tons per year (tpy) of urea, 1.2 million tpy of triple superphosphate (TSP) and 0.65 million tpy of ammonium sulfate (AS). The total fertilizer requirements of the Indonesian farmers are obtained essentially from the above producers, supplemented as required through imports, and provided to the farmers through a fertilizer distribution network solely managed by PUSRI. There has been concern, however, that the absence of competition in the domestic marketplace has prevented all achievable efficiencies from being reached. Fertilizer Consumption Trends 1.3 The historical consumption of the four major fertilizer products is presented in Annex 2-1 and summarized in Table 1.1 below.

9 - 2 - Table 1.1: INDONESIA - HISTORICAL GROWTH IN FERTILIZER CONSUMPTION (thousand tons of product) Year Urea TSP AS KW1 Total , , , ,607 1, , ,715 1, , ,686 1, , ,930 1, , (Estimated) 3, ,867 Annual Growth Rate (Percentage) 1975/ / Indonesia's fertilizer c3nsumption is characterized by heavy reliance on nitrogenous fertilizers--mosuly urea--for rice cultivation. But the share of urea has fallen in recent years, from about 65 percent in 1975 to about 52 percen. in 1989, as urea dosages approached saturation and application levels of TSP and potash rapidly increased. The share of Java in total fertilizer consumption is about 75 percent of urea, 64 percent of TSP, and about 86 percent of AS, but only about 28 percent of potash. which is mostly used for plantation and commercial crops. The importance of fertilizer supplies to the foodcrop sector is reflected by the share of fertilizer consumed in foodcrop production in recent years--about 95 percent of urea and TSP, but only about 15 percent of potash. The rapid growth in fertilizer consumption and the present high levels of application are due to high fertilizer subsidies resulting in favorable farmgate fertilizer prices relative to paddy support prices. Until the mid-1970s, Indonesia depended for fertilizer supplies nearly entirely on imports--except for a small contribution from PUSRI I commissioned in Since the 1970s, substantial capacities--totaling about 6.8 million tpy--have been added, mostly for urea. As a result, Indonesia now meets its entire domestic urea requirements and is a major exporter of urea. However, all the potash and increasing requirements of TSP will continue to be imported, since Indonesia does not possess the r'w material base for their competitive production. 1.5 Most of the increase in fertilizer consumption took place from 1975 onward. The growth rate in consumption during the last five years has only been 3.3 percent for urea, 9.6 percent for TSP, 9.9 percent for AS, and 20.3 percent for muriate of potash (KC1). Various studies have estimated that to maintain rice self-sufficiency, rice production in Indonesia will have to increase annually b- about 2.5 percent. However, the present levels of fertilizer application are already high for the varieties of paddy seeds now available, as reflected in the declining growth rate of urea consumption. The required increase in rice production cannot, therefore, be achieved mainly

10 - 3 - through increased fertilizer application. Urea consumption growth rates can, therefore, be expected to remain at somewhat low levels. TSP and KC1 conruciption growth will be higher than the growth in urea consumption. The lneasures, now being considered by the Government, to improve fertilizer application efficiency would also reduce the need for additional fertilizers for ach1ueving the same production targets. These measures include the use of urea briquettes placed appropriately below the soil, more selective use of AS and potash, and use of partially acidulated phosphate rock where appropriate. Based on these considerations, the fertilizer ccnsumption projections in this report reflect growth rates of 3.5 percent, 6.5 percent, 7.5 percent, and 7.5 percent, respectively, for urea, TSP, AS, and potash for the Repelita V period and 3.0 percent, 6.0 percent, 7.0 percent, and 7.0 percent, respectively, for the Repelita VI period. As seen in Table 1.2 below and in Annex 2-2 these projections are somewhat lower than those prepared by MOA and MOI, but are judged to be more appropriate for capacity planning purposes. Table 1.2: INDONESIA - PROJECTED FERTILIZER CONSUMPTION (thousand tons of product) Year Urea TSP AS KCI Total 1988 (actual) 2,930 1, , (est.) 3,065 1, ,867 A. Second National Fertilizer Study - Revision (ii) ,132 2,366 1, ,257 B. Ministry of Industry 1994/95 4,913 2,342 1,067 N.A. N.A. 1999/2000 6,422 2,989 1,670 N.A. N.A. C. World Bank Estimate ,770 2,210 1, , ,370 2,960 1,450 1,410 10,190 N.A.: Not available. 1.6 Except in the case of urea, the domestic production of fertilizer will be short of requirements. Some AS capacity may become available as a coproduct, should Indonesia proceed with a caprolactam plant. The additional requirements of fertilizer products other than urea will be met through imports. According to the estimates contained in Annex 2-9 if all the investment programs now under consideration are implemented as scheduled, the projected urea production will be about 6.4 million tpy by The requirement of urea for industrial purposes--mainly for the productior ;c resins for the plywood industry--will be about another 0.3 million tr The planned capacities for additional urea production will, t--. <e

11 - 4 - be adequate to meet the projected domestic requirements and to maintain a significant Indonesian presence in the international urea trade. Disttibution and Marketing 1.7 Since 1979 the Government entrusted to PUSRI the total responsibilit,ie, for dlistlibuting and morketing all types of fertilizers--both domestically produced and imported. During the past ten years, PUSRI has mobilized and arranged for an impressive infrastructure to fulfill that responsibility; its marketing unit works as an independent cost center. To support its fertilizer marketing operations, PUSRI maintains a central marketing office in Jakarta, regional marketing offices in each of the 25 provinces, six fertilizer bagging units, and 92 fertilizer warehouses located throughout the country. Tbe company owns such transport facilities as railway wagons, fertilizer vessels, and one ammonia tanker. In addition, the company hires and uses similar facilities owned by such other agencies as the state and private railways. Three of the fertilizer bulk carriers and one of the bagging plants now being used by PUSRI are privately owned. PUSRI also uses the large fleet of trucks owned and operated in the private sector for fertilizer movement. Increasingly, the additional fertilizer warehousing facilities required are being obtained through hiring of privately owned storage facilities. 1.8 The flow of fertilizer products in the present marketing system is shown in Annex 2-3. PUSRI obtains its fertilizer supplies either from the domestic producers or through imports (Line I). For each agricultural season, starting from October, the MOA estimates the fertilizer requirements of its planned agricultural program. Taking into account expected domestic production, imports are planned, as appropriate, through the Ministry of Trade. The imported fertilizers are taken over by PUSRI at the erntry port. The annual strategy to minimize distribution costs is developed by PUSRI and discussed with all concerned. Based on the agreed plans, an amount of the domestic production is reserved for domestic use. The producers are then free - to export their extra production at international prices. PUSRI transports the products from the plants or the importing ports (Line I) to bulk terminals/ports at the provincial level (Line II). The bulk material is bagged and then shipped to inland supply warehouses at the district levels (Line III). Fertilizers are sold from these warehouses to the dealers, who market them to the final consumers (Line IV). In the past the dealers could be government institutions, cooperatives, or private agencies; ho.'ever, in 1988 the Government decided that the marketing of fertilizers to the farmers in rural areas would be done only through the village cooperative units, known as Koperasi Unit Desa (KUDs). At present, except for sales to plantations, which can still be made through government institutions and private dealers, all retail marketing of fertilizers is through the KUDs. As a result, the share of KUDs in the marketing of fertilizers has increased substantially-- from 13 percent in 1'84/85 to 64 percent in Thers are concerns that this restraint of compecition has caused efficiency losses. A Fertilizer Marketing and Distribution Study, to be supported under the Project, will evaluate the scope for efficiency improvements in a competitive environment and recommend an action plan to implement such improvements.

12 -5- Fertilizer Pricing 1.9 Fertilizer prices at the farmgate and ex-factory levels are set by the Government. The differentiul from this two-level price setting is funded by the Government in the form of a budgetary fertilizer subsidy. In general, farmgate fertilizer prices are set annually from October 1 of each year, keeping in view the need to promote adequate Fertilizer application, to ensure that the levels of farm incomes are not unduly eroded, and to maintain rice self-sufficiency. Fertilizer is sold to farmers throughout the country at the same price; the extra cost of delivery to remote locations is borne as a subsidy by the Government. Until October 1988, all the fertilizer products-- u.ea,?sp, AS, and KCl, were sold at the same product price irrespective of nutrient content and farm economics. From October 1988, the Government has started to change this situation. At present, delivered prices of TSP and KC1 (Rp 260 per kg) are somewhat higher thar. the prices of urea and AS (Rp 210 per kg). Also, since the fertilizer pricing (and subsidy) system covers only the four major single nutrient products (urea, TSP, AS, and KCl), manufacturers are reluctant to diversify and provide the farmers with a wider range of nonsubsidized products, that would have to be sold at higher market prices Ex-factory fertilizer prices are set annually by the government, taking into account the actual costs for the two previous years and the individual fertilizer enterprise's budget for the coming year. The pricing proposals, prepared by the enterprises as part of their annual budget process, are reviewed by an interministerial committe--moa, MOI, Ministry of Finance (MOF) and EKUIN--and become applicable from January 1. The ex-factory prices provide for depreciation and interest charges but do not include a provision for return on -quity. The rpoducers, subject to fulfilling certain performance targets, are entitled to a profit of Rp 5,000 per ton of product irrespective of the capital employed Natural gas, the major input for all the urea plants, is priced uniformly at $1.0 per million British thermal unit (MMBtu), thus indirectly subsidizing urea production at some locations. The breakdown of the present ex-lactory fertilizer prices is presented in Annex 2-4 for urea and Annex 2-5 for TSP and AS. In the case of urea, the production costs (excluding depreciation and interest) range from Rp 92,026/ per ton for Kujang to Rp 100,375/ per ton for Kaltim. The higher production costs at Kaltim are mainly due to the higher energy consumption of Kaltim I, a situation being addressed under the proposed Projoct's Optimization Component. The capitalrelated costs of Kaltim and PIM are higher due to their recent plant vintages The fertilizer is delivered by the producers to PUSRI against letters of credit. The producers are paid against despatch an amount equal to the distribution costs allowed to PUSRI for supplies from the particular producer. The producer issues claims on the Government for the difference between the agreed ex-factory price and the payment already received from PUSRI. In the case of Kujang, there is a negative receipt from the Government. In the case of PUSRI, about 80 percent of the ex-factory price of urea is received against despatches. In the case of PI'i and Kaltim, the receipts against despatches amount to about 70 percent of the production costs of bulk urea, excluding capital-related costs. Gresik, however, receives only 40 percent of the production costs (excluding capital related costs) for TSP and 64 percent for AS against despatch. Gresik thus faces a cash crtunch if

13 there are delays in the receint of the Government's share of the ex-factory price. The Government has recently assured the PFEs that these payments will be made within 90 days and that, in case of defaults, the companies will be reimbursed interest charges Fertilizer Subsidy. As mentioned above, fertilizers are delivered to the farmers at prices well below costs. The difference between the cost of delivering thr fertilizers to the farmers and the price realized through sales is borne by the Government as a budgetary subsidy. With the growth in the agricultural program, the increase in fertilizer consumption and the higher fertilizer prices, the size of the fertilizer subsidv has been steadily increasing, from Rp 219 billion in 1981 to an estimated Rp 721 billion in In 1988(89 subsidies on agro-inputs other than fertilizer, like those on pesticides, have been eliminated The actual budgetary fertilizer subsidy for any particular year has to be adjusted for carrying forward some expenses from other years, interest charges and taxes. For purposes of evaluating the impact of various policy options on the fertilizer subsidy, the subsidy accruing within anv particular year has been estimated exclusive of the above adjustments. Details of such estimates for 1988, 1989, and 1990 are contained in Annex 2-6, Annex 2-7 and Annex 2-8 and are summarized in Table 1.3 below. The 1988 estimates are based on actual sales and costs. The 1989 estimates are based on actual sales up to August 1989 and on projections for the rest of the year. The 1990 estimates are based on i989/90 fertilizer sales, as projected by the MOA and at the present price levels. The fertilizer economic subsidy has been split into "production" and "farmgate" subsidies using economic delivered costs based on border prices. In the case of urea, where Indonesia is competitively placed for exports, the border price is the export-parity price. In the case of TSP, AS, and KCI, for which Indonesia is not a competitive producer, the border price is the landed cost Table 1.3 indicates that the Indonesian urea producers -re internationally competitive and are being paid ex-factory prices well below export prices. For TSP and AS, domestic competitiveness is very sensitive to international relative prices of fertilizer products, raw materials, and intermediates. The competitiveness of AS production is also partly affected by the high-cost of fuel oil-based ammonia produced to enable operation of one of Gresik's AS plants. The economic production cost of TSP tends to be marginally higher or lower than the landed cost depending on the prevailing international prices. Fertilizer Production 1.16 Fertilizer production in Indonesia started with the commissioning of PUSRI I in 1963, with an installed capacity of 100,000 tpy of urea. By 1989 the fertilizer capacity had reached a total of million tpy. The capacities of the existing plants and those being planned are summarized in Annex 2-9. At present, domestic fertilizer production meets the entire requirements of urea and AS, and most of the requirements of TSP. Indonesia is now an exporter of ammonia (0.24 million tons in 1987) and of urea (1.04 million tons in 1988). The recent exports of ammonia and urea, and the major importers of Indonesian urea, are given in Annex 2-10.

14 Table 1.3: ESTIMATED FERTILIZER ECONOMIC SUBSIDIES (Rp billion) Urea TSP AS KC1 Total A Delivered cost ,422 Sale realization Subsidy Total (Budgetary) Production (314) (247) FaLmgate B (est.) Delivered cost ,745 Sale realization ,024 Subsidy Total (Budgetary) Production (364) (260) Farmgate C (est.) Delivered cost ,795 Sale realization ,217 Subsidy Total (Budgetary) Production (436) (329) Farmgate Most of the recent additions to fertilizer produttion capacity have been for urea, based on the abundant natural Pas resources of Indonesia. The only domestic plant (at Gresik) for the production of TSP and AS relies on imports of sulfur, rock phosphate, and phosphoric acid. All the potash requirements are met by imports. Annex 2-9 and Annex 2-11 contain details about domestic fertilizer production capacity and output The fertilizer plants in Indonesia have, in Sr-'eral, stabilized production at high levels soon after commissioning. Many of them have also carried out optimization investments to improve plant reliability and stream efficiency. For example, such investments in Kujang have enabled it to be one of the best-run plants in the world. Similarly, optimization investments on Kaltim I, which had encountered serious initial commissioning and operation problems, have enabled the plant to stabilize its operations. The overall good performance of the Indonesian fertilizer plants is reflected by their high capacity utilization, as seen in Table 1.4 below for the year 1989.

15 -8- Table 1.4: FERTILIZER PRODUCTION CAPACITY AND OUTPUT IN 1989 Capacity Plants Capacity Output Utilization --- (thousand tons) ---- (percent) Urea PUSRI II, III, & t! 1,520 1, Kujang ASEAN Aceh Kaltim I, II, & III 1,710 1, Iskandar Muda Total Urea 5,020 4, TSP Gresik I & II 1,200 1, AS Gresik I, II & III Investment Program 1.19 The Government's investment program in the fertilizer sector includes both investments for new capacity and for performance improvements, ; following the recommendations of the Fertilizer Industry Sector Report, prepared by the Bank in The estimated total cost of this program is about $1.0 billion. Three projects for capacity additions have been prioritized and are in advanced stages of planning. These include the PUSRI Ib project, which will add a 1,350 tpd capacity ammonia plant and a 1,750 tpd capacity urea plant to the PUSRI facilities at Palembang. The surplus ammonia will be converted to urea in the optimized PUSRI II urea plant, to be funded under the proposed Project. The contracting arrangements for the PUSRI Ib facilities and the financing arrangements have been finalized. The second large capacity addition will be the Gresik ammonia/urea complex proposed for financing under the Project. Kujang has been authorized by the Government to finalize arrangements with a private partner for a Kujang II ammonia/urea project, with majority private financing. This project will add 570,000 tpy of urea capacity, half of which will be reserved for exports. A fourth company, Iskandar Muda is also considering expansion with a private partner. As a result of energy audits and feasibility studies, optimization investments will be undertaken in several plants and supported under the proposed Project. These investments will aim for, inter alia, energy savings, increased capacity, upgrading of technology, amelioration of industrial pollution, and safety. The impact of the above investments will be to increase urea capacity in Indonesia to 6.9 million tpy, which will make available about 4.4 million tpy of urea to meet domestic requirements up to the year No addition to TSP capacity is being planned, beyond optimization investments, since the economic viability of domestic production

16 from new investments has not been established. No additional direct capacity for AS production is planned. B. The Policy Framework 1.20 The successful development of the Indonesia fertilizer industry has been associated with: (a) controlled and heavily subsidized fertilizer prices at the farmgate (the economic subsidy is forecast at about $317.0 million for 1990), which have promoted intensive and possibly inefficient use; (b) natural gas and ex-factory fertilizer prices that differ from economic prices and have resulted in production inefficiencies (for TSP and AS) and inappropriately low returns to equity; (c) regulations on product distribution and marketing that have constrained competition and efficiency; and (d) inadequate assessment and monitoring of the environmental impact of '.ertilizer production The Government is aware of the impact of the above existing distortions on its budget and on the overall economic efficiency of the fertilizer industry. As it has demonstrated its determination to deal with similar problems by undertaking substantive deregulations in trade, industry, and the financial sector, the Government has also decided to redress the above distortions. In May 1990, the Government issued a new deregulation package which covers reduced import restrictions on fertilizer but introduced a marginal increase in tariffs coupled with temporary surcharges to offset the elimination of some import restrictions and assist producers to adjust to the new regulations. These measures will mainly affect imports of TSP and potash. During the past two years, the Government has raised AS prices at the farmgate to their economic level, and has made some upward adjustments in the farmgate prices of urea and TSP, the prices of which are still about 47 percent and 33 percent lower, respectively, than their economic levels. Because of the concern to maintain rice production in line with domestic demand and to protect farm incomes, the G(vernment intends to make the remaining fertilizer farmgate price adjustments toward their economic level gradually, but within the Repelita V period (1989/ /94), as indicated in the Policy Statement issued prior to negotiations. The Statement, which is satisfactory to the Bank, is attached as Annex 1. In addition, the Government plans to: (a) replace the cost-plus formula for setting ex-factory prices for fertilizer by linking the ex-factory price of urea to its export parity and the exfactory prices of all other fertilizers to their import parities (these adjustments will also be phased in during Repelita V, together with the adoption of an appropriate dividend policy for fertilizer enterprises; (b) establish the price of natural gas to the fertilizer industry between a floor corresponding to the economic cost of the resource and a ceiling corresponding to its netback value, and eliminate economically unjustified price differentials among natural gas users; (c) open up the marketing and distribution system to wholesalers and retailers to foster competition, improve efficiency, and provide better service to farmers on the basis of a study to quantify efficiency improvements and to recommend an action plan; and (d) prepare an environmental management and monitoring plan for the fertilizer industry, on the basis of a study of the current and projected environmental impacts and of environmental standards and targets.

17 C. The Sector and the Natural Environment 1.22 Since 1986, in accordance with Indonesian laws and regulations, sponsors of major industrial projects, such as those proposed under the Project, must prepare environmental impact analyses. The policies, regulations and review procedures of environmental matters in Indonesia are the responsibility of the Ministry of Population and the Environment (KLH), which is not a line ministry but advises operating ministries, for example MOI. Thus, all activities supported by the project will be in accordance with environmental guidelines stipulated by KLH and executed by MOI.11 The environmental review procedures covering the Gresik Restructuring Component and the Optimization Component of the proposed Project consist of the following steps. A Preliminary Environmental Evaluation Report (PEL) for the proposed activity is submitted by the sponsor to the Environmental Planning Commission, either at the central government level or at the provincial government level, depending on the size of the project. Terms of reference, outlining the scope and procedure for conducting the project's Environmental Evaluation Study (SEL) are then drawn up by the sponsor and approved by the Environmental Planning Commission. The completed study is submitted for approval to the Commission along with an environmental management plan (RKL) and an environmental monitoring plan (RPL). Under the Gresik Restructuring Component, a SEL has been drawn up for the Gresik ammonia/urea plant and found satisfactory to the Bank (para. 5.18). In the Optimization component, a satisfactory environmental impact analysis would be a condition of the Bank's approval of each subproject Sites and Activities. The Indonesian fertilizer industry consists of two groups. First, there are the ten ammonia/urea plants--including the ASEAN plant at Aceh--, in five locations, with three additional plants under construction or planning, to be added over the next 5-10 years. Second, there is the large TSP and AS complex at Gresik, near Surabaya. The fertilizer plants in Indonesia have adopted the latest proven technologies available when they were built, taking into account both technological advancements and environmental requirements. The Government, at both central and provincial levels, and plant management are also increasingly becoming aware of the need to minimize adverse environmental impacts from industrial plants. There are, however, still inadequacies in standards, monitoring, and management. Provisions are included under the Project to assist the Government and the fertilizer industry to remove these inadequacies Ammonia/Urea Plants. The two major effluent streams in these plants are the liquid effluent stream, which contains ammonia and urea, and the gaseous effluent from the urea prilling tower, which contains urea dust. Most plants built before 1985 adopted bag filters for the urea prilling tower exhaust, which are not as effective in urea dust removal as technologies developed later. The more recent plants use scrubbers for more complete removal combined with hydrolyzers to decompose the urea to ammonium and then to recover the ammonia. Whereas the earlier vintage plants have liquid l/ In June 1990, a presidential decision formed an Environmental Impact Control Board as part of KLH. The Board will serve to further strengthen eavironmental impact analysis, pollution control standards, monitoring and enforcement.

18 effluent streams containing about parts per million (ppm) cf ammonia. the more recent urea technologies reduce the ammonia content in the liquid effluents to below 5 ppm through the use of hydrolyzer-strippers The industry has already made some progress in pollution control. Water treatment designs have been changed to eliminate the use of chromium, and some plants have adopted energy-saving schemes to reduce use of natural gas. New technology is being adopted to reduce ammonia effluents, although at a slow pace for existing units. All new plants are being designed with stateof-the-art technology that will lower ammonia effluents to under 5 ppm. Kaltim II & III, built after 1985, have achieved such levels, and the company is also considering installing a hydrolyzer-stripper plant for Kaltim I to reduce its effluent to under 5 ppm. The environmental analysis carried ovt for the Kujang II plant has proposed the setting up of facilities at Kujang to degrade the effluent biologically, converting the ammonia into nitrogen, also to under 5 ppm. The 5 ppm standard is an achievable and desirable standard for ammonia effluent. The MOI and KLH are currently reviewing the standards for the nitrogen industry. The proposed industry-wide environmental study to be implemented under the Project will assist the government in developing appropriate standards and management systems to ensure compliance on a sustained basis. A reasonable approach would be to impose a strict (but technically achievable) standard for new construction--i.e., 5 ppm maximum-- for ammonia, and to give existing industry a reasonable time to reach similar standards, taking into account technology and overall contribution to effluent levels Safety is an important part of industrial operations in the fertilizer industry, particularly in ammonia plants. Each company has a wellestablished safety department that reviews safety programs and manages a safety awareness pregram. It is common practice internationally to design fertilizer factories with safety in mind, and this was the case with all such plants in Indonesia. The safety program is fully supported by the MOI and the emphasis on safety has paid off. For example, the two oldest facilities, PUSRI and Gresik, have never had a work-related fatality, and both have operated for over three years without a lost-time accident The industry also maintains a good record with regard to social programs. Most facilities were installed in remote, unpopulated areas and needed a comprehensive program of housing, health, schools, and other urban infrastructure to attract and keep staff. In two locations, (Palembang and Gresik), nearby urban-industrial development has increased sufficiently to make the companies consider urban development in their corporate planning. This issue is being addressed in the environmental assessment programs of the Project. There have been no reported problems with regard to resettlements or local claims. Several factories were built on agricultural land but the improved productivity resulting from increased fertilizer availability more than offsets this loss With regard to fertilizer use, inadequate attention has been given to any adverse environmental impact. The emphasis has been on increasing supply at a uniform low price to ensure rice self-sufficiency. Although no serious environmental issue has emerged, there is some concern that subsidized fertilizer prices may lead to overuse, resulting in ground water contamination, and that the right type and specification for fertilizers are not being

19 used. Some decisions have already been taken that have a positive environmental effect: (a) nitrates are not used; (b) production is moving closer to consumption; (c) phosphate specification changes are being considered; (d) use of urea briquettes is being tried; and, perhaps most important, (e) the fertilizer pricing subsidy is being phased out From an environmental viewpoint, the fertilizer sector is in transition. While overall performance is good, there is a need to develop a comprehensive planning system to ensure that minimal environmental impact is achieved. To support this objective, the Project will provide support to environmental impact analyses and appropriate action plans for each of the PFEs and to a sector-wide environmental study that will develop an environmental management program for the sector, to be monitored by the Government. II. THE BANK'S PAST LENDING, STRATEGY, AND RATIONALE FOR INVOLVEMENT IN THE SECTOR A. The Bank's Past Lending in the Fertilizer Sector 2.1 Bank involvement in the Indonesia fertilizer sector began in Since then, two credits and four loans have been completed, and another loan is being implemented for a total amount of $375.0 million (Table 2.1). During the Bank made four credits/loans, all to PUSRI, that enabled this company to expand urea production to 1.4 million tpy by These operations concentrated on expanding capacity, on ensuring gas supplies to the plants, and on improving overall management capability in the areas of project design and implementation, procurement, finance, and marketing. Although the approach was largely project-specific, it resulted in Indonesia developing competent management capability that enabled the industry to evolve successfully. Many of the early PUSRI staff are now successful senior managers scattered throughout the industry and the Government. 2.2 In the mid-1970s, serious constraints began to appear in the distribution network, given that most of the production was concentrated in one location (PUSRI, Palembang) and consumption mostly in Java, and that other islands needed supply. The Government then decided to expand production at other locations and to improve the distribution system. During , the Bank assisted in upgrading the fertilizer distribution system through two operations designed to improve the physical infrastructure, including maritime, rail, and road systems, plus storage and bagging facilties. With Bank support, Indonesia took a lead in promoting bulk transport.f fertilizer in developing countries. At present, about 75 percent of output is transported in bulk, up to the retail level. These operations were also directed at improving management of the marketing system, which is also under PUSRI's responsibility. During this period, other expansions of supply took place without Bank assistance. Both groups of Bank-supported operations were highly successful. Fertilizer consumption and production increased fourfold and eightfold, respectively, during PUSRI is widely recognized as a world leader in fertilizer production. Distribution efficiency has improved, including the ability to handle the larger volumes produced. Today, Indonesia is a competitive producer and exporter of nitrogen fertilizer.

20 Table 2.1: SAN OPERATIONS AND EVALUATIONS OF PROJECT PERFORMANCE IN THE FERTILIZER SECTOR Approval Credit/Loan Amount Project date No. (8 million) Status Production Fertilizer Plant Expansion and Can Conservation 6/16/70 C a0.0 Completed Fertilizer Supplementary 6/21/73 C Completed Third Fertilizer Expansion 2/20/74 L Completed Fourth Fertilizer Expansion 6/20/76 L Completed Distribution Fertilizer Distribution 7/10/76 L Completed National Fertilizer Distribution 4/05/92 L Completed Industrial Energy Conservation 11/09/87 L Ongoing Total Sustainabilitv of Prolects - Review of Experience in the Fertilizer Subsector; Report No. 6078, Operation Evaluation Department, February 26, 1986 Indonesil - Fertilizer Industry Sector Report; Report No IND, February 18, Project Performance Audit Reports (PPARs) No Credits 193-1/-2 No Loans 1089-IND; and 1264-IND No Loan 1139-IND Prolect Completion Reports (PCRs) No Loan 2120-IND 2.3 By the mid-1980s, several problems developed in the sector that needed urgent attention and required a broader sectoral perspective: (a) increasing subsidies due to price controls; (b) industrial efficiency lagging behind international standards, also in part because of price contrals; and (c) some economically unjustified investment decisions. During , the Bank undertook two activities to assist the Government in resolving these issues: an Industrial Energy Conservation Project and a Fertilizer Sector Strategy Study. The Industrial Energy Conservation Project (Loan 2879-IND), currently under satisfactory implementation, concentrates on optimizing energy consumption, the key variable in urea production, within existing fertilizer plants at PUSRI. This project is enabling PUSRI to upgrade for energy savings arnd increased output and profitability. It has also helped establish an Industrial Energy Conservation Center (Koneba) to build up expertise in energy efficiency in the fertilizer and other sectors. 2.4 The Fertilizer Sector Strategy Study prepared during 1987/88 was designed primarily to assist the Government to develop a strategy for removing price distortions and reducing subsidies, and to prepare a viable investment program. This work too has been very successful. Through discussions of the sector report and project preparation activities, the Government has developed a good understanding both of the adverse effects of price controls and

21 subsidies and of the investment priorities. As a result, it has adopted an investment strategy (para. 1.19) and has moved towards a comprehensive policy reform program (para. 1.21) that should enable the sector to maintain and enhance its internationally competitive position. During Project preparation two other areas of concern for the fertilizer industry emergeds its environmental impact and the distribution and marketing efficiency. The proposed Project provides for studies that will assist in the resolution of the main issues in these areas. 2.5 Project Completion Reports (PCRs) and Project Performance Audit Reports (PPARs) as well as the OED's Review of rxperience in the Fertilizer Subsector Report, listed in Table 2.1, have attributed such favorable performance of Bank-assisted operations to the following main elements: (a) firm commitment by the Government and the fertilizer enterprises to attain the projects' objectives; (b) presence of a competent, strong, and stable management core at the fertilizer enterprises, assisted by capable technical support for project implementation; (c) use of competent and highly experienced licensors and engineering firms; (d) comprehensive arrangements to facilitate procurement; and (e) provision of on-the-job training opportunities for fertilizer enterprises' staff. The reports also noted, however, that these operations focussed on the development of physical aspects of the industry but did not attempt to address fertilizer policy issues. Experience from Bank-financed fertilizer projects in other countries has identified other lessons: (a) the choice of optimization investments should be based on both economic considerations and expected improvements in operating costs, avoiding optimistic implementation sc&edulee; (b) project activities should be integrated with normal plant operations to ensure their timely execution; (c) the effective transfer of technology and the skill upgrading of managerial and technical staff should be assessed carefully. The above elements have played a central part in the design of the proposed Project. In addition, a key message from the implementation experience of Bank-supported fertilizer optimization investments is that their complexity has put heavy demands in terms of supervision. Therefore, the proposed Project supervision strategy would be carefully planned to ensure the adequate allocation and effective utilization of resources for this purpose. B. The Bank's Strategy and Rationale for Involvement in the Sector 2.6 Bank strategy in the sector has evolved over the past two decades from an emphasis on increasing supply, principally through financing selected investments, to a broad, policy-based strategy to attain the sector development objectives detailed in para The main rationale for Bank involvement with the proposed Project is to ensure that the continuing evolution of policy reforms is implemented in a consistent and timely fashion to support the development of the fertilizer sector. The proposed Project conforms well with this strategy by building upon an established policy dialogue and assisting the Government to implement key policy reforms agreed ujpon by the Government and the Bank (para. 1.21). Moreover, the proposed Project will apply important lessons learned under previous Bank-assisted activities. The main thrust of the proposed Project is on economic efficiency, distribution and marketing improvements, and pollution abatement.

22 III. THE PROJECT A. Obiectives and Description 3.1 The primary objectives of the proposed Project would be to: (a) assist the Government in implementing significant sector reforms, already initiated and reflected in the draft Government Statement of Policy, that will sustain the continued development of the fertilizer sector on an economically efficient and environmentally sound basis; (b) support an industry-wide priority investment program; (c) identify the scope for improved efficiency in marketing and distribution; and (d) assess the industry's environmental impact and standards, and develop an environmental management program. 3.2 To achieve these objectives, the Project includes: (a) a Gresik Restructuring Component to provide financial assistance to P.T. Petrokimia Gresik for the construction of a new ammonia/urea plant and for modernization of Gresik's existing fertilizer plants; (b) an Optimization Component to support investments in four participating fertilizer enterprises (PFEs)-- Iskandar Muda, Kaltim, Kujang and PUSRI--to realize energy savings, capacity and productivity gains, and pollution control improvements; and (c) a Studies Component to undertake analyses of the scope for improved efficiency in fertilizer marketing and distribution and of the environmental impacts of the fertilizer industry, including identification of long-term objectives for environmental improvement and preparation of an environmental management program to ensure that the industry meets appropriate standards. B. The P.T. Petrokimia Gresik Restructuring Component 3.3 This component will comprise: (a) building a new ammonia/urea plant at Gresik, with a cadacity of 1,350 tpd of ammonia and 1,400 tpd of urea, to provide low-cost ammonia to existing operations and to reduce urea distribution costs in East Java, including provison of engineering services and licenses therefor; (b) supporting modernization investments in Gresik's existing fertilizer plants to increase output of phosphoric acid and improve performance of the AS facilities and ameliorate environmental pollution. Gresik's New Ammonia/Urea Plant ($305.4 million) 3.4 The new ammonia/urea plant to be built at Gresik will be based on natural gas and have a capacity of 1,350 tpd of ammonia and 1,400 tpd of urea. The Gresik complex already contains a range of plant facilities, mainly for the production of TSP and AS. Half of the phosphoric acid--amounting to about 151,000 tpy, required for TSP production--is obtained from the company's own facilities, and the rest is imported. The TSP facilities require imported phosphate rock, phosphoric acid, and sulfur. The production of phosphoric acid, by the sulfuric acid acidulation of rock phosphate, generates about 750,000 tpy of gypsum, which needs to be either utilized or disposed of. The local pollution control requirements do not permit the discharge of gypsum into the sea. About 335,000 tpy of the gypsum is utilized for the production of cement retarder sold to Indonesian cement plants. The company exports about 65,000 tpy of purified gypsum and uses the rest of the gypsum, about 350,000 tpy, for the production of AS. This AS plant also requires both ammonia and carbon dioxide as raw materials. The company, therefore,

23 continues to operate a 72,000 tpy capacity, fuel-oil-based ammonia plant at the minimum level to generate the carbon dioxide requirements of AS production plus a small amount of carbon dioxide for industrial sales. The high cost of this ammonia adversely affects the economics of AS production. Another existing AS plant produces tpy of AS by direct neutralization of ammonia and sulfuric acid; the latter in turn is produced from imported sulfur. The ammonia requirements for this plant are purchased from Kaltim. 3.5 The proposed new plant will use, to the extent possible, the utility and infrastructure facilities already available in the complex. The company has finalized a contract with two well-known ammonia and urea licensors, and the plant will therefore be based on one of the proven, energy-efficient technologies with environmental considerations consistent with present international standards. The size of the plant is large enough to achieve economies of scale, and at the same time is in the well-proven capacity range to avoid undue technical risks. The plant will be located -within the existing Gresik complex, and land has already been cleared for the purpose. The new ammonia plant will allow the existing ammonia plant to be closed, replace purchased ammonia, and maintain sales of industrial carbon dioxide. 3.6 Natural gas for the project will be provided by Perusahaan Pertambangan Minyak dan Gas Bumi Negara (Pertamina) under a contract to be signed with Gresik. The contract will provide for a normal daily supply of 48 million standard cubic feet per day (MMSCFD) with a maximum of 60 MMSCFD, starting from The gas will have a gross calorific value not below 950 MMBtu per SCF and not above 1,200 MMBtu per SCF, and it will be delivered at the plant site at a fixed price of $2.00 per MMBtu. This contractual gas price is within the economic cost of supply, which has been tentatively estimated by the Bank at $l /mbtu on the basis of the long run marginal cost of supply, including risk and depletion premiums. The gas will be delivered from the Pegerungan reserves of the Kangean Block--located across Madura Island and north of Bali and developed by Atlantic Richfield Bali North Inc. (ARBNI) and Britoil (Alpha) Ltd. (Britoil) along with Pertamina. According to present indications, the above reserves total abctt 2,500 billion standard cubic feet (BSCF) consisting of 2,300 BSCF proven and 200 BSCF probable. The gas contractors intend to build an appropriately sized pipeline--about 255 miles long, based on delivery of 180 MMSCFD to the PLN Gresik thermal power plant, 60 MMSCFD to the Gresik ammonia/urea plant, and about 90 MMSCFD for domestic and other industrial use in the Surabaya/Gresik area. A feasibility report on the routing and sizing of the pipeline was prepared by P.T. Bimantara, the Indonesian partner of the contractors. All contractual arrangements are being finalized and the pipeline would be completed in time for the commissioning of the ammonia/urea plant. Modernization of Gresik's Existing Fertilizer Plants ($15.8 million) 3.7 Gresik produces about 1.2 million tpy of TSP, partly with its own but mostly with imported phosphoric acid, and 650,000 tpy of AS. At present the phosphoric acid plant, with an installed capacity of 171,400 tpy, produces only about 151,000 tpy due to equipment problems. The company is already changing some equipment to reduce production interruptions. It should be possible to increase phosphoric acid producti3n further through modernization of the facilities, including increased output of phosphoric acid and changing product specifications in the TSP plant. To the extent additional phosphoric

24 acid can be produced, sulfuric acid that will be converted to AS will be reduced. Feasibility studies will also assess utilization of waste calcium carbonate in the adjacent cement factory and improvements in the performance of the AS production facilities, including improved ammonia recovery and minimizing ammonia and sulfur dioxide (SO 2 ) discharges into tih environment. To address the above issues Gresik, assisted by consultants and process licensors, is evaluating an investment program which will be supported under the proposed Project. C. The Optimization Component ($122.2 million) 3.8 The Indonesian fertil'zer industry has an ongoing strategy to modernize its facilities to current levels of proven technolcgy and to enhance efficient operations to maintain an exportable nitrogen surplus and to minimize costs of the local supply of fertilizers. A major part of that optimization work is being supported under the Industrial Energy Conservation Project, Loan 2879-IND. The Optimization Component of this proposed Project will support the next phase of modernization of the sector, covering four PFEs: Iskandar Muda, Kaltim, Kujang, and PUSRI. It will support investments for energy and raw material efficiency, enhanced output, and improved environmental performance of the plants. These investments are well defined at this stage, but require additional detailed feasibility work prior to implementation. All subprojects will be reviewed and approved by the Bank, on the basis of their technical, managerial, financial and economic viability, as well as on the assessment of their environmental impact. 3.9 P.T. Iskandar Muda Ammonia/Urea Optimization Subproject. PIK facilities in Aceh, North Sumatra, include a 1,000 tpd ammonia plant and a 1,725 tpd urea plant. The facilities were commissioned in 1984 and have been operating consistently above rated capacities. The present energy consumption is about 38 M4Btu per ton of ammonia, which indicates further scope for energy savings through appropriate investments. An energy audit of the facilities has been carried out by Koneba. PIM is also examining several product diversification schemes, including industrial chemicals such as hydrogen peroxide, and maintenance improvements. The various possibilities are being put together by PIM in a feasibility study for inclusion within the Project Kaltim I Ammonia/Urea Optimization Subproject. Kaltim operates three ammonia/urea plants in Bontang, East Kalimantan. Kaltim II and III operate extremely well. Kaltim I ammonia and urea plants were originally designed as a ship-borne facility capable of being moved to different offshore gas fields. This concept proved nonviable, however, and a decision was made in 1975 to locate the plant on land at Bontang. Construction of the plant was completed, and commissioning started, in Because of the long storage of equipment under less than ideal conditions and inappropriate design specifications, the plants could not operate at rated capacities on a sustained basis. A study by the original process designers, recommended a rehabilitation scheme that was carried out in Following its implementation, stable operations could be achieved, and in 1988 production factors of 88 percent for ammonia and 82 percent for urea were achieved. Kaltim I is now reported to be operating at an annual average capacity of over 90 percent, and running for sustained periods above rated capacity. Ho-wever, the plant continues to have problems. Some of the equipment is still unreliable, thereby affecting sustained production. The energy consumption per ton of ammonia is 44 t4mbtu

25 per ton--indicating strong potential for achieving energy savings. There is also scope for improving effluent quality on the basis of an energy audit carried out by Koneba, conceptual studies undertaken by process engineering companies, and Kaltim's own experience with the plants, the company has developed an optimization program with fourfold objectives: to improve efficiency, to achieve better reliability, to expand capacity, and to improve maintenance. The studies indicate that the Kaltim I ammonia plant capacity can be increased by up to 20 percent, if the existing ammonia converter is replaced with a largercapacity modern, low-pressure, radial-type converter. The capacity of the urea plant would be increased by about 10 percent. Kaltim I will utilize this extra urea capacity to produce melamine, under a joint venture with a company from The Netherlands Kuiang Ammonia Optimization Subproject. Kujang facilities at Ciampek in West Java consist of a 1,000 tpd ammonia plant and a 1,725 tpd urea plant commissioned in From direct operating experience and following a consultant study carried out in 1980, certain plant modifications have been carried out. As a result, the plant produced 391,500 tpy of ammonia and 645,500 tpy of urea in 1986, corresponding to 119 percent and 113 percent, respectively, of original rated capacity. The objectives of this optimization subproject are to: (a) increase ammonia availability at Ciampek to support product diversification schemes; (b) reduce energy consumption by about 2.67 MMBtu per ton of ammonia through energy-saving investments; (c) maintain plant reliability after a decade of operations; and (d) decrease ammonia effluents to a Fatisfactory level. After joint analysis by Kujang and Koneba, seven energy conservation opportunities were identified and further studied by Koneba in consultation with the various process owners. The present Kujang optimization proposals are based on the March 1989 Koneba study. These proposals were selected based on a gas price of $1.00 per MMBtu. Since the economic value of natural gas at Kujang (located in Java) would be higher (likely about $2.00 per MMBtu), Kujang is evaluating further modifications that could be just.fied by the higher gas price. The subproject's scope will be finalized on the basis of these studies PUSRI II Urea Optimization and Effluent Treatment Facility Subproject. PUSRI has four ammonia/urea plants at its production :acilities in Palembang, South Sumatra. PUSRI II facilities consist of a 660 tpd ammonia plant and a 1,150 tpd urea plant that have been in operation since The performance of these plants has been good, but serious problems have occurred since 1983 because of deterioration of the titanium lining of the urea reactor. Its replacement is necessary for the continued operation of the PUSRI II urea plant on a sustained basis. PUSRI II has a urea prilling tower of the same size as those in PUSRI III and IV, capable of processing up to - 1,725 tpd of urea. As a result of the optimization of the PUSRI II, III, and IV ammonia plants--now being carried out under the Bank-financed Industrial Energy Conservation P-oject (Loan 2879-IND)--the total ammonia output at PUSRI will go up by about 315 tpd, with a reduction in energy consumption from an average of 41.5 MMBtu per ton to 37.2 MMBtu per ton. Also, the decision to build a larger 1,350 tpd ammonia plant as part of PUSRI Ib while building only a 1,750 tpd urea plant will generate an additional ammonia surplus of 350 tpd. Its location and the draft limitations at its jetty will make it difficult for PUSRI to export the 220,000 tpy of ammonia surplus that will become available

26 when FUSRI Ib is commissioned. The PUSRI scheme is to convert part of the surplus ammonia to urea by optimizing the PUSRI II urea plant, taking advantage of the surplus carbon dioxile available from PUSRI Ib. The additional urea will go mostly to the domestic market via coastal ships of medium size PUSRI has invited proposals from international firms and has evaluated alternative optimization options, taking into account not only technical and economic features but also reliability and commercially proven processes. The optimization subproject is now proposed to be based on the MTC/TEC (Japan) Aces Process. The proposed modifications will include: (a) replacement of the synthesis section--including the old titanium-lined reactor; (b) additional high-pressure recycle-solution feed pumps; (c) replacement of the carbon dioxide booster compressor and driver; (d) an additional evaporator/coaidenser; and (e) modifications to the prilling section, which will also alm to reduce air and water contamination. In addition, PUSRI has prepared, assisted by consultants, an investment for installation of a wastewater treatment plant, which would also be supported under this subproject. D. The Studies Component ($900,000) 3.15 The proposed Project includes provision for undertaking studies to: (a) identify the scope for improved efficiency in fertilizer marketing and distribution; and (b) assess the environmental impact and standards of the fertilizer industry, including identification of long-term objectives for environmental improvement and preparation of an environmental management program Stud) of Fertilizer Marketing and Distribution ($400,000). There is general consensus within Indonesia that the present system is performing reasonably well, mainly becatse fertilizer is delivered to farmers at a set price and on time. However, this system is characterized by PUSRI's monopoly at the wholesale level and cooperatives' monopoly at the retail level (paras. 1.7 through 1.9). As a result, there is a lack of domestic competition that has constrained improved efficiency and, coupled with high distribution costs and controlled fertilizer prices has led to an increased budgetary and economic subsidy. The proposed Project includes provisions for a study that will identify means of improving fertilizer distribution and marketing efficiency in a competitive environment. The study will comprise two parts. The first, to be undertaken by PUSRI, will cover: (a) updating the data contained in the 1986 Distribution and Marketing Study done by PUSRI; (b) assessing the current distribution system for both local sales and exports, in terms of ownership and operation costs; (c) preparing a ten-year forecast of fertilizer supply and demand; and (d) evaluating the logistical and physical changes required in the distribu-tion network over the next ten years. The second part, to be undertaken by a team comprising primarily foreign experts, will include: (a) identification of the existing marketing inefficiencies and constraints; (b) a compa-ative analysis of the costeffectiveness of the Indonesian marketing b,stem with that in other countries in the Asia Region; (c) an assessment of the impacts of changes in policy and fertilizer use--product types and application prospects--on the marketing system and on the natutal environment (para. 1.30); and (d) a recommended plan

27 of action to improve the competitiveness and efficiency of the fertilizer marketing system. Detailed terms of reference are given in Annex 3-A Development of an Environmental Management Program for the Fertilizer Industry ($500,000). The Government is committed to implement a program of environmental i-provement within the coantry. A system of laws and regulations has been adopted, but some key issues remain unresolved. For the fertilizer industry: (a) inadequate standards and targets; (b) lack of an environmental management program; (c) absence of an environmental monitoring program and enforcement arrangements; and (d) lack of a priority investment program to meet the proper standards and targets. To assist in the resolution of these issues, provisions have been incorporated under the Project to undertake a study, to be done by a team composed of local and foreign consultants, with the following main objectives: (a) to assess Indonesian environmental standards for the industry and recommend changes, including a target-based, phased implementation program of compliance; (b) to assess the environmental impact of current and planned fertilizer production facilities, including safety performance, and to recommend measures to bring these into compliance with the revised targets and standards; (c) to recommend an investment program to accomplish (b) above; (d) to develop an environmental management program for the industry; and (e) to assess environmental monitoring and enforcement practices and recommend specific improvements. Detailed terms of reference are in given Annex 3-B. Policy-related Actions E. Project Organization and Implementation 3.18 Overall, the proposed Project will be implemented in accordance with the principles stated in the Government Statement of Policy, as detailed in para and in Annex 1. An assurance to this effect was obtained during negotiations. During negotiations, the following understandings were reached: Ca) that the revised farmgate fettilizer prices for 1991 adopted by the Government, as agreed during the exchange of views on these prices in September 1990, between the Government and the Bank, represent a satisfactory progress in bringing these prices ultimately to their economic levels; (b) that the Government will, by October 1 of each year, commencing not later than October 1, 1991, review the farmgate and ex-factory prices of fertilizers, exchange views with the Bank on the results of the review, and thereafter, if required, revise such prices taking into account the principles set forth in the Statement; and (c) that actions will be taken during Repelita V ( ) to bring the prices of fertilizer products gradually to their economic level and eliminate the associated subsidy payments from the Government's budget. The Gresik Restructuring Component 3.19 The New Ammonia/Urea Plant will be built by Gresik within the boundaries of its existing complex. The plant will be constructed through a fixed-price turnkey contract, based on commercially proven and energy efficient technology. Gresik will be responsible for overall project coordination and for the supply of utilities. A local firm, P.T. Inti Karya Persada Tehnik (IKPT) has been appointed as General Contractor. IKPT was selected by Gresik, in consultation with MOI, after reviewing IKPT's extensive

28 experience in industrial design and plant construction, which includes one large ammonia/urea plant. The provision of the ammonia and urea facilities has been contracted from internationally experienced licensors, following International Competitive Bidding (ICB) procedures. In August 1989, Gresik, with prior agreement of the Bank, prequalified six firms (three for ammonia and three for urea) and prepared the invitation to bid and draft contracts. All these documents have been reviewed and found satisfactory by the Bank. Bids were opened on February 28, The prequalified engin.jering/licensor firms submitted proposals covering basic engineering and technology, offshore equipment and materials supply, supervision of implementation and commissioning, and operational performance guarantees, all under a subcontract with IKPT. IKPT submitted a bid for onshore equipment and materials supply, detailed engineering, project management and procurement, and erection services. Gresik will be responsible for overall management and supervision, land preparation, and supply of selected equipment (i.e., water cooling tower, water demineralization plant, electric substations and other equipment) based on licensors' specifications. Gresik completed the bid evaluation on June 5, 1990, and proposed to award the contract to the lowest evaluated bids: Kellog Overseas Corporation (USA) as the ammonia licensor, and Toyo Engineering Corporation (Japan) as the urea licensor. The Bank reviewed the bid evaluation report and provided a no-objection for Gresik to proceed with contract negotiations with IKPT and the two licensors. The contract, satisfactory to the Bank, was signed on September 7, Construction of the ammonia/urea plant started on October 4, 1990, and would take 36 months to complete, including 3 months for commissioning. The Government has indicated to the Bank that construction of the gas pipeline that will supply natural gas to the plant will have started by January 1, 1991, and that it is scheduled to be completed by December 31, 1993, which is satisfactory. It would be a condition of disbursement for the Gresik Restructuring Component that a contract for the provision of the required natural gas to Gresik has been executed on behalf of Gresik and PERTAMINA and found satisfactory to the Bank Modernization of Gresik's Existing Fertilizer Plants will be the responsibility of Gresik. For these investments, Gresik will prepare an appraisal report and an environmental impact analysis, which will be submitted to the Bank for review and approval. Gresik, assisted by foreign consultants, is currently preparing these documents, which are expected to be completed not later than June 30, For implementation purposes, Gresik will set up a project management team and will be using the services of local contractors, foreign licensors and engineering firms, as required For purposes of project implementation, Gresik will require the assistance of highly qualified engineering services. These services would be provided by fertilizer engineering experts, for a period of about three years, to be financed under the loan..hese experts will be internationally recruited in accordance with Bai.k guidelines. The terms of reference for the consultants, to be appointed not later than May 1, 1991, were agreed during negotiations. Gresik will set up a project management team composed of its own experienced staff and supplemented by staff to be hired from other domestic fertilizer enterprises, as required.

29 The Optimization Component 3.23 The implementation of this component will be the responsibility of each of the four PFEs concerned with these investments. Three enterprises, Kaltim, Kujang, and PUSRI, have prepared preliminary proposals that were reviewed during appraisal. Detailed feasibility studies are under way and are expected to be completed by March PIM has started to develop a proposal, assisted by Koneba, which would also be fully appraised by March In addition, each PFE will prepare an environmental impact assessment of these investments. Appraisal reports and environmental assessments will be submitted to the Bank, not later than June 30, 1992, for review and approval. These investments are expected to be implemented during a period ranging from 1 to 3 years. PIM, Kaltim, Kujang and PUSRI will, not later than May 1, 1991, appoint consultants to assist them in the imp'ementation of their respective optimization subprojects, under terms of reference satisfactory to the BAnk and procured in accordance with Bank Guidelines for the Use of Consultants. The Studies Component 3.24 The Distribution and Marketing Study will be managed by the Directorate General of Chemical Industry of the MOI; this Directorate will entrust PUSRI with the distribution part, and will appoint a team of foreign and local consultants for the marketing part. Both parts would be undertaken under terms of reference acceptable to the Bank. For the marketing part of the study, the above Directorate will employ qualified and experienced consultants. To coordinate and supervise the implementation of this study, the Government, not later than May 1, 1991, will establish a Steering Committee comprising representatives from MOI (Director-General of Chemical Industry as Chairman); EKUIN; MOA; the Ministry of Trade; the Ministry of Cooperatives; and the Indonesian Fertilizer Producers' Association (APPI). The study is scheduled for completion by March 1, The Government and the Bank will review the recommendations of the Distribution and Marketing Study, not later than 60 days after this completion, and agree on an action plan to implement them. Assurances to the above effects were obtained during negotiations Development of an Environmental Management Program for the Fertilizer Industrv will be undertaken by a team of qualified and experienced foreign and local consultants, (to be appointed by the Directorate-General of Chemical Industry of the MOI), under terms of reference acceptable to the Bank. The Government will set up, not later than May 1, 1991, a Steering Committee to coordinate and supervise the implementation of this study, chaired by the MOI's Director General of Chemical Industry and composed of representatives from EKUIN, MOA, KLH and APPI. The study is scheduled for completion by March 1, The Government and the Bank will review the recommendations of this study, not later than 60 days after this completion, and agree on an action plan to implement these recommendations. Assurances to the above effects were obtained during negotiations.

30 Project Implementation and Supervision 3.26 Overall Project monitoring and coordination will be the responsibility of the Directorate General for Chemical Industry of the MOI. A set of key implementation indicators is given in Annex 8, Section A. The Project will require about 10 staff-weeks of Bank staff annually for supervision, comprising mainly enginteering, financial, environment and project management expertise. A Project supervision plan is at Annex 8, Part B. IV. PROJECT COST, FINANCING PLAN, AND LOAN FEATURES A. Project Cost 4.1 The total financing required for the Project is estimated at $444.3 million equivalent, including $222.4 million in foreign exchange (50 percent), as detailed in Annex 4 and summarized in Table 4.1 below. The estimates include appropriate physical contingencies, expected price increases, interest during construction, and incremental working capi-l. The total installed cost for the new Gresik ammonia/urea plant is based on the actual contract price, and therefore no contingencies have been added for this investment. The base-cost estimates for the optimization subprojects were prepared by the various PFEs and have been reviewed and adjusted to mid-1990 prices. Price escalations have been estimated using the expenditure schedules prepared by the PFEs. The price contingencies are based on: (a) domestic inflation of 6.5 percent in 1990 and 1991, and 6 percent in the subsequent ye'.rs; and (b) international inflation rates of 3.6 percent in 1990 and thereafter. The Rupiah costs have been converted to U.S. dollars using an exchange rate of $1.0 = Rp 1,830 for the life of the Project. Interest during construction has been calculated using an interest rate of 18.0 percent per annum. Table 4.1: PROJECT COST SUMMARY /a Foreign Percent of Component Local Foreign Total Local Foreign Total Exchange Total Base - Rp billion S million Percent Cost Gresik Restructuring L sa 78 Optimization Studies Total Base Cost Physical Contingencies / Expected Price Increases /c Interest During Const Working Capital Total Prolect Cost and Financing Requirod S0 128 /a = Rp 1,830 Lb Includes identifiable taxes on services estimated 84.0 million. Lc Applicable only to the Gresik Modernization SubproJect and the Optimization Component.

31 The P.T. Petrokimia Gresik Restructuring Component. This component, with a total cost of $321.2 million, comprises two subprojects: the new amnonia/urea plant and the modernization of Gresik's existing plants. The new Gresik ammonia/urea plant would cost a total of $305.4 million, including incremental working capital ($20.0 million) and interest during construction ($42.6 million). The capital cost is based on firm price bids and assumes that the natural gas feedstock will be delivered by Pertamina at the plant premises at the agreed tariff ($2.0 per MMBtu), with all pipeline facilities owned and operated by Pertamina and with no gas transmission capital costs required of Gresik. The total direct foreign exchange requirements of the new ammonia/urea plant are estimated at $126.3 million. Details of the capital costs are given in Annex 5-1 and are summarized in Table 4.2. The proposed ammonia/urea plant will be located within the existing Gresik complex near Surabaya and will share the already existing plant infrastructure such as the port, water supply, power generation, and maintenance facilities. Capital costs are therefore considerably lower than a comparable 'greenfield facility," and the subproject is much less likely to experience capital cost Table 4.2: P.T. PETROKIMIA GRESIK RESTRUCTURING COMPONENT - CAPITAL COST ESTIMATE ($ million) Local Foreign Total 1. Ammonia/Urea Plant Ammonia process licensor Urea process licensor Civil works and erection Gresik-supplied equipment and services Subtotal Working Capital Interest During Construction Total Subproject Cost Modernization of Fertilizer Plants Subtotal Physical contingencies Expected price increases Subtotal Interest during construction Total Subproject Cost Total Component Cost

32 overruns and construction delays. The capital cost of the Gresik modernization subnroject is estimated at $15.8 million, including contingencies; $9.8 million is in foreign exchange, and $3.8 million in interest during construction. Details of the capital costs and expected operating benefits and costs are being prepared by Gresik and would be fully developed before the subproject is submitted to the Bank for review and approval. 4.3 Optimization Component. The estimated financing requirements of the various schemes being considered for inclusion in the Optimization Component of the Project amount to $122.2 million equivalent, including total foreign exchange requirement of $85.6 million equivalent. The estimate includes adequate provisions for physical contingencies, price escalation, and interest during construction. Table 4.3 summarizes the financing requirements of the individual components that would be included in the Optimization Component, and details for some of these investments are given in Annex 5-2 through Annex 5-4. Table 4.3: OPTIMIZATION COMPONENT - ($ million) CAPITAL COST ESTIMATE Local Foreign Total Base Cost Estimate Pusri II Urea Pusri Effluent Treatment Facilities Kaltim I AmmonialUrea Kujang Ammonia PIM Ammonia Total Base Cost Estimate (BCE) Physical contingencies Expected price increases Total Component Cost Interest during construction Total Financing Required Capital cost estimates of the optimization component have been prepared by the individual companies. In the case of PUSRI II urea optimization the company has invited proposals from the major urea process licensor and has evaluated them for both technical and cost considerations. The capital cost estimates are based on the selected proposals, which include details of the proposed plant modifications and the expected cost estimates. The PUSRI effluent treatment subproject includes a package of schemes aimed to improve effluent quality, and the estimates have been prepared by PUSRI from in-house information. The scope and cost estimates for the Kaltim I optimization project have been determined in-house by the Kaltim technical

33 staff. This subproject envisages consultant studies to evaluate and firm up the various options; the cost estimates should, therefore, be considered preliminary. The potential options arising from this study are being further evaluated by Koneba to determine the scope and cost estimates for the Kuiang ammonia optimization subproject. PIM has contracted Koneba to evaluate optimization options for the Iskander Muda ammonia plant. The present estimates for the PIM ammonia optimization project--based on similar schemes in other plants--should be considered preliminary, to be firmed up when the Koneba studies are completed. 4.5 Studies Component. This component includes support for the preparation of the two studies: a marketing and distribution study, and development of an Environmental Management Plan for the Fertilizer Sector. The cost of the two studies (Table 4.4) has been estimated in consultation with the Indonesian authorities, considering the scope of the studies and the local and foreign expertise required to implement them. Table 4.4: STUDIES COMPONENT - ($ million) COST ESTIMATE Local Foreign Total Marketing and Distribution Development of Environment Management Plan for the Fertilizer Sector Total Cost B. Financing Plan 4.6 The financing plan is presented in Table 4.5. Overall, the Bank loan of $221.7 million would finance 50 percent of project costs and almost all (over 99 percent) of the estimated foreign exchange requirements. The PFEs would provide $144.5 million, or 33 percent of project costs. Local cost loans from Bank Negara Indonesia 1946 (Bank BNI) to P.T. Petrokimia Gresik would provide $78.1 million, or 17 percent of project costs.

34 Table 4.6: FINANCING PLAN Local Foreign Total X of total m- (l illion) Gresik Restructurina Component Equity (Gresik) LT borrowing - World Bank MT borrowing (Bank BNI) ST borrowing (Bank BNI) Subtotal Optimization Component Equity (four fertilizer companies LT borrowing - World Bank Subtotal Studies Component Equity (five fertilizer companies) Subtotal Total Financina Equity LT borrowing - World Bank S0 MT borrowing (Bank BNI) S ST borrowing (Bank SNI) Total Financing Required Onlending Arrangements C. Features of the Loan 4.7 Lending and Allocation Arrangements. The proposed Bank loan of $221.7 million would be lent to the Republic of Indonesia at the Bank's standard variable rate and on standard country terms: 20 years, including a grace period of 5 years. The MOF would act as the Government's agent. During negotiations an agreement was reached that the Government would allocate the proceeds of the loan as detailed below: (a) Each of the PFEs will subscribe to a portion of the loan, based on the amount of funds it expects to utilize for its respective components. The allocations are shown in Table 4.6. (b) The Government would charge the PFEs a commitment fee on the undisbursed balance of their respective loan allocations equal to the commitment fee payable by the Government to the Bank.

35 Table 4.6: INITIAL ALLOCATION OF LOAN PROCEEDS TO PARTICIPATING FERTILIZER ENTERPRISES PFE Amount ($ million) Gresik Restructuring Component P.T. Petrokimia Gresik: Ammonia/Urea Plant Modernization of Existing Plant 9.8 Subtotal Optimization Component P.T. Pupuk Sriwidjaja 25.1 P.T. Pupuk Kalimantan Timur 37.1 P.T. Pupuk Kujang 12.7 P.T. Pupuk Iskandar Muda 10.7 Subtotal 85.6 Total (c) Funds to the PFEs will be lent by MOF through Subsidiary Loan Agreements (SLAs) with each institution. Loan proceeds onlent to Gresik for the new Gresik ammonia/urea plant would be for a fixed term of 15 years, including 5 years of grace. Loan proceeds onlent to the PFEs for the Optimization Component and the Gresik modernization subproject would be for a fixed term of 10 years, including 3 years of grace. At negotiations, the Government and the Bank reviewed the draft SLAs between MOF and the PFEs. All PFEs would sign a Project Agreement with the Bank outlining their obligations in implementing the proposed Project. Signing of SLAs between MOF and the five PFEs, on terms and conditions acceptable to the Bank, for undertaking of the respective project components would be a condition of loan effectiveness. (d) To ensure that the onlending rate for Bank funds reflects the market rate for domestic term-funds to Indonesian enterprises, the onlending rate to the five PFEs will be at a variable interest rate pegged to BI's three-month SBI (until the introduction of a sixmonth certificate in June 1990, this was BI's SBI of longest tenor). This rate would be adjusted on January 1 and July 1 of each year, based on the average of SBI three-month maturity quotations during the preceding six months plus one percentage point. While the Government would bear the foreign exchange risk, this formula for establishing the cost of funds from the Government to the PFEs includes an implicit premium reflecting market expectations regarding exchange rate changes. Since deposit rates in Indonesia are market-determined and capital flows are generally unrestricted, this approach would result in a rate that approximates the market rate for prime industrial enterprises borrowing from local financial

36 institutions. To protect the PFEs from possibly excessive volatility in the reference rate, the onlending rate would not exceed the average of end-of-day quotations of the five SCBs' threemonth time deposits during the same preceding six-mcnth period plus one percentage point. (e) Gresik, for its modernization subproject, and the other PFEs, for their optimization subprojects, will, not later than June 30, 1992, submit to the Bank for review and approval a Subproject Appraisal Report and an snvironmental impact assessment of the subproject, including an Executive Summary of the latter (in English). The subproject appraisal reports would include: (i) subproject objectives and description; (ii) estimated cost, local and foreign, including physical and price contingencies, incremental working capital, and interest during construction (if applicable); (iii) proposed financing plan; (iv) procurement method; (v) subproject organization and management; (vi) benefits; (vii) financial and economic analysis, including FRR and ERR and sensitivity analysis; (viii) environmental analysis (summary of the EIA and proposed remedial actions, as appropriate); (ix) risks; and (x) detailed implementation schedule. Environmental Impact Assessments would include: (i) an executive summary (not to exceed 10 pages) of the environmental assessment (in English) including the significant findings and recommended actions; (ii) baseline data (not to exceed 10 pages) of the study area's existing relevant physical, biological and socio-economic conditions, including the relevant government environmental regulations pertaining to the subproject and the status of any environmental assessment required by government authorities; (iii) a description of the potential environmental impacts, positive and negative, direct and indirect resulting from the subproject; (iv) the proposed feasible, cost effective mitigation plan for the subproject, outlining the measures to reduce any significant adverse impacts on the environment to acceptable levels; and (v) the environmental monitoring and management plan for the subproject, including how it will be implemented and by whom. Assurances to the above effects were obtained during negotiations. Conditions of disbursement for these subprojects would be that each subproject appraisal report and environmental impact assessment will have been found satisfactory to the Bank. 4.8 Retroactive Financing. The Government has requested retroactive financing of up to $22.2 million to cover advanced procurement of imported equipment and services incurred by the PFEs. Such advanced procurement is necessary to avoid Project implementation delays due to the long lead time required to purchase certain items of equipment and to appoint key engineering services, for which there is no other source of financing a'ailable. Procurement of the equipment and services covered by the retroactive financing would be in accordance with Bank Guidelines. Retroactive financing would be limited to 10 percent of the Bank loan and restricted to costs incurred after January 15, 1990.

37 Loan Administration 4.9 Procurement. The procurement arrangements for the Project are summarized in Table 4.7. Equipment and materiale as well as engineering Table 4.7: PROCUREMENT ARRANCEUENTS (- m1 I ion) /s Project Components Total and Elements ICB LIB LCB Other N.A. Cost A. Gresik Restructuring (a) Amnmonia/Uree Plant Ammonia Process Equipment and Materials (12 1) (10-0) (8.2) (80 3) Engineering Services and 12)8 ( Licenses (12.8) (128) Urea Process EquIpment and Materials B (12.4) (8.0) (8. 1) (23.5) Engineering Services and Licenses (9.0) (9.0) Civil Works, Erection and Commissioning Gresik Supplied Equipment (b) Plant Modernization Equipment and Materials e (.0(.8) )Q8 Engineering Services and (.87) (0.8) -(0.4) 02.7 Licenses (1.7) (1.7) (c) Consultants for: (i) Ammonia/Urea Plant (0.7) (0.7) (ii) Plant Modernization (0.8) (0.3) S. Optimization Equipment and materials for: i) Iskander Muds (ii) Kaltim.6(2) ) (88.6) (iii) Kujang 2.4 1(0) ~94) (10) f0:8) (11.2) (iv) PUSRI f (80.6 (184) (2.0) (0.8) (21.2) Engineering Services and Licenses for: (l) Iskander Muds (1.25) (1.25) (ll) Kaltim (8.25) (8.25) (lli) Kujang (iv) PUSRI (1. 26) (1.26) (lv) PUSRI 3:~ (8.65) (8.85) Consultnnts for: (i) Isksnder Muds (0.25) (0.25) (li) Knitim (iii) Kujang ( (0.25) 0.26 (iv) PUSRI ( ) (0.25) 0.26 (0.26) (0.26) C. Studies Consultants D. Others /b Total (176.6) (24.4) - (21.8) - (221.7) ZE Figures In parenthesis are the respective amounts to be financed under the Bank loan. Comprises working capitel and Interest during constuction.

38 _ 31 - services and licenses, with a total value of $142.6 million equivalent will be procured through ICB in accordance with Bank guidelines. Exceptions to ICB will be made for: (a) equipment proprietary to the process design, with an estimated value of $19.8 million, to be procured by direct purchase from original suppliers eligible under the Bank guidelines; (b) contracts with an estimated value of less than $400,000 each (about $24.4 million) to be procured under limited international bidding procedures (LIB) after solicitation of quotations from at least three suppliers eligible under the Bank guidelines; and (c) contracts with a value of less than $100,000 each (in total about $9.0 million) to be procured by international shopping procedures acceptable to the Bank. The aggregate of equipment contracts financed under the Bank loan to be procured under LIB and international shopping procedures will not exceed $32.0 million equivalent. To the maximum extent possible, identical or similar items would be grouped together r purposes of bidding and procurement. For purposes of evaluation and comparison of bids for the supply of goods under ICB, qualified domestic suppliers will be allowed a preference of 15 percent of the c.i.f. price or the applicable import duty, whichever is lower. Contracts for equipment and materials exceeding $1.0 million and all contracts for engineering and consultancy services financed under the loan will be subject to the Bank's prior review of procurement documentation, resulting in a coverage of about 70 percent of the total estimated value of Bank-financed contracts. Other contracts for equipment and materials will be reviewed by the Government Procurement Control Units, as required, and by the Bank on a sample basis, subsequent to their award Ci-iil works contracts totaling $25.0 million, to be financed wholly by the PFEs, will be awarded through local competitive bidding (LCB). None of these civil tiorks contracts will exceed $1.5 million, and they are not likely to attract interest from foreign bidders. Contracts for consulting services financed by the Bank ($2.0 million) will be awarded in accordance with the Bank Guidelines for the Use of Consultants. A General Procurement Notice for the Project has been published. Disbursements 4.11 Disbursements of the proposed Bank loan would be made as shown in Table 4.8. Disbursements will be made against full documentation. The estimated schedule of disbursements for the Bank loan (Annex 6) has been made on the basis of the disbursement profiles of industry projects in Indonesia and the Asia Region. It is anticipated that the loan would be conmitted by June 30, 1996, and fully disbursed in seven years; thus the Project is expected to be completed by June 30, 1997, and the loan closing date will be December 31, 1997.

39 Table 4.8: ALLOCATION OF BANK LOAN ($ million equivalent) Component/Category Amount Percent of Costs to b Financed (I million) A. Gresik Restructuring (a) Equipment and Materials for: 1OOX of foreign expenditures for (i Ammonia/Ures Plant directly iuported items: 90 of local (ii) Modernization 7.8 expenditure for locally manufactured items (ex-factory costs); and 60! of other items procured locally. Subtotal (b) Engineering Services and Licenses for: (i) Ammonia/Urea Plant 21.8 (li) Modernization 1.7 Subtotal % of expenditur e. (c) Consultants for: (i) Ammonia/Urea Plant 0.7 (ii) Modernization 0.8 S. Optimization Subtotal 1.0 1OOX of expenditures. (a) Equlpment and Materials for: (I Iskander Muds X of foreign expenditures for (ii Kaltim 88.6 directly Imported Items; 90% of local (ii Kujang 11.2 expendituroe for lo-illy manufattured (iv PUSRI 21.2 tems (ex-factory..sts); and 6OX of other items procured locally. Subtotal 76.2 (b) Engineering and Services and Licenses for: (I Iskander Muds 1.26 *ii) Kaltim 8.26 (ili Kujang 1.26 (iv PUSRI 8.66 Subtotal l of expenditures. (c) Consultants for: I) Iskander Muda 0.26 (ii) Kaltim 0.26 (iii) Kujang 0.26 (Iv PUSRI 0.26 Subtotal OOX of expenditures. Total Auditing and Reporting. The financial accounts of the PFEs would be audited by the Financial and Development Supervisory Board (BPKP), which is acceptable to the Bank. Each PFE would submit to the Ba-:.; the report of BPKP (in English) no later than six months after the end of its fiscal year. All PFEs woul be required to submit semiannual progress reports (in English), acceptable to the Bank, covering their respective operations under the Project. These auditing and reporting arrangements have been confirmed at negotiations. The Project Completion Report will be prepared by the Directorate General of Chemical Industry in MOI.

40 V. FINANCIAL, ECONOMIC, AND ENVIRONMENTAL ANALYSIS AND PROJECT RISKS A. Financial Analysis Financial Analysis of Gresik Ammonia/Urea Plant 5.1 Past Financial Performance. Gresik's past financial performance has been satisfactory and reflects the combined effect of the steady output of its two principal products, TSP and AS, Government-controlled prices, and a good volume of sales of industrial chemicals. In the four-year period , sales have increased by an average of 13 percent p.a. The production volume of TSP has increased at a rate of only 2 percent p.a., while AS production has increased by 4 percent p.a. during Earnings throughout the four-year period have been consistently positive, althougn at times marginal, primarily as a result of steadily increasing costs due to inflation and sporadic Government price adjustments. In 1988, fertilizer prices were reduced by an average of 2 percent; as a consequence, after-tax net income declined to only Rp 2.4 billion in 1988 compared with Rp 37.8 billion in Net income levels were satisfactory at Rp 18.5 billion in 1989, representing a 6.9 percent return on equity or a 3.5 percent return on total assets. Gresik's current financial condition is sound, with a total long-term debt/equity ratio averaging 1:1 for The current ratic is favorable, at 1.4 times for year-end Debt service coverage has ave_aged a satisfactorv 2.4 times over the past four years. Gresik's recent operating performance and key financial indicators are summarized in the Table 5.1. Detailed financial assumptions and data are shown in Annexes 7-1 through 7.4. Table 5.1: GRESIK - HISTORICAL FINANCIAL DATA (Rp billion, unless otberwise stated) Item /a Sales Net income Accounts Receivable Internal cash generation lb Net income/sales, (percent) Net income/total assets, (percent) Current ratio Debt/equity ratio 1/1.7 1/2.1 1/2.0 1/2.6 Debt service coverage, times Net income/equity, (percent) Accounts Receivable/Sales /a Unaudited. /b Net income plus depreciation. 5.2 Production Volumes and Unit Prices. During , Gresik's TSP volume increased from 1,120,000 tons in 1986 to 1,200,000 tons in 1989, an

41 average annual '^crease of 2 percent, while its production of AS increased from 577,000 tons in 1986 to 632,000 tons in 1989, a 4 percent per year increase. Unit prices for AS during the same period declined by an average of 2 percent from Rp 215,000 per ton in 1986 to Rp 211,000 per ton in 1988 but rebounded to Rp 226,500 per ton in 1989, an increase of 7 percent. TSP unit prices, in contrast, increased by an average of 12 percent per year, from Rp 276,600 per ton in 1986 to Rp 307,100 per ton in 1988, and in 1989 were further raised to Rp 381,000 per ton, an increase of 24 percent. 5.3 Operating Costs and Margins. In contrast to the modest increases in production volumes and unit prices, operating costs (not including interest charges) increased an average of 14 percent per year during Consequently, gross profit and operating profits (on sales) were reduced from the 19 percent gross profit and 9 percent operating profit experienced in 1986 to a 5 percent operating loss in In 1988, however, income from subsidiaries and outside income from Gresik's metal fabrication facilities turned the operating loss into a modest profit of F billion. In 1989, Gresik showed an operating profit of Rp 15.6 billion, representing a 2.5 percent return on sales. 5.4 Financial Structure. Gresik's level of long-term debt to equity is very conservative (1989 long-term debt/equity ratio was 1:1), and no additional paid-in capital would be required during the construction period for the new ammonia/urea plant. Projected long-term debt to equity (paid-in capital plus retained earnings) is not expected to exceed 1:1 during Gresik markets its two principal products, TSP and AS, through PUSRI's marketing and distribution system. This sales arrangement results in Gresik carrying on its balance sheet an accounts receivable that in the past four years has averaged nine months of sales--very high for an enterprise producing a baa' commodity such as fertilizer; comparable commercial enterprises would be expected to carry receivables of from 60 to 90 days of sales. Some of the receivables can be offset by withholding or delaying payments to creditors or suppliers (accounts payable), but purchases of imported raw material or payroll obligations must be met on time. The Government offers interim financing of 80 percent of Gresik's receivables from PUSRI at a nominal interest rate of only 3 percent. Thke consequent high receivables and payables result in a balance sheet that con3ists mainly of current accounts (four-year average: 70 percent). 5.5 Financial and Operating Strategy of the Gresik AmmoniajUrea Plant Subproject. The construction phase of the new ammonia/urea plant would take an estimated 36 months from start to production. At completion, Gresik's total assets will be more than doubled. Under the subproject, the production levels of TSP and AS would remain at the pre-project levels of 1,220,000 tons for TSP and 650,000 tons of AS, but a cleaner, more efficient natural gas conversion plant would substitute for the existing and aging fuel-oil conversion plant that is now used to produce ammonia. In addition, the new ammonia plant would supply feedstock to an urea plant (also built as part of the subproject) with an annual capacity of 460,000 tons of urea. Because the ammonia/urea plant is scheduled to commence commercial production in late 1993, only 190,000 tons of urea would be produced in Froum a financial standpoint, the subproject, because of lower unit production costs, would enable Gresik to adjust its fertilizer unit prices to border prices by 1994 while obtaining a satisfactory return on assets and stockholders' equity.

42 Without the new ammonia/urea plant, Gresik's earnings with border prices would not be sufficient to cover even routinely needed equipment replacements. 5.6 Comparison of Production Volumes and Gross Profits. Projections, shown in Annex 7-5, compare, in 1989 values, the "with" and "without" project production volumes and gross profits with border prices. As seen, with border prices and no urea production, Gresik's gross profit from its main products (TSP and AS) would be significantly reduced. It is only with the addition of by-product revenue that Gresik would show a minimal gross profit (Rp 12.9 billion) that would result in a break-even situation when administrative, marketing, and other charges are added. However, 'with project" at border prices for urea, gross profit would double from Rp 42.5 billion in 1989 to Rp 88.3 billion at full production in 1994, before by-product revenue. 5.7 Projected Financial Performance. Under the Project, with current prices and projected border prices for the main products, all financial parameters are forecast to remain favorable. During construction, financial ratios (such as net income to sales) will increase from the 2.9 percent in 1989 to 6.5 percent by 1994, due primarily to the reduced variable costs caused by the switch from oil to natural gas and the inclusion of urea production at border prices. The same trend holds for net income to assets (1989: 2.3 percent; 1994: 5.0 percent). Current ratios are projected to remain at 1.3 or above during the project period. Debt service coverage averages an adequate 2.2 times during Net income to equity yields a satisfactory 15.5 percent at full production (1994). A summary of Gresik's financial performance under the project is shown in Table 5.2 and in more detail in Annex 7-4. Table 5.2: GRESIK - PROJECTED FINANCIAL DATA WITH PROJECT (Current Rp billion, unless otherwise noted) Item Sales Net income Internal cash generation Net income/sales, (percent) Net income/total assets, (percent) Net income/equity, (percent) Current ratio Debt/equity ratio 1/2.3 1/1.0 1/ /1.4 Debt service coverage, times Optimization Component 5.8 Summary financial statements for PUSRI, Kaltim, Kujang, and PIM are shown in Annexes 7-6 through 7-9. These four PFEs are generally lightly leveraged, with long-term debt/equity ratios ranging in 1989 from no long-term debt in the case of Kujang to a still conservative, long-term debt/equity ratio of 1.9 for PIM. Another structural characteristic of the four urea/

43 ammonia-producing enterprises is their high percentage of current assets to total assets (average 45 percent in 1989). In the case of PUSRI, the percentage of current assets to total assets is 73 percent, which is explained by its marketing and distribution responsibilities, whereby it must maintain relatively larger proportions of working capital and inventory. The remaining three have no requirement or facilities for keeping extensive inventories, and the major portion of current assets consists of cash, short-term securities, and receivables, indicating a slow payment practice by the Government in settling accounts. The PFEs have adapted to this payment procedure by keeping a sizable cushion of cash and short-term securities on hand (1989 average for Kaltim, Kujang, and PIM: 27 percent of annual sales). All four of the urea/ammonia-producing enterprises have ample capacity to take on the equity and debt requirements of the optimization subprojects. Each subproject represents a much smaller project in terms of the ratio of new assets acquired to existing assets compared with the proposed new Gresik ammonia/urea project, in which Gresik's total assets will more than double. By contrast, the investment requirements of the Kaltim subproject (the largest optimization subproject at $41.4 million), represent only 6 percent of Kaltim's total assets at year-end All of the four PFEs carry equity investments on their balance sheets, ranging from only $0.2 million in the case of PIM to $16 million for Kujang. Kujang has invested in several downstream chemical operations. 5.9 Past Financial Performance. Past financial performance of the four current ammonia/urea producers has been satisfactory, but returns have been relatively low in terms of net income to total assets or total capital (equity). In 1989, the four enterprises returned a 5.4 percent average of net income to assets and an 8.2 percent average return on capital. Net income to total sales performance has been consistently positive, with an average for the four PFEs in 1989 of 9.8 percent (a high of 10.9 percent for Kaltim and a low of 4.9 percent for PIM). Financial Rate of Return (FRR) and Sensitivity Analysis 5.10 New Gresik Ammonia/Urea Plant. The base FRR of this subproject of the Gresik Restructuring Component has been calculated using constant 1990 price levels for costs and 1990 border price levels for the urea production (Table 5.3). Under the base situation, the subproject shows a 16.6 percent rate of return over a period from 1990, the start of construction, until Annex 7-10 is a summary of the incremental costs and revenues of the base case which is derived from the income statement and sources and application of Gresik projected in 1990 values (Annex 7-3). Sensitivity analyses were based on projected border prices, current domestic ex-factory prices, reduced border prices, lagged construction schedules, and 20 percent capital cost overruns.

44 Table 5.3: P.T. PETROKIMIA GRESIK AMMONIA/UREA PLANT SUMMARY OF FINANCIAL RATES OF RETURN (1990 prices) Item FRR (percent) Base case - at projected 1993 border price for urea ($155/ton) 16.6 /a Border price projections for urea percent of border price projections for urea 15.3 Capital costs increased by 20 percent 13.6 Construction period extended by five months (until 1994) 15.1 Lengthened construction period with 20 percent increased capital costs 12.3 At 1990 domestic ex-factory prices for urea ($125/ton) 12.2 /a Landed, bagged price per ton (1990 prices): Base case i Border price projection Z of border price projection 124 1V Optimization Component. The subprojects of the Optimization Component that have been worked out in detail all show satisfactory financial returns. The PUSRI optimization subproject (Annex 7-11) shows a FRR of 32 percent using 1990 border prices. Using projected border prices, the return is even higher. The same is true for the Kaltim optimization component (Annex 7-12), which has a base FRR of 37 percent. Relatively high capital costs and a relatively modest increase in production limit the Kujang subproject (Annex 7-13) to 16 percent using 1990 border prices. PIM has not yet completed all the financial projections required for its subproject. Each of the subprojects will be subject to further review and approval when submitted by the PFEs to the Bank. B. Economic Analysis 5.12 Economic Costs and Benefits. The principal assumptions used in the economic analysis of the various components of the Project are described in Annex The economic costs and benefits of internationally traded items have been valued at border prices. Wherever possible, prices have been obtained from the latest commodity price forecast revisions of the Bank's Commodity Studies and Projections Division. In all other cases, price projections have been derived by maintaining an appropriate relationship among the different prices. Ammonia and urea, in which Indonesia is in a competitive position and is already a significant exporter, have been valued at border export prices. Other items have been valued at landed costs.

45 Natural gas has been valued at fuel-oil equivalent at Gresik and Kujang, since at these locations there is a significant demand for gas for alternative energy uses. At Kaltim and PIM, natural gas has been valued in economic terms at the present delivered cost of $l.oo/mmbtu. All prices have been expressed in constant 1990 U.S. dollars. Since no duties and taxes are applicable on capital investments in the fertilizer industry, the economic capital costs are the same as the financial project costs, less price escalations and interest during construction. Conservatively, local currency costs have been converted to U.S. dollars at an exchange rate of $1.00 = Rp 1,830, without further deflation The major economic benefits from the various subprojects under the Project are: (a) for the new Gresik ammonia/urea facility, additional production of urea and replacement of ammonia (para. 3.5); (b) for PUSRI II urea optimization, additional urea production converting a part of the surplus ammonia becoming available from the ammonia optimization project and PUSRI Ib new ammonia/urea facility; (c) for Kaltim I optimization, additional urea production, partly in granular form, and reduction in energy consumption; and (d) for Kujang ammonia optimization, additional ammonia production and a reduction in energy consumption. For PUSRI effluent treatment, PIM ammonia optimization, and Gresik plant modernization subprojects, no economic analysis has been carried out because, in the first case, the benefits are not quantifiable and, in the other two cases, the subprojects are still in the preparation stage New Gresik Ammonia/Urea Plant Subproject. Since the ammonia produced from the project will substitute (a) ammonia and carbon dioxide now being provided from the existing fuel-oil-bas-i ammonia plant for gypsum-based AS production and (b) ammonia delivered from Kaltim, the impact of the project on the overall economics of the complex is assessed on the basis of the entire complex with and without the project. The base ERR of the new Gresik ammonia/urea plant, considering the subproject as an integral part of the complex, is calculated at 19.5 percent (Annex 7-15) The sensitivity analysis contained in Table 5.4 indicates that the ERR of the subproject remains adequate, over a wide range of project risks. The switching-value analysis indicates that the capital cost has to go up by more than 75 percent, and the urea price has to come down by more than 28 percent, before the subproject's ERR will go below 10 percent. Such large changes due to one or a combination of the risks are unlikely to occur, and the project will therefore be economically viable over a range of unfavorable conditions.

46 Table 5.4: P.T. PETROKIMIA GRESIK AMMONIA/UREA PLANT - SUMMARY OF ECONOMIC RATES OF RETURN (1990 prices) ERR (percent) Base Case (total complex basis) 20.7 Sensitivity Tests (total complex basis) Capital cost up by 20 percent 17.6 Construction period extended to four years 17.4 Drop in urea price by 20 percent 16.2 Gas price up by 20 percent 18.4 Switching Values for 10 percent Economic Rate of Return Capital Increase by 98 percent Urea price Decrease by 43 percent 5.16 Optimization Component. On the basis of the cost and benefit streams for the PUSRI II urea optimization contained in Annex 7-16, the subproject will have an ERR of 37.2 percent. If adjustments are made for a part of the investment for the above subproject, such as replacement of the existing titanium-lined urea reactor (which will in any case be necessary for the continued operation of the existing PUSRI II urea plant), the subproject's ERR will be even higher. The cost and benefit streams for the Kaltim I optimization contained in Annex 7-17, show that the subproject will have an ERR of 57.1 percent, based on an economic value of natural gas of $1.00 per MMBtu. Since the increase in gas requirements after the optimization is very small, the ERR changes only marginally, even though the economic value of gas is taken as $2.00 per MMBtu Foreign Exchange Earnings. The total Project, including all its components, has a foreign exchange investment requirement of about $220.0 million. The project will contribute an additional urea output of about 820,000 t, of which about 119,000 t will be in granular form. At border prices per ton of urea (prill) of $150, urea (granule) of $160, and ammonia of $110, the additional output could contribute about $135 million per year as incremental net export income. C. Environmental Analysis 5.18 Gresik Fertilizer Complex. In June 1990, Gresik completed a SEL 2/ (para. 1.23) for the Gresik complex which has been approved by the Central Environmental Commission (CEC). The SEL has been reviewed by the Bank 2/ Study of Environmental Evaluation of Petrokimia Gresik Industrial Area, by PPKL Lemlit Unair, June 1, 1990.

47 and found satisfactory. The principal environmental problems outlined in the SEL relate to gaseous NH3 and S02 emissions from various parts of the complex and to liquid effluents containing dissolved NH 3, chemical oxygen demand (COD) and biochemical oxygen demand (BOD) from the wastewater treatment facility Gaseous Effluents. Emissions of NH 3 and S02 in excess of local or accepted international standards originate from four locations in the Gresik complex: the present ammonia plant (NH 3 and NO.). the sulfuric acid plant (SO 2 ), the power generation facility (SO 2 ), and the AS plants (NH 3 ). Under the proposed Project, the old ammonia plant will be permanently closed and dismantled, thus eliminating the existing hazardous gaseous NH 3 emissions. The power generation facilities at Gresik would be converted to natural gas under the Project, thereby eliminating SO 2 emissions from that source. Gresik has two sulfuric acid plants. One is a modern facility and the S02 emission levels are acceptable. The other sulfuric acid plant was built in 1972 and is relatively inefficient with regard to energy and sulfur recovery. SO 2 emission levels of 2,400 ppm compare with the locally acceptable level of 2,100 ppm and the international standard of 2 kg S02 per ton of acid produced. Ambient SO2 levels are acceptable (less than 0.2 ppm SO 2 ). Gresik has held up retrofitting or renlacing the older plant with less polluting technologies until the overall demand for sulfuric acid would justify the investment. The disposition of the old sulfuric acid plant will be assessed under the Gresik plant modernization subproject. Gaseous effluents of the AS operations at the complex contain from 40 ppm to 70 ppm of NH 3 and are scrubbed to reduce the ammonia. The environmental impact study identified the scrubbing operations as areas requiring improvement. Another potential source of toxic gaseous emissions is the phosphoric acid plant, which produces fluoride gas that is i recovered and processed effectively into aluminum fluoride, a valuable byproduct Liquid Effluents. At present the Gresik complex utilizes a centralized wastewater treatment plant that collects and processes all runoff and other liquid effluents for discharge into the sea. The environmental impact study notes that, during periods of high throughput (high rainfall), effluen: from the treatment plant exceeds local and international standards for NH 3, COD, and BOD. The liquid effluents from the new ammonia/urea plant will contain less than 5 ppm NH 3 and will lower the total NH 3 effluents though total liquid volume will be larger. In its environment management plan, Gresik will incorporate a provision for increasing the capacity of the centralized wastewater treatmer.. plant to reduce total effluent discharge, including maximum flows to meet international standards for all contained pollutants Solid Waste. Problems with solid wastes at the Gresik complex relate to the proper management and location of landfills for unwanted byproducts, precipitated sludge, and spent catalysts. The plan to sell the byproduct calcium carbonate to an adjacent cement manufacturer to substitute partially for natural limestone has not materialized, and calcium carbonate is stockpiled in areas adjacent to the complex. The waste liquid effluents from the various parts of the complex contain high amounts of fluorine (up to 4,000 ppm). These are collected and treated with lime in the centralized wastewater treatment plant to precipitate as a sludge containing calcium silicofluoride. The sludge is thickened, filtered, and then landfilled. The water effluent contains virtually no residual fluoride. Many of the chemical processes in

48 the complex utilize catalysts containing heavy metals such as chromium and vanadium. At present, the spent catalysts are disposed of routinely in a landfill whereas they should be recycled and subsequently treated as hazardous materials The anvironmental impact of the new ammonia/urea plant to be funded under the Project would be to reduce NH, emissions to 5 ppm (well within acceptable standards) and eliminate S0 2 discharges from the existing ammonia and power generation operations. In addition, to overcome the principal problems identified in the environmental impact study that would not be directly remedied by the installation of the proposed new ammonia/urea plant, Gresik agreed at negotiations to develop, not later than November 30, 1991, an environmental management plan to include: (a) the treatment of high S0 2 emissions from the existing sulfuric acid plant; (b) the treatment of gaseous NH 3 discharge from he AS operations; tc) increasing the capacity of the present wastewater treatment facilities to cope with overload conditions and the proposed new nmonia/urea plant; and (d) providing for the safe treatment, recycling, storage, and disposal of solids including calcium carbonate, wastewater treatment plant sludge, and spent catalysts. Gresik is studying these possibilities for inclusion under the modernization of their existing fertilizer plant subproject. D. Project Risks 5.23 The Project is not expected to encounter any major technical or managerial risks because the technologies to be used in the several components are commercially proven, and because Indonesia has considerable experience in construction and operation of modern fertilizer facilities. The new Gresik ammonia/urea plant is substantially identical to two other recent projects in Indonesia. Each of the PFEs has considerable experience, and each has an extensive training program to develop new staff and to retrain existing personnel. The timely availability of natural gas to the Gresik ammonia/urea plant is a potential risk. The offshore gas supplies are proven, but completion of the pipeline could be delayed. To account for this risk, no disbursements would be used for expenditures under the Gresik Restructuring Component until a contract, satisfactory to the Bank, for the provision of the required natural gas has been executed on behalf of Gresik and PERTAMINA The main sector-wide risks are that domestic ex-factory prices may not be increased to border prices as anticipated (para. 3.18) and that international fertilizer prices may not be in line with the level projected in the Bank's commodity forecast. The first risk is minimized by the Governmentstated objective in the Policy Statement to bring these prices to their economic level by actions taken during Repelita V. The latter risk is acceptable because the industry as a whole has a relatively low variable cost structure and so should be able to maintain a reasonable financial viability even with prices significantly lower than the present forecast. In fact, the proposed Project is in part designed to enhance Indonesia's already favorable competitive position with regard to nitrogen exports, and to improve substantially Gresik's present cost structure.

49 VI. UNDERSTANDINGS AND AGREEMENTS REACHED 6.1 During negotiations, agreements were reached with the Government on the following: (a) that th6 Project will be implemented in accordance with the Policy Statement (para. 3.18); (b) that the studies of Fertilizer Distribution and Marketing, and of the Development of an Environmental Management Program for the Fertilizer Industry will be prepared by March 1, 1992, under terms of reference satisfactory to the Bank and by qualified and experienced consultants, and that for each of these studies MOI will establish, not later than May 1, 1991, a Steering Committee (paras and 3.25); (c) that the Government and the Bank will review jointly the recommendations of the two studies mentioned in (b) above and supported under the Project, not later than 60 days after their completion, and agree on Government action plans to implement these recommendations (paras and 3.25); (d) that the arrangements for the allocation of loan proceeds and the onlending terms to the PFEs will be as indicated in para. 4.7; 6.2 During negotiations, the following understandings were reached with the Government: (a) that the revised farmgate fertilizer prices for 1991 adopted by the Government, as agreed during the exchange of views on these prices in September 1990, between the Government and the Bank, represent a satisfactory progress in bringing these prices ultimately to their economic levels (para. 3.18); (b) that the Government will, by October 1 of each year, commencing not later than October 1, 1991, review the farmgate and ex-factory prices of fertilizers, exchange views with the Bank on the results of the review, and thereafter, if required, revise such prices taking into account the principles set forth in the Policy Statement (nara. 3.18); and (c) that E tions will be taken during Repelita V ( ) to bring the prices of fertilizer products gradually to their economic level and eliminate the associated subsidy payments from the Government's budget (para. 3.18). 6.3 During negotiations, the following agreements with the PFEs were reached: (a) that Gresik will, not later than May 1, 1991, appoint consultants to assist in the implementation of the ammonia/urea plant and of the modernization subproject (para. 3.22); (b) that PIM, Kaltim, Kujang and PUSRI will, not later than May 1, 1991, appoint consultants to assist them in the implementation of their respective optimization subprojects (para. 3.23); (c) that Gresik, for its modernization s tbproject, and the other PFEs, for their respective optimization subprojects, will, not later than June 30, 1992, submit to the Bank for review and approval a

50 subproject appraisal report and an environmental impact assessment of the subproject, including an Executive Summary (in English) (para. 4.7(e)); and (d) that Gresik will, not later than November 30, 1991, develop an Environmental Management Plan to overcome the main environmental issues identified in the Environmental Impact Study of the Gresik complex and not dealt with as part of the implementation of the new ammonia/urea plant to be built under the Project (para. 5.22). 6.4 A condition of loan effectiveness would be the signing of Subsidiary Loan Agreements between MOF and the five PEFs for undertaking of the respective project components, on terms and conditions acceptable to the Bank (para. 4.7(c)). 6.5 Conditions of disbursement would bet (a) for the Gresik Restructuring Component that a contract for the provision of the required natural gas to Gresik has been executed on behalf of rresik and PERTAMINA and found satisfactory to the Bank (para. 3.20); and (b) for subprojects under the Optimization Component and for the Gresik modernization subproject that the appraisal report and the Environmental Impact Assessment for these investments by each PFE will have been found satisfactory to the Bank (para. 4.7(e)). 6.6 With the above agreements and understandings reached at negotiations, the proposed Project would be suitable for a loan of $221.7 million equivalent to the Republic of Indonesia for 20 years, including a grace period of five years, at the Bark's standard variable interest rate.

51 ANNEX 1 Pagei 1 REPUBLIC OF INDONESIA NAIlONAL DEVELOPMENT PLANNING AGENCY JAKARTA, INDONESIA Mr. Attila Karaosmanoglu Vice-President Asia Regional Office The World Bank 1818 H Street, N.W. Washington, D.C USA. 10 October 1990 Dear Mr. Vice President: I. The Government of Indonesia has requested assistance from the World Bank to support a program of restructuring in the fertilizer sub sector. This letter provides infornation on the latest measures taken by the Government to strengthen the industrial policy framework, particularly as it affects the sub sector, and on the direction of planned policy actions to be implementeduring Repelita V. 2. The Government' s main policy objectives in the area of trade and industry are di-ected to: maintaining a competitivexcchange rate; removing non-tariff barriers; rationalizing tariffs; and simplifying domestic regulations. To maintain the momentum of ongoing trade and industrial policy reforms, we intend to continue to employ a comprehensive approach that will give priority to: (i) removing more non-tariff barriers, especially those that will have the greatest impact on increasing efficiency and reducing cost; (ii) rationalizing tariffs further to lower the average tariff level and its dispersion; (iii) further reducing the remaining constraints on investment; and (iv) reviewing a number of other regulations, with a view to eliminate those that no longer serve a positive purpose or have the effect of raising production costs.

52 ANWE 1I Page 2 3. These initiatives are being supported by a comprehensive reform of financial sector policies, with the objectives of increasing resource mobilization, improving efficiency and lowering costs in financial intermediation, and ensuring greater availability of term funds for investment. The Government is also committed to promoting technological upgrading and strengthening technical and managerial capabilities in the industrial sector. 4. During the past two decades, the fertilizer industry has achieved impressive result. Nevertheless, there remain problems that need to be overcome in order to ensure a sustained development of this industry. The problems relate, among others, to how to improve the currently used technology, pricing of fertilizer product (at farmgate and ex-factory levels) and feedstock and the distribution and marketing system. The Government has already taken steps and will continue to take furither measures to ensure an economically more efficient fertilizer industry. This objective will be supported under the Proposed fertilizer project through investments in new production facilities, optimization of existing plants, and studies which will address marketing, distribution, and environmental issues. 5. With regard to the pricing of fertilizer products, the Government has begun and will continue to adjust these prices so that they will gradually reflect economic prices. A major outcome of this adjustment wiil be the gradual elimination of the associated subsidy payments from the Government budget. 6. With regard to the marketing and distribution system, the L-overnment will continue to make efforts to improve efficiency of the existing system and service to farmers. Thus, a study will be prepared for conmletdon before the end of November 1991, to develop recommendations and appropriate timing for introducing increased competition at wholesale and retail levels. 7. The Government is concerned about the environmental impact of industrial activities, including fertilizer enterprises, and has adopted comprehensive legislation for environmental protection. In this regard a special study in conjunction with the proposed ferdlizer project will also be