Document of The World Bank FOR OFFICIAL USE ONLY PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN AND A PROPOSED GRANT FROM THE

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$50.0 MILLION AND A PROPOSED GRANT FROM THE GLOBAL ENVIRONMENT FACILITY TRUST FUND IN THE AMOUNT OF US$lO.O MILLION TO THE REPUBLIC OF PERU FOR A RURAL ELECTRIFICATION PROJECT FEBRUARY 7,2006 Finance, Private Sector and Infrastructure Department Bolivia, Ecuador, Peru and Venezuela Country Management Unit Latin America and the Caribbean Region Report No.: PE This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization

2 CURRENCY EQUIVALENTS (Exchange Rate Effective 02/07/06) CurrencyUnit = Soles 3.31 Soles = US$1 US$ = SDRl FISCAL YEAR January 1 - December 31 ADINELSA CAS CONAM CONATA DEP DGE EA EMPs ERR ESMAP FIRR FONAFE FONCODES FONER FOSE FMRs GEF GoP IADB IBRD INEI IPDF ISDS MEF MEM NGOs NPV OSINERG PDC PEU PID PPIAF PV SA SIL SNIP SOE TA UNDP UNFCCC VAD WB ABBREVIATIONS AND ACRONYMS Administration Office of Electric Infrastructure Country Assistance Strategy National Council for the Environment National Council for Taxation Executive Office for Projects General Office of Electricity Environmental Assessment Environmental Management Plans Economic Rate o f Return Energy Sector Management Assistance Program Financial Internal Rate o f Return National Fund for Financing of the Entrepreneurial Activity of the State National Fund for Compensation and Development Fund for Rural Electrification Fund for Social Compensation of Electricity Financial Management Reports Global Environmental Facility Government of Peru Inter American Development Bank International Bank for Reconstruction and Development National Institute of Statistics and Information-Technology Indigenous Peoples Development Framework Integrated Safeguards Data Sheet Ministry of Economy and Finance Ministry of Energy and Mines Non-Governmental Organizations Net Present Value Supervisory Commission for Energy Investment Project Directory Committee Project Executing Unit Project Information Document Public-Private Infrastructure Advisory Facility Photovoltaic Special Account Specific Investment Loan National System o f Public Investment Statements o f Expenses Technical Assistance United Nations Development Program United Nations Framework Convention on Climate Change Value Added for Distribution World Bank Vice President: Country ManagedDirector: Sector Director: Sector Manager: Task Team Leader: Pamela Cox Marcel0 Giugale Makhtar Diop Susan G. Goldmark Susan V. Bogach I Demetrios Papathanasiou

3 PERU Rural Electrification CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE... 1 B Country and sector issues... 1 Rationale for Bank involvement... 2 Higher level objectives to which the project contributes... 2 PROJECT DESCRIPTION Lending instrument Project development objective and key indicators Project global environmental objective and key indicators Project components Lessons learned and reflected in the project design Alternatives considered and reasons for rejection... 9 C. implementation Partnership arrangements Institutional and implementation arrangements., Monitoring and evaluation of outcomes/results Sustainability and replicability Critical risks and possible controversial aspects Loan conditions and covenants D. APPRAISAL SUMMARY Economic and financial analyses Technical Fiduciary Social Environment Safeguard policies Policy exceptions and readiness... 19

4 Annex 1: Country and Sector Background Annex 2: Major Related Projects Financed by the Bank and/or other Agencies Annex 3: Results Framework and Monitoring Annex 4: Detailed Project Description Annex 5: Project Costs Annex 6: Implementation Arrangements Annex 7: Financial Management and Disbursement Arrangements Annex 8: Procurement Arrangements Annex 9: Economic and Financial Analysis Annex 10: Safeguards Policy Issues Annex 11: Project Preparation and Supervision Annex 12: Documents in the Project File Annex 13: Statement of Loans and Credits Annex 14: Country at a Glance Annex 15: Incremental Cost Analysis MAP IBRD No

5 PERU RURAL ELECTRIFICATION PROJECT PROJECT APPRAISAL DOCUMENT LATIN AMERICA AND CARIBBEAN LCSFE Date: February 7,2006 Country Direcior: Marcel0 Giugale Sector Managerhlirector: Susan G. GoldmarWMakhtar Diop Project ID: PO Lending Instrument: Specific Investment Loan Global Supplemental ID: PO Lending Instrument: Specific Investment Loan Focal Area: C-Climate change Supplement Fully Blended?: Yes Team Leaders: Susan V. Bogach / Demetrios Pap at hanas iou Sectors: Power (85%); Renewable energy (15%) Themes: Rural services and infrastructure Environmental screening category: Partial Assessment Safeguard screening category: Limited impact Team Leader: Susan V. Bogach / Demetrios Papathanasiou Sectors: Renewable energy (100%) Themes: Rural services and infrastructure (P) Source Local Foreign BORROWEWRECIPIENT INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT GLOBAL ENVIRONMENT FACILITY ENTERPRISES Total: Total Responsible Agency: Ministry of Energy and Mines Av. Las Artes Sur 260, San Borja, Lima 41 Lima, Peru?Y 2007 hual 3.10 kmulative Y nnual Jumulative Project implementation period: Start July lst, 2006 End: June 30,201 1 Expected effectiveness date: July 1 st, 2006 Exnected closing. date: December 31st. 2012

6 Does the project depart from the CAS in content or other significant respects? Ref: [ ]Yes [XINO PAD A. 3 Does the project require any exceptions from Bank policies? Ref: PAD D. 7 [ ]Yes [XINO Have these been approved by Bank management? ]Yes [ IN0 Is approval for any policy exception sought from the Board? [ ]Yes [XINO Does the project include any critical risks rated substantial or high? r L vivae r i X T ~ AJ I L 1 i lw Ref: PAD C.5 Does the project meet the Regional criteria for readiness for implementation? Ref: [XIYes [ 3 No PAD D. 7 Project development objective Ref: PAD B.2, Technical Annex 3 The objective of the proposed Project would be to increase access to efficient and sustainable electricity services in rural areas of Peru. Global Environment objective Ref: PAD B.2, Technical Annex 3 The project s global environmental objective is to achieve reduction of greenhouse gas emissions through use of renewable energy in rural areas for provision of electricity. Project description [one-sentence summary of each component] Ref: PAD B.3.a, Technical Annex 4 The proposed Project has five main components: (a) investment in rural electrification sub-projects by private and state-owned enterprises, supported by central government subsidies, to provide new electricity connections for rural households, businesses and public facilities, using both conventional grid electricity or renewable energy systems that would serve dispersed or remote populations; (b) technical assistance to catalyze private sector participation and create capacity for a demand driven approach for rural electrification (projects proposed by service providers in coordination with local communities and governments), as well as particular promotion of renewable energy; (c) a pilot program to promote productive uses; (d) a small hydro generation financing facility to provide project financing, during the construction and initial operation period, for grid-connected plants; and (e) project management. Which safeguard policies are triggered, if any? Ref: PAD 0.6, Technical Annex 10 The safeguard policies that apply are: Environmental Assessment, Involuntary Resettlement, Indigenous Peoples, and Safety of Dams. Significant, non-standard conditions, if any, for: Ref: PAD C.7 Board presentation: None Loadcredit effectiveness: There will be a single effectiveness condition of adoption of the Operational Manual by MEM and dated covenants as follows: 1. ii. iii. iv. Disbursement conditions will include: i. ii. appointment of external financial auditors within three months; a Supreme Decree creating the Project Directory Committee within three months; evidence that an adequate financial management system has been created within three months; and appointment of procurement auditors within six months. Administrative Financial Agreement established for rural electrification subsidy funds and contracts in place for key staff of the PEU (Component 1); and Administrative Financial Agreement established and Fund Manager services contracted for Small (Component 4) Hydro Generation Financing Facility, Independent Investment Committee established

7 A. STRATEGIC CONTEXT AND RATIONALE 1. Country and sector issues More than six million people in the predominantly poor rural areas of Peru do not have access to electricity. At about 30% coverage, this is one of the lowest rural electrification rates in Latin America. Together with scarcity of other infrastructure services, lack of electricity results in high costs for basic energy services, a lower quality of life, poor medical care and education, and limited opportunities for economic development. The incidence of poverty in rural areas highlights the importance of investing in provision of basic infrastructure such as electricity, as part of the national rural development agenda. Rural electrification in Peru, after the power sector reform of the early nineties, has been limited to direct investment by the central government. The existing framework has not leveraged potential additional hnds from communities, regional governments, or the service providers. Electricity distribution companies hold concession areas concentrated in small areas around urban centers, with an obligation to meet service requests only within 100 meters of the existing network. To expand coverage, the Government of Peru (GoP) has been spending, in the last ten years, on average US$40-50 million per year for electrification investments through the public sector. Investments were carried out through social funds (e.g. FONCODES) and more importantly, by the Executive Office for Projects (DEP), a division of the Ministry of Energy and Mines (MEM). DEP plans, designs and constructs projects. Once the construction phase is completed, rural electricity systems are turned over for operation either to state-owned distribution companies, or to a specially created state-owned asset-holding company that manages the systems under operation contracts with state-owned companies, or municipalities. The current model has a number of acknowledged limitations. Several attempts have been made to change the existing institutional and legal framework for rural electrification. Two laws have been passed by Congress but not implemented in recent years, because of conflicts with provisions of other laws (Law for Electrification of Rural and Isolated or Frontier Areas in 2002, and Law to Regulate the Promotion of Private Investment in Rural Electrification in 2004). Both initiatives, while incomplete, contained a number of positive elements, including incentives for private investment, decentralized planning, and the proposed creation of a Rural Electrification Fund. Peru recently reiterated its commitment to reduce the electrification gap, aiming to increase rural coverage from 30% to 75% by To help achieve these goals, the GoP aims to develop a new rural electrification framework that would increase economic efficiency in the sector and attract broader participation and financing from communities, regional governments and electricity service providers. Such a framework would need to: (a) encourage planning and implementation of projects in a demand-driven, decentralized manner; (b) introduce specific regulations to ensure the economic and financial viability of projects in rural areas; (c) create incentive mechanisms for rural electrification investments by existing and new electricity service Of the 9.4 million people living in rural areas of Peru in 2002, 78% were poor and 5 1 % were extremely poor (compared to 42% and 10% for urban areas). See the Rural Electrification Plan of This is estimated by MEM to require about US$860 million (US$86 million annually). 1

8 providers; and (d) expand the use of new technologies to serve remote populations, especially renewable energy. The World Bank is assisting MEM, through the Public Private Infrastructure Advisory Facility (PPIAF), to prepare proposals to reform the Rural Electrification Sector in Peru. Under this assistance, a new general framework for rural electrification was prepared in January 2005, Propuesta para un Nuevo Marco General para la Electrificacih Rural en el Peru. To provide incentives for investment in rural electrification, it was proposed in the general framework document to create a Fund for National Rural Electrification, which would be an entity specifically created to manage the mobilization, management and disbursement of funds for rural electrification. The Fund would also support productive uses promotion campaigns. The general framework is being used to assist preparation of a model law for rural electrification. 2. Rationale for Bank involvement There are complex and interwoven issues that need to be addressed in introducing a new decentralized framework for rural electrification. Under this approach, electrification will be driven by communities, local and regional governments, and electricity providers to replace the current centralized provision. The proposed Bank and Global Environment Facility (GEF)- assisted Project would demonstrate key elements of the proposed approach for rural electrification. The Bank would leverage its ongoing support to decentralization in Peru and exploit its comparative advantage in projects that use public-private service models for infrastructure services, as well as its experience with rural electrification and renewable energy. The proposed Project would function under the existing legal framework, in parallel with the development of legal and regulatory instruments. GEF participation would support full integration of renewable energy options, including support for small and mini hydro grids, solar and wind systems into all activities of the proposed project and the future legal and regulatory framework. Renewable energy options are likely to be cost effective in many jungle and highland areas of Peru, where populations are remote and/or dispersed. Where electricity demand and capacity to pay are low, minimum service packages would be considered to provide power to schools, health clinics and other public facilities. 3. Higher level objectives to which the project contributes The Bank s participation in the proposed project would support the objectives of employment generation, access to basic services and decentralization as set out in the Country Assistance Strategy (CAS), and discussed by the Board on December 7, With expansion of electricity service, the proposed project intends to improve the quality of life in rural areas and, in coordination with the productive uses promotion program, new opportunities for commercial and agro-industrial activities. The Project would aim not only to provide electricity service to rural households and businesses that do not have access to modern energy services, but also to introduce an approach to rural electrification that would result in more efficient provision of rural electricity services and higher leveraging of subsidies of the central government with funds from electricity service providers, regional governments and local communities. The result would be increased access to electricity service in areas currently without service, and provision of more 2

9 efficient and sustainable rural electricity services. The capabilities of regional and local governments to identify, plan and realize rural electrification projects would also be increased. The Project is consistent with GEF Operational Program Number 6, Promoting the Adoption of Renewable Energy by Removing Barriers and Reducing Implementation Costs. In the Project, IBRD and GoP funds would provide minimum capital cost subsidies necessary to catalyze investments in rural electrification. Subsidies would be available to projects for grid extension or off-grid systems, including renewable energy. GEF support would be made available to fully integrate renewable energy into the Project. The GEF would provide for: (a) creation of specific norms and regulations for renewable electricity provision, as well as capacity building of all participants to develop and propose renewable energy projects (strategic priority CC-3); (b) the creation of a small hydro generation financing facility that would provide bridge financing to cover the construction period of small hydropower plants connected to the grid (strategic priority CC-2); and (c) the pilot program for productive uses of electricity in areas that would increase income generation opportunities to rural communities using renewable energy (strategic priority cc-4). The GoP is taking important actions to tackle some of its environmental problems. The National Council for the Environment (CONAM) was established in 1994, as an autonomous body within the Presidency of the Council of Ministers. Its mandate is to propose, coordinate, manage and evaluate national environmental policy. The overall mission of CONAM is to conserve environment and take advantage of natural resources in coordination with the public sector and civil society in order to contribute to the sustainable development of the country3. Peru signed the United Nations Framework Convention on Climate Change (UNFCCC) in May of 1992, and the Acuerdos Marrakech and Plan de Acci6n de Buenos Aires in Peru has also ratified the Kyoto Protocol Agreement, while a number of projects have been recently developed with World Bank assistance under the Clean Development Mechanism. CONAM also has biodiversity, climatic change, air quality, solid waste, and environmental education programs. All of the above mentioned initiatives indicate the Peruvian Government s commitment to environmental sustainability. B. PROJECT DESCRIPTION 1. Lending instrument This fully blended Project includes both a GEF grant and an IBRD loan. The lending instrument is a Specific Investment Loan (SIL) implemented over a five-year period. This approach was decided taking into account the need for a substantial investment component in order to demonstrate a new approach to rural electrification in Peru. A five-year period was considered both necessary and sufficient to demonstrate the new approach, as well as to assist GoP to develop the necessary instruments to incorporate the approach into Peru s overall rural electrification program. CONAM website: 3

10 2. Project development objective and key indicators The objective of the proposed Project would be to increase access to efficient and sustainable electricity services in rural areas of Peru. The proposed Project would achieve this by: (a) investment in sub-proj ects to supply electricity services to about 160,000 currently unserved rural households, businesses and public facilities, such as schools and health clinics (serving about 800,000 people), using both conventional grid extension and renewable energy sources; (b) demonstration of key elements of a framework for electricity provision in rural areas of Peru that would attract investment from private and public sector electricity providers, as well as national, regional and local governments; and (c) implementation of a pilot program to increase productive uses of electricity that would increase opportunities for income generation in rural areas. The key performance indicators would be the number of new electricity connections, as well as increased productive use of electricity in targeted rural areas (see Annex 3 for details). 3. Project global environmental objective and key indicators The project s global environmental objective i s to achieve reduction of greenhouse gas emissions through use of renewable energy in rural areas for provision of electricity. The key global performance indicator is avoided carbon dioxide emissions. Total estimated emission reductions from facilities installed during the project s life are estimated at 3.61 million metric tons of COz, over the lifetime of the systems. The long-term national impact of this Project is expected to be much larger than this number, as broad replication is expected to occur through the establishment of a national framework for rural electrification and the development of financing for small hydroelectric projects. 4. Project components The proposed Project has five main components: (a) investment in rural electrification subprojects by private and state-owned enterprises, supported by central government subsidies, to provide new electricity connections for rural households, businesses and public facilities, using both conventional grid electricity or renewable energy systems that would serve dispersed or remote populations; (b) technical assistance to catalyze private sector participation and create capacity for a demand driven approach for rural electrification (projects proposed by service providers in coordination with local communities and governments), as well as particular promotion of renewable energy; (c) a pilot program to promote productive uses; (d) a small hydro generation financing facility to provide project financing, during the construction and initial operation period, for grid-connected plants; and (e) project management. Each of these components is described below (and in more detail in Annex 4): Rural Electrification Sub-projects to provide service to about 160,000 newly connected rural households, businesses, and health centers, schools and community centers (serving about 800,000 people). The Project would provide targeted subsidies to public and private electricity 4

11 service providers investing in rural electrification sub- project^.^ Service providers would include qualified existing and future electricity distributors (public and private), and other qualified enterprises. Rural electrification sub-projects are defined as projects to provide service to new customers in rural areas outside of existing concession areas. Subsidies would make investments in electrification sub-projects financially viable and would leverage complementary financing from the electricity service providers, regional and local govement~.~ Sub-projects would compete for the subsidies in competitions held periodically. Service providers would present proposals for sub-projects, according to guidelines. The sub-projects would need to meet minimum criteria such as an acceptable rate of economic return under the SNIP system. If there are more eligible sub-projects than funds, sub-projects would be selected for financing using the principal criterion of minimum subsidy per connection. Possible types of sub-projects would include: (a) sub-projects to increase connections outside the existing concession areas; and; (b) sub-projects to provide isolated communities with service through mini-grids (diesel, smallhydro or wind systems), or through individual household systems (solar). It is estimated that about 20,000 of the rural connections to be financed under the program would be made to systems using renewable energy (about 12% of total), mainly small hydro microgrids, solar photovoltaic household systems, or solar photovoltaic/diesel hybrid grid systems. In order to have a pipeline of potential projects, MEM solicited from distribution companies proposals for potential sub-projects to be implemented in the first year of the Project. The companies responded with 49 proposals for sub-projects. Technical, economic and financial appraisal of these sub-projects has been conducted and indicates that 9 projects with a total estimated capital cost of US$20.3 million and an average subsidy requirement of US$457 per connection could meet the eligibility criteria of the Project and could be selected for implementation in year one of the Project (see Annex 9). (Estimated cost US$ million: US$ million IBRD, no GEF.) Technical Assistance for Rural Electrification. Technical assistance would be provided to support the implementation of the proposed rural electrification approach including: (a) development of the institutional framework and regulations for rural provision of electricity service, on- and off-grid; (b) capacity building for demand-driven and decentralized identification, planning and development of projects; (c) promotion of private sector investment in rural electrification; and (d) renewable energy promotion. Activities would include: a. Development of institutional framework and regulations for grid-connected and off-grid rural electricity service, including renewable energy service provision, specifically designed Consumption cross subsidies would also be provided, separately, under the existing Fondo Social de Electrificacih (FOSE) scheme, to customers that use less than 100 kwh per month. The lack of a legal framework for the direct provision of investment subsidies, or the transfer o f funds or assets (and some taxation implications), is the principal outstanding issue for private sector participation. In the case o f public companies, this situation could be solved by considering the subsidy as a capital infusion by the Government, or the transfer and holding of assets by ADINELSA. In countries such as Chile and El Salvador, specific legal provisions have been adopted to overcome these problems and allow the Governments to provide these subsidies for rural public infrastructure. TA is underway and will be continued within the Project to obtain similar exemptions in Peru. In order to prevent inordinate delays in private sector participation, the fallback option of proceeding through bidding of concessions will be adopted within a year of effectiveness if no private sector proposals have been financed under the Project (see Annex 4). 5

12 b. C. d. to improve the economic and financial efficiency of the sector, including procedures for issuing rural concessions; guidelines for electricity systems design and construction appropriate for rural areas; norms for operations; procedures for calculating rural tariffs; and norms for rural quality of service. Capacity building for identijkation and development of sub-projects that are effectively linked to regional development plans. The Project would strengthen the capacity of electricity service providers to prepare and propose sub-projects. It would also strengthen the capacity of regional and local governments to coordinate planning and management of electrification projects with other rural development activities (especially those with substantial revenues from resource development). The Project would assist the selection of appropriate, least-cost technologies --such as renewable energy-- to electrify remote areas, or regions with dispersed populations, where grid extension would not be economically viable. Promotion of private sector investment in sub-projects. This sub-component would catalyze private sector investment in sub-projects. It would include: development of the legal framework and associated regulations to facilitate provision of capital cost subsidies to private sector providers; promotion of the electrification investment opportunities to potential private investors (e.g. mining companies and agribusiness); assistance to private investors to develop sub-project proposals; and, development of bidding procedures and, bidding out of specific sub-projects that could be attractive to the private sector. Promotion of renewable energy. This sub-component would focus on renewable energy for rural electrification and supply to the grid, especially using small hydropower, including activities such as: development of appropriate policies and incentives; support for development of MEM s capacity to promote and manage renewable energy; cost-sharing preparation of proposals and feasibility studies for renewable energy investment projects; and carrying out technical studies such as resource assessments. (Estimated cost US$3. 75 million of which US$O. 75 million IBRD and US$2.5 million GEF.) Pilot Program for Promotion of Productive Uses of Electricity. Electric power can result in productivity gains and economic growth, thus transforming the underdeveloped rural areas - if complementary elements for development such as market access, human and enterprise capacity, financial services, and resourceshaw materials are available. From a rural community or enterprise viewpoint, access and use of electricity can contribute to a significant increase in income by reducing production costs, increasing efficiency and improving product quality. Currently, the use of electricity in rural areas of Peru is overwhelmingly dedicated to evening lighting. The electricity load curve of rural systems presents a sharp peak for three to four hours (peak to base ratio in many systems is five to ten) which indicates significant under-utilization of system resources and undermines the economic and financial viability of rural electrification. The use of electricity for productive activities would make better use of the underutilized electricity assets and therefore enhance the viability of electrification sub-projects. This component would support the removal of key barriers to productive use of electricity. Enterprises targeted would be those that currently use diesel power or other energy intensive farm and off-farm enterprises that could benefit from use of electricity. The proposed approach is one of capacity building. It is a marketing approach in the broadest sense - identifying target markets and segments; increasing awareness and skills, assisting potential productive users, user 6

13 groups and communities to identify opportunities, barriers and solutions; working closely with the electricity service suppliers to ease access; and facilitating access to other necessary services, including financing. Initially, about 4-6 areas would be targeted, with services extended to other regions during the five-year implementation period of this component. They could be either areas newly electrified by the project, or areas that already have had electricity service for some years. The target areas will be selected based on the following criteria: (i) low load factor in the grids serving the area due to underutilized capacity, and not due to supply side constraints; (ii) the electricity service company is committed to support the promotion of productive uses; (iii) presence of significant potential energy intensive productive activities in farm and off-farm enterprises including artisans and rural industries that might benefit from a shift to electricity; (iv) existence of basic infrastructure (i.e. transport, communications, finance); and (v) for the renewable energy-focused market segment, service areas predominantly supplied with renewable energy-based electricity. (Estimated cost US$3.95 million of which US$2.0 million IBRD and US$1.5 million GEF.) Small Hydro Financing Facility: Peru i s a country with significant hydroelectric resources due to its geography (Andean mountain range) and climatic conditions. In addition, irrigation and water resources management projects have created civil engineering structures that present competitive hydroelectric generation opportunities for small-scale schemes. Through its carbon financing activities in the country, the World Bank has reviewed a significant number of privately sponsored small hydro schemes that would be viable and could provide least-cost provision of electricity to the grid. Nevertheless, although the financial system in Peru is quite liquid, local financial institutions are not experienced in project financing of this type, and in general there is no debt-financing available on a limited recourse basis. Project sponsors for small-hydro have to finance projects fully on equity, borrowing on balance-sheet, or pledging other assets for collateral. Given the shortage of equity funds in the country and the inability to leverage equity with debt, financial closure for small hydro projects that present attractive returns at the project level has been difficult. This has been a significant barrier to investments in small hydro schemes. This project component would address the above barriers by using GEF funds to leverage private equity and commercial debt financing for grid-connected small hydro generating plants that would sell power to the interconnected grid. The purpose of the Small Hydro Financing Facility would be to assist in the financial closure of small hydroelectric electricity generation plants (installed capacity less than 10 MW) on a project finance basis. The facility would provide bridge-financing for small hydro projects, i.e. loans, at commercial interest rates, assuming the risk and covering the period of construction and initial operation; after that period the loans would be refinanced by commercial banks. Beneficiaries of the facility would be private companies that would invest in, own, and operate, such small hydro plants. (This small hydro financing facility would not finance connections or distribution systems). (Estimated cost US$l5.0 million, of which US$5.0 million GEF.) 7

14 projects; c. Promotion of private sector investment d. Promotion of renewable electricity 3. Pilot Program to Increase Productive Uses of Electricity I a. Technical assistance for marketing and business I development services 1 b. Demand Driven TA 4. Small Hydro Financing Facility 5. Project Management I a. Project management and administration (procurement and financial management) b. Technical unit to evaluate investment sub-projects c. Monitoring and evaluation unit, including safeguards d. Administrative financial agreement fee Total Baseline Cost (excludinet front-end fee and unallocated see Lessons learned and reflected in the project design The Project builds on the Bank s extensive experience in rural electrification. Many of the lessons documented in the Bank s 1994 study of rural electrification in Asia6 are still valid and have been built into the Project. Recent rural electrification projects by the World Bank and others were examined, in Argentina, Bolivia, Chile, Ecuador, Laos, Philippines and Vietnam. Experience from other Latin American countries that have successfully established similar approaches to rural electrification, including Chile, Ecuador, and El Salvador, was also used to prepare the project. Lessons learned and incorporated into the project include: (a) preparation should include a detailed estimate of financial viability of projects and amounts of subsidy required, as well as a rigorous analysis of benefits expected; (b) estimated costs of supply should reflect generation costs at peak periods when rural demand largely occurs; (c) tariffs should be set high enough to cover the full costs of generation and transmission at the medium voltage as well as the operation and maintenance costs at low voltage; (d) project design should include productive uses components to increase demand during the off-peak period and increase the economic impact of projects; (e) selection of sub-projects to be financed should be based on a simple, clear and transparent methodology; and (f) criteria for allocation of subsidies should be technology neutral Rural Electrification in Asia: a Review of World Bank Experience, June 30, 1994; Meeting the Challenge of Rural Electrification in Developing Nations: The Experience of Successful Programs, ESMAP Report (2005). 8

15 and should assure that the least-cost technology, including renewable energy, is used where most viable technically and economically. Other important lessons include the need for active participation of communities, local and regional governments in both planning and implementation of projects, especially their contribution of financial resources. Experience has also shown the benefits of demand driven identification and design of projects, with communities proposing projects to the distribution companies, that then package and design sub-projects, based on clear and transparent criteria that are related to economic efficiency. In the absence of an interested distribution company, the community, local governments, or private enterprises can propose projects to the fund for specific preparation and competitive bidding to interested sponsors. While renewable energy technologies are fully integrated into the Project from the start, GEF support has been included in order to develop necessary institutional and regulatory requirements and processes, as well as build capacity of all actors and provide data and technical assistance on resources and technologies. This i s to ensure that renewable energy technologies will take the place that is justified by their economic and technical characteristics. 6. Alternatives considered and reasons for rejection Exclusive Focus on Private Sector Participation. The two rural electrification laws passed in the last four years were limited to promotion of private investment in rural electrification. The approach proposed under those laws is for MEM/DEP to identify and prepare potential rural electrification projects which would be bid out to private sector entities and awarded on the basis of least subsidy. The Project approach would instead provide subsidies to sub-projects developed and proposed by service providers, with projects competing for the subsidies. The onus is on the service providers to identify, prepare and propose sub-projects to the fund, rather than having the sub-projects identified by a central authority and then bid-out. Since commercially-managed, state-owned distribution companies are the most important actors outside of Lima, the Project would encourage involvement in rural electrification projects by commercially-managed public enterprises as well as private enterprises. The Project would also promote the participation of small private sponsors/concessionaires, ensuring long-term financial sustainability and adequate rate of return on project equity contribution to these new rural electrification projects. Nevertheless, theoretical analysis and empirical evidence show that cost functions in electricity distribution exhibit important economies of scale, increasing returns to scale and economies of output and customer density. Therefore, existing distribution companies, already serving relatively extensive territory with an established customer base, have a natural economic efficiency advantage in expanding their service to new areas. It is likely that The costs of a distribution system are the costs of building and operating and maintaining the system of service lines, mains and transformers. These costs depend upon: (i) the total number of customers served; (ii) the maximum demand on the system; (iii) the size of the distribution area; (iv) the capacity of the transformers; (v) the length of distribution lines; (vi) the total kwh sold; (vii) the price of labor; and (viii) the price of capital. Cost functions showing economies of scale in the electricity distribution industry are well documented theoretically and in empirical research (see references in Annex 1). 9

16 most of the new rural electrification project proposals will come from existing distribution companies. Approach of Competition Among Projects Proposed by Distributors. The approach proposed in the Project for provision of subsidies with competition among projects proposed by electricity distributor companies is now being used successfully in several countries, including Chile, Ecuador and El Salvador. These countries include those with private sector distribution companies (Chile and El Salvador) as well as public sector companies (Ecuador). Both Chile and El Salvador first tried a process of bidding out concessions, but after limited success they opted for the system of competition among projects that is proposed in this Project. Exclusion of productive uses component. The pilot program for productive uses complicates the project. However, it is considered important to explore ways to maximize the development impact and enhance the economic and financial performance of the project. GEF assistance is sought to support promotion of productive uses, for communities to be supplied with renewable energy. Inclusion of Activities in Other Sectors. The proposed project i s ambitious in that it attempts to introduce a new demand driven mechanism for provision of subsidies to service providers rather than the centralized approach currently in place, where the MEM itself actually plans, designs, and constructs projects that are then transferred to others to operate. Because of the challenges expected in implementing a new framework, and its importance to the future development of the sector, it was decided not to broaden the Project to include activities in other sectors. However, every effort will be made to ensure coordination with other projects on the Bank and GOP side. C. IMPLEMENTATION 1. Partnership arrangements Project implementation includes partnership among MEM, MEF and OSINERG (Supervisory Commission for Energy Investment) in a Project Directory Committee, which would approve the subsidies for sub-projects. Implementation also includes partnerships with banks, private firms and NGOs that will assist in implementing productive uses technical assistance activities, as well as with distribution companies and local and regional governments. Project preparation has been coordinated with: (a) the PPIAF-financed Technical Assistance on Design of Enabling Framework for Public-Private Participation Models in Rural Electrification, which aims to develop a proposal for a new legal and regulatory framework for rural electrification; (b) an ESMAP assisted Rural Energy Survey conducted by MEM to support a strategy for rural electrification; (c) an earlier World Bank assisted study, Integral Strategy of Rural Electrification (Estrategia Integral de Electrijkacidn Rural) in November 1999; and (d) USAID s past rural electrification program in Peru. During implementation, efforts would be made to leverage the Bank s other on-going and projects under preparation on rural infrastructure (roads, water) and rural and social development (indigenous peoples, Sierra rural development, health and education). In addition, the project will coordinate with the implementation of the technical assistance and programmatic loans of 10

17 the World Bank for decentralization in Peru, as well as with other agencies such as GTZ, which are supporting activities in rural areas. One year overlap i s expected between this Project and the GEF-assisted UNDP Photovoltaic- Based Rural Electrification Project in Peru. The design of this proposed Project has taken into account the experiences of the UNDP Project and will coordinate closely and build on the remaining activities of that project. The UNDP Project will have developed experience with management models for implementation of solar photovoltaic systems, as well as norms for PV systems and a GIS system with information on demand for electricity and the characteristics of potential beneficiaries. 2. Institutional and implementation arrangements The Project would be implemented over a five-year period. Project implementation would be guided by a Project Directory Committee, presided over by the Vice-Minister of Energy and including the Vice Minister of Economy and the President of the electricity regulatory commission, OSINERG. Final approval of sub-projects would be by the Directory Committee. The Directory Committee would review the results twice per year, together with Bank supervision team. There would be a Project Executing Unit (PEU) in MEM that would include: (a) an administrative unit responsible for procurement and financial management; (b) a technical unit responsible for evaluation of rural electrification sub-projects (including supervision of compliance with safeguards requirements), as well as technical oversight of the financial facility for small hydropower and the productive uses program; and (c) a monitoring and evaluation unit. An administrative financial agreement with a bank would be established for the administration of the subsidies awarded to rural electrification sub-projects and the loans awarded under the small hydropower financing facility. Implementation arrangements for each component are described below and in more detail in Annex 6. Rural Electrzjkation Sub-projects. Rural electrification sub-projects would compete for subsidies. There would be periodic calls for sub-project submissions. Sub-projects would be proposed to the PEU by existing or future electricity service providers, in coordination with the communities and regional and local governments. The service provider would present a detailed sub-project proposal, and an estimate of the subsidy required, together with a commitment from the company and, if applicable, the regional or local government to provide the remaining financing of the project. The technical unit of the PEU would evaluate the sub-project, based on technical, economic and financial soundness and the selection criteria (principally minimum subsidy), and after reporting to the National System of Public Investment (SNIP) proposes that it be accepted or rejected by the Directory Committee. The evaluation would be made using a methodology and benchmarks previously prepared by the PEU. If approved to receive a subsidy, the service provider would conduct a bidding process acceptable to the Project, mobilize other financing and construct the sub-project. The subsidy would be paid in relation to satisfactory completion of the construction contract. Technical Assistance for Rural Electrij kation. This would be executed by the technical unit of the PEU and carried out by national and international consultants. 11

18 Pilot Program for Productive Uses Component. The technical unit of the PEU will have overall responsibility for implementing this component. The PEU would recruit a support services contractor to assist the PEU to assist in supervising and coordinating the work of a number of regionally-based consultants. Each regional consultant would be responsible to implement the component in its regional area of responsibility under the supervision of the PEU. The PEU would select 4-6 departments or regions for support. The regional consultants would work collaboratively and build alliances with the critical facilitative services for credit, equipment supply, business development services, market linkages, etc. and development stakeholder organizations that already are available in the communities and, when necessary, mobilize the entry of additional ones. The regional consultants would also work closely with the local electricity service company to ensure that known issues are resolved in advance and that ones that arise during the campaign s implementation are resolved. Small Hydro Financing Facility. The facility will include an investment decision making function and a separate administrative financial agreement to handle the disbursement and recuperation of specific project loans (lending back-office functions). A qualified company will be competitively selected to act as Fund Manager with responsibilities that will include: marketing and promotion of the facility, preliminary screening of project proposals, detailed evaluation and due diligence on projects, negotiation of conditions and terms for specific loans and supervision of investments. A separate three-member Investment Committee will be appointed by the Project Directory Committee of the project to approve investments proposed by the Fund Manager. For approved investments, the disbursement and repayment of loan will be handled through an administrative financial agreement with a qualified bank. 3. Monitoring and evaluation of outcomes/results Direct project output indicators will be measured by the PEU and reported semi-annually. Comprehensive monitoring and evaluation arrangements will be implemented, that are consistent with Bank and GEF guidelines and requirements for measurement and evaluation. A comprehensive and detailed national Rural Energy Survey was carried out by MEM supported by the Bank s Energy Management Assistance Program (ESMAP). The survey, carried out through the National Statistics Institute and international consultants, will provide important socio-economic data, which will be complemented by surveys to be carried out prior to the midterm review and closing date of the project. Such surveys will be particularly useful in estimating the socio-economic impact of the project. Local and regional governments, together with outreach by the PEU, will be used to monitor consumer satisfaction in sub-project communi ties. 4. Sustainability and replicability Sustainability. The Project s approach, which relies on electricity service providers to propose sub-projects, together with the use of capital cost subsidies only, is intended to ensure the sustainability of the rural electrification sub-projects. After receiving the capital cost subsidy, the electricity service provider is solely responsible for operation and maintenance of the system. The Government s equity objectives would be implemented by incorporating the sub-projects 12

19 ~ ~ into the GoP s overall FOSE scheme, where small consumers (especially below 30 kwh per month) are cross-subsidized by other consumers. OSINERG has proposed to implement a tariff increase for rural projects, as well as to increase the tariff categories as required, to ensure that operation and maintenance as well as renovatiodreplacement expenses would be covered. Replicability. The Project demonstrates key elements of a new framework for rural electrification. In parallel to project implementation, the GoP is preparing proposals for a new legal and regulatory fkamework, with assistance fiom the PPIAF. The replicability of the Project ultimately depends, however, on the establishment of a Rural Electrification Fund. A key challenge during implementation of the Project will be to build consensus on a new mechanism to mobilize funds, such as a surcharge on generation, or reduction of the use of FOSE to cover only consumers of less than 30 kwh per month and transfer of the funds released to subsidies for increasing access to rural electrification. 5. Critical risks and possible controversial aspects Risks Change in political commitment to Project approach Insufficient demand for subprojects, especially renewable energy sub-projects Inadequate legal and regulatory framework, especially for private sector participation Inadequate institutional and political support for rural electrification Changes to the distribution sector, e.g. privatization of existing distribution Risk Mitigation Measures Consensus building activities among main actors in the sector, including MEM, MEF, FONAFE, OSINERG, regional governments, electricity service providers. All stakeholders have been keen participants in project preparation, including OSINERG, the distribution companies and FONAFE (the government holding company for public enterprises). Regional and local governments are increasingly funding Rural Electrification and are expected to welcome the ability to leverage their funds through the Project. PPIAF support assisting consensus building on approach. Distribution companies already presented 49 conventional grid extension projects. Project to provide guidelines and TA to existing and future companies, including those from the private sector, during preparation and implementation to increase their awareness and capacity for preparation of conventional and renewable energy projects. The Project is designed to be implemented within the existing legal framework. However, in order to improve efficiency and effectiveness of private sector participation, TA is provided for development of appropriate legal framework and regulation. This work builds on ongoing PPIAF assisted TA. Agreement has been reached with OSINERG to create new tariff categories, if required, to ensure adequate coverage of operation and maintenance, renovation and replacement costs. GoP has consistently funded rural electrification at a level of US$40-50 million per year for the last 15 years. Interest in the issue of rural electrification in Congress is broadbased, reflected by passage of two laws on Rural Electrification in 2002 and Project model would work equally well with privatized companies, as shown in Chile and El Salvador that have privatized distribution but have successfully used a similar Risk Rating S M M M L 13

20 Risks companies or merging of several regional companies to form larger entities Risk Mitigation Measures model to that proposed in the Project for rural electrification. Public distribution companies I The Project would finance about US$20 million in sub- I unable to mobilize their share of financing Failure to create rural electrification fund Financial Institutions not refinancing small hydro plants after construction and operation period Capacity constraints that may prevent effective sfchonization of the ~ - ~ u a l operating and Procurement Plans and budgets, resulting in inadequate disbursements and flow of funds. Overall Rating projects-per year. The requirement for financing from any given company in any given year would be unlikely to exceed US$l million, which could be mobilized from their own funds. This is within the capacity of distribution companies. FONAFE has confirmed willingness to include investments in the budgets of distribution companies. TA and support for consensus building on financing rural electrification is included within project Minimum requirement of equity contribution (at 30%) would guarantee that asset value of plant would be at about 140% of debt refinancing needs. Interest rates charged for the project would be commercial and higher than regular corporate financing rates to provide incentives to all parties for refinancing 1. highly qualified professionals in key positions (profiles in the Operations Manual) 2. highly qualified and experienced Financial Manager (profile in the Operations Manual) 3. Technical assistance and capacity strengthening measures will be provided by the financial management and disbursement teams 4. Successful implementation of the FM action plan. Risk Rating M S L S M S: Substantial; M: Moderate; L: Low 6. Loan conditions and covenants There would be a single effectiveness condition of adoption of the operational manual by MEM and dated covenants for: 0 appointment of external financial auditors within three months; 0 a Supreme Decree creating the Project Directory Committee within three months; 0 evidence that an adequate financial management system has been created within three months; and 0 appointment of procurement auditors, within six months. Disbursement conditions would include: 0 Administrative financial agreement established for rural electrification subsidy funds and contracts for key staff in place (Component 1). 0 Administrative financial agreement established, Fund Manager services contracted for Small Hydro Generation Financing Facility, and Independent Investment Committee established (Component 4). 14

21 D. APPRAISAL SUMMARY 1. Economic and financial analyses Although the full results of a survey conducted in July 2005 have yet to be fully evaluated, most of the critical assumptions (such as average monthly consumption levels) have been tested against survey results and may be taken as firm. The benefit estimates based on Willingness to Pay (WTP) are derived from end-use data ffom the survey. The technical and cost assumptions for subprojects have been confirmed by a detailed assessment (involving extensive consultation with the distribution companies). A detailed report on economic and financial analysis documents the assumptions, results and methodology that are summarized in Annex 9. The approach to the economic and financial analysis involved five steps: Preliminary screening: The first step was to assess the 49 proposals submitted by the distribution companies to MEM in May 2005 for general economic and financial feasibility: this resulted in the selection of a short-list of1 6 sub-projects for more detailed analysis. Detailed analysis of the short-list, including comparison of key assumptions (e.g. for monthly consumption per household) against the results of the survey, and discussions with the distribution companies to verify technical assumptions. 9 projects passed the short-list analysis for all criteria (ERR>14%, financially sustainable at current tariff levels after the subsidy, maximum subsidy US$800/HH, minimum size of 1000 HH). The estimated ERR of the accepted subprojects ranges from 21.7% %, with an average of 3 1.7%. Extrapolation of the initial sub-project results to the entire program (again using survey results, for example to assess the market size of potential grid-based RE projects). The risk of not finding enough subprojects to consume US$92.4m in subsidy is found to be extremely small. Estimate the ERR for the project as a whole. The aggregate ERR is estimated at 23.8% (which is lower than that estimated for the first group of projects as a result of more conservative assumptions for projects selected in subsequent years of the program). Comparison of the proposed project against the project alternative (i.e. a continuation of the existing approach to RE). We show that for equivalent funding, the new approach would electrify about 150,000 HH, as opposed to 100,000 HH under the existing MEM approach; with a 20% contribution from distribution companies, 175,000 could be electrified for the same cost. Tariff levels to be paid by customers are affordable when compared to previous expenditures, and would be made even more affordable to rural consumers through the cross-subsidies provided by the FOSE. It should be noted also that OSINERG proposes to raise the tariffs for category 5 (rural areas) in the next tariff revision. OSINERG has also proposed to put in place additional tariff zones, as needed, in order to cover the full operating and maintenance costs of rural electrification sub-projects An Incremental Cost Annex was prepared to show the with and without GEF Project case, and to demonstrate how barriers to renewable energy use would be removed by using GEF funds. By hlly integrating renewable energy into all project activities, it is expected that the project would 15

22 result in 20,000 connections of households or business customers to electricity provided using renewable energy. Additionally, 30 MW of grid-connected renewable energy generating capacity would be established. In total, an estimated GWh of electricity would be generated from renewable sources, reducing C02 emissions by an estimated 3.61 million tons over the lifetime of the equipment installed. The estimated incremental cost per tons of C02 emission reduction is US$ Technical Peru already has in place standards for rural electrification by extension of the grid, based on the standards of the National Rural Electricity Cooperative s Association from the USA. The Project is expected to assist MEM to develop or modify the following: procedures for issuing rural concessions; norms for electricity systems design and construction appropriate for rural areas; norms for operations; procedures for calculating rural tariffs; and norms for rural quality of service. The aim of these changes would be to make rural service provision more financially and economically sustainable. Development of above norms, guidelines and procedures would be done separately for rural electrification sub-projects involving grid-extension, isolated grids using diesel or renewable energy sources, and individual renewable energy systems. It would focus on increasing financial viability by ensuring flexibility for use of low cost options. The Project would provide training to all stakeholders with respect to the revised norms. Successful development, adaptation and cost-effective implementation of renewable energy technologies will be one of the major challenges of the demonstration subprojects of this Project. Three main technologies are expected to emerge as cost-effective: hydro-based micro-grids, solar photovoltaic individual home systems; and renewable (hydro, solar)/diesel hybrid mini-grids. 3. Fiduciary A financial management assessment has been undertaken in accordance with OP/BP and the Guidelines for Assessment of Financial Management Arrangements in World Bank Financed Projects, in order to determine whether the Borrower has or will have in place acceptable financial management arrangements prior to effectiveness, capable of providing with reasonable assurance, accurate and timely information on the status of the project in agreed reporting formats. Currently, the overall inherent and control risks have been assessed as moderate. More specifically, at the country and entity level the risks are moderate, while at the project level the risk profile is high. In order to mitigate the risks posed by the lack of an established PEU and of recent engagement with the Bank, the following actions will be required: (a) high quality coordination and fluid communication within the Project Executing Unit and between the Unit and the participating entities; (b) high quality annual operating and procurement plans; (c) high quality annual and semi-annual budgets; (d) strong internal controls; (e) clear flow of funds schema; (f) sound inter-institutional agreements; (g) qualified and skilled professionals in key positions (profiles in the Operations Manual); (h) a qualified and experienced Financial Manager (profile in the Operations Manual), (i) considerable degree of technical assistance and capacity strengthening measures (to be provided by the financial management and disbursement Bank teams), and (g) successful implementation of the FM action plan. 16

23 Similarly, a procurement capacity assessment was carried out at appraisal, together with detailed design of the procurement arrangements of the Project and a Procurement Plan for the first two years of operation of the Project. 4. Social A National Rural Energy Survey has been completed, sponsored by MEM and carried out by INEI (National Institute of Statistics and Information Technology). The survey provides: (i) extensive data on consumption and expenditures of energy in households with and without electricity; (ii) information to enable more accurate assessment of potential consumption in subprojects; (iii) estimates of the consumer surplus from rural electrification; (iv) socio-economic information on income, social characteristics, attitudes and perceptions of benefits that will serve as baseline information and be valuable to qualitatively evaluate the socio-economic benefits of electrification. The Project is expected to have positive social impacts through increased access to electricity among rural households. It is expected that increased access to electricity would: (i) significantly improve the quality of lighting, as well as disposable income of rural households, since cost of electricity would be less than alternatives (kerosene, candles, car batteries and dry cell batteries); (ii) provide increased opportunities for households to engage in income generating activities; (iii) allow household members to have more flexible working hours and work longer in the evenings; (iv) improve the access of the household to news, information and entertainment; and (v) allow children to study and adults to read in the evening. 5. Environment Environmental impacts of the Peru Rural Electrification Project are expected to be minimal given the type of interventions planned under this project, which has the potential to be very positive environmentally due to the reduction of COz emissions. The project includes provisions to ensure that potential impacts, including induced and cumulative impacts, are assessed and mitigated in accordance with the Bank s safeguard policies. Since the project will be supporting investments through a dedicated subsidy fund, an environmental screening criteridguidelines and management procedures have been prepared as part of the project s environmental management framework. This framework will be used for screening all subprojects. The project s EA work has also addressed the institutional environmental management responsibilities and capacities, and has set forth enhancement provisions as needed to ensure that participating institutions have the capacity to address any environmental impacts associated with the project. The main stakeholders were consulted as a part of the process of the preparation of EA. Additional consultations (rural communities) are planned during the implementation of the project, as part of the preparation of EMPs. The EA was made available at the offices of the Project Executing Unit (PEU) and in the World Bank s Infoshop by appraisal. Future EAs and EMPs will similarly be made available to the public. 17

24 6. Safeguard policies Safeguard Policies Triggered by the Project Yes No Environmental Assessment (OP/BP/GP 4.01) [ XI [I Natural Habitats (OP/BP 4.04) [I [X 1 Pest Management (OP 4.09) [I [X 1 Cultural Property (OPN 11.03, being revised as OP 4.1 1) [I [X 1 Involuntary Resettlement (OP/BP 4.12) [X 1 [I Indigenous Peoples (OD 4.20, being revised as OP 4.10) [X Forests (OP/BP 4.36) [I [ XI Safety of Dams (OP/BP 4.37) [XI [I Projects in Disputed Areas (OP/BP/GP 7.60)* [I [ XI Projects on International Waterways (OP/BP/GP 7.50) [I [X 1 Environmental Assessment and Safety of Dams Policies Project interventions could trigger the environmental and the safety of dams safeguard policies (OP 4.01 and OP 4.37), depending on the type of interventions proposed in the specific subprojects designs. Although not likely, specific subproject proposals for small dams (<1 Om) could be accepted under the project. To comply with these policies, the borrower has prepared an environmental screening framework and specific environmental guidelines that have been reviewed by the environmental safeguard specialist in the team, who has found them acceptable to the Bank. The environmental screening framework will be used for identifying the typology of each subproject proposal, while the environmental guidelines would serve for the preparation of specific environmental management plans to be considered during construction and operation phases of each subproject. Both the environmental framework and guidelines include specific provisions mandated by the Safety of Dams policy OP 4.37, i.e. the design and construction of a new dam has to be supervised by experienced and competent professionals and requires the adoption of certain dam safety measures for the design, bid tendering, construction, operation, and.maintenance of the dam and associated works. Social Safeguard Policies The project could trigger the two social safeguard policies (OD 4.20 and OP 4.12), depending on site characteristics and specific subprojects designs. Because the project is demand driven, the locations where it will be implemented will not be known before implementation begins. In order to comply with these policies and to avoid unnecessary adverse impacts as well as to ensure that the most poor and vulnerable people benefit from project implementation, the borrower has prepared two frameworks that have been reviewed by the social safeguard specialist in the team who has found them acceptable to the Bank: an Indigenous Peoples Development Framework (IPDF, see Annex 10) and a Resettlement Policy Framework (RPF, see Annex 10). * By supporting theproposedproject, the Bank does not intend to prejudice the final determination of the parties' claims on the disputed areas 18

25 The IPDF depicts the process and the principles by which Indigenous Peoples Development Plans would be prepared if the policy is triggered due to its implementation in lands owned or used by Indigenous Peoples in the highlands and the upper selva regions, or whenever IP become beneficiaries of the project. The IPDF provides an assessment of the social, economic and cultural traits of the Indigenous Peoples in these regions as well as demographic information; and assess the impacts, both adverse and positive ones that the project might have in these communi ties. The IPDF has been submitted to a preliminary consultation. One consultation was held in the highland city of Huancavelica, on July 20, 2005 with participants representing peasant communities, producers associations and local authorities. A second consultation was held in the central upper selva, in the town of Pichanaki on July 24, 2005 with participants representing indigenous communities, indigenous organizations and members of the electrification district committee. These consultations have provided useful feedback regarding the kind of productive activities that these communities would like to develop when having access to electricity (more information is available in Annex 10). The framework identifies the Project Management Unit as the entity responsible for the preparation of IPDPs. This unit will include a social specialist responsible for all social issues within project management. A Resettlement Policy Framework for Rural Electrification Sub-projects and Small Hydropower Facilities has been prepared by the borrower in case the policy is triggered due to civil works, rights of way for transmission lines and use of water for hydropower facilities. Due to the small sizes of the required works it is very unlikely that the policy will be triggered regarding physical displacement of affected populations. It is more likely though that the policy will be triggered due to land acquisition, rights of way or water usage. Nonetheless, the RPF details the process, the criteria and the principles to be followed for the preparation of site specific Resettlement Plans as required by the policy (more information is available in Annex 10). The framework identifies the Project Management Unit as the entity responsible for the preparation of RAPS and the DGAAE as the unit within MEM responsible for the supervision of land acquisition, rights of way and relationships with local communities. The frameworks were disclosed prior to appraisal in-country in the Ministry of Energy and Mines website as well as in the Infoshop. 7. Policy exceptions and readiness The operation complies with all applicable Bank policies. 19

26 Annex 1: Country and Sector Background PERU: Rural Electrification Country Background Peru has had four years of sustained economic growth with an average growth of 4%. The economic program of the present administration has focused on maintaining macroeconomic stability, with the goal of supporting a sustained recovery in economic activity and employment in a context of low inflation and limited external vulnerability. Peru s economic performance is likely to continue improving in the coming years, contingent on a favorable external environment. However, increasing economic globalization and the ongoing free trade agreements, continues to demand from Peru more dynamic, equitable, and sustainable growth. The recent economic growth has not yet had a significant effect on reducing poverty, but has stopped the worsening trend in poverty that began during the recession of the late 1990s, when the poverty rate increased by 7.5 percentage points between 1998 and 2001, Since then, the poverty rate has held steady at just over half the country s population, while the extreme poverty rate fell by almost 3 percentage points between 2001 and the end of Poverty remains more severe in rural areas than in urban areas, and is 20 percentage points higher in the sierra (highlands) and the selva (jungle) than on the coast. For example, in 2003, 73% of rural inhabitants lived in conditions of poverty8, Likewise, more than six million people in the predominantly poor rural areas of Peru do not have access to electricity. The incidence of poverty in rural areas highlights the importance of investing in provision of basic infrastructure such as electricity, as part o f the national rural development agenda. The government strategy to reduce poverty is organized around three central objectives, which form the framework for the CAS: (i) competitiveness and employment generation; (ii) equity and social justice, including access to health, education, culture and basic services; and (iii) institutionality, creating an efficient, transparent and decentralized state. Key to these objectives is the presence of an economic program and institutions ready to buffer the impact of shocks, and thus ensure that poverty reduction gains are not lost, while addressing structural sources of poverty. In light of the high dollar indebtedness of the economy, government is working to strengthen fiscal balances through controls on expenditures, improved debt management, and increased tax collections, as well as initiating a national competitiveness program for addressing barriers to private sector growth and increasing exports. However, a lack of government resources and the GOP s fiscal austerity measures present challenges in achieving these goals. Energy Sector Background In 1992, a new legal and regulatory framework was put in place for the energy sector (electricity and hydrocarbons), in line with Mr. Fujimori s first administration thorough economic reform. Under the reform, it was planned that the private sector would be the principal actor and the public sector would concentrate its activities in regulation and supervision. An ample privatization program was established to transfer controlling ownership of public enterprises to the private sector. * Herrera, Javier (2004) La Pobreza en el Ped, 2003, Institut de Recherche pour le DCveloppement (1RD)-Instituto Nacional de Estadistica e Informatica (INEI), Lima. *Poverty is defined by Basic Needs Unsatisfied (BNU) who resides in homes with at least one basic need unsatisfied. 20

27 In the hydrocarbon sub-sector, the business model chosen was an open competitive market in production and commercialization. Petroperu, the state-owned monopoly company, was partially divested (the integrated business was broken-up in production, refineryhtorage and commercial lines, divested separately.) In the electricity sub-sector, the integrated utility model was replaced by a new sector structure based on the unbundling of generation, transmission, distribution and commercialization. Competitive markets would operate in the generation and commercialization segments and transmission and distribution would be regulated, based on free-entry and open-access. The main regulatory body created by the new law was the Organism0 Supervisor de la Lnversi6n en Energia (OSINERG) ( Supervisory Commission for Energy Investments ), in charge of tariff setting, supervision and monitoring of the legal and technical regulations for the electricity sector. Electrolima and Electroperu, the two publicly-owned and vertically integrated electricity utility companies (serving Lima and the remainder of the country, respectively), were divested. Following the reform process, power shortfall was reduced, distribution losses fell drastically, and electricity tariffs stabilized to economic levels. Although the reform process was successful in general, with the active participation of the private sector, the scheme suffered a setback in the distribution segment outside of the capital city]. The failure of privatization of electricity distribution companies can be mainly attributed to inadequate tariffs and the lack of a cross-subsidy mechanism among different consumers which is implicit in companies of a large enough scale. Both of these issues are being gradually addressed (introduction of FOSE, see below, and contemplation of additional incremental tariff for rural areas), but the rural sector remains challenging for distribution and around the world requires subsidization. In the restructuring of the sector, the electricity tariff scheme was predicated on full-cost recovery. An initial transition period of four years was established during privatization to adjust tariffs to their economical efficient levels. This situation prevailed until the middle of 2001, with no explicit subsidies to the electricity rates. Under the new Toledo government, Congress passed legislation in August 2001, which established a social tariff for electricity consumption (the so called FOSE, Fondo de Compensacih Social ElCctrica ). The application of the FOSE subsidy began in November 2001, with a temporary duration of three years. However, in July 2004, the Congress extended indefinitely the application of the subsidy, increasing the levels of tariff reductions (increasing the amount of the subsidy). Presently, the private sector owns about 65% of installed capacity in generation and all of transmission (with the government owning only small minority stakes that it is seeking to divest.) In distribution, two private companies serve Lima, while state-owned companies still serve the remainder of the country, with about half of the total nationwide electricity users. Electricity generation in 2004, was 22,613 GWh, of which 76% came from hydro (considerably less than in 2003, when hydro represented 86% of generation.) Quality of electricity service in urban areas is considered satisfactory and the electricity distribution companies generally operate professionally. However, the existing electricity distribution COPRI (the Peruvian private investment promotion entity, now called ProInversion) indicated initial strategic investments of over two billion US Dollars, and about US$700 in agreed new investments in the sector, in its 2000 report Evaluacion del Proceso de Privatizacion del Sector de Electricidad. lo Distriluz, an electricity distribution holding corporation composed of four regional companies (Electronorte, Hidrandina, Electronoreste, and Electrocentro), was privatized in 1998 only to be returned to public hands in August 2001, after failing to comply with its contractual obligations with the State. Now Distriluz is administered by FONAFE, the Fondo Nacional de Financiamiento de la Actividad Empresarial del Estado, a management unit under the Ministry of Economy and Finance. Distriluz companies serve 12 Departments with a total of 1.1 million customers (about 6 million people.) 21

28 companies hold concession areas concentrated in small areas around urban centers. Their obligation is to meet service requests only within 100 meters of the existing network. Background on Tariffs Regarding the sector tariff structure, the LCE established two different hnds of electricity users, the small retail users under regulated prices (denominated regulated users), and the large users with demands above 1,000 kw (denominated free users), which could contract their electricity service directly to generators or distributors, under bilateral contracts at negotiated generation prices. Generation prices are determined by merit order cost-based economic dispatch. Generators trade their energy surplus or deficits at the short-term ( spot ) marginal price (see figure below for a schematics of the system.) - ( Free MWh Distribution System Figure 1.1: Schematic of Tariff System Distributors Contestable Market Clients) Regulated Market (Regulated Clients) I Contract 1 I, Client Retailing Retailing Services Regulated Competition Generation prices to the regulated users (called busbar prices) are calculated periodically (it was twice a year before a recent reform to the LCE that modified this to once a year) based on a three-year (one historical and two future years) economic operation simulation. The transmission network has open access and tariffs are regulated under an economic cost-based procedure. The transmission tariff is recalculated every year. The distribution system, consisting mainly of medium voltage (MV) primary distribution linedfeeders and low voltage (LV) distribution circuits, is regulated under a cost-based efficient model company, for each of four typical distribution sectors (urban high density; urban medium density; urban-rural; and rural), based on users average maximum demand and consumption, load density and geographic dispersion. The distribution tariff is called the VAD (Value Added for Distribution). The VAD for the different zones and distribution companies are recalculated every four years (a VAD tariff review is underway and will enter into effect in November 2005; for this review, a new zone was established, by subdividing the actual zone two.) 22

29 Table 1.1: Distribution Tariffs as of June 2005 (in S/kWmonth) VADM VAD, Zone 1 Zone 2 Zone 3 Zone These per unit capacity costs are converted to more suitable energy units, using typical consumers demand curves, for establishing consumers tariffs. The tariff for a typical regulated residential final user consists of: the generation tariff, GT (the busbar price) + the transmission tariff, TT + the distribution tariff, VAD (VADM + VADL, the distribution added value for MV and LV networks.) For example, the electricity tariff for a residential consumer in Lima, the capital city, with a consumption above 100 kwh per month, is S/ kWh (about USSO.l02/kWh.) The tariff for a similar consumer in a rural area of Peru is S/ /kWh (about US$0.127/kWh), 25% higher than in Lima. These are the fill-cost tariffs. In the restructuring of the sector, the electricity tariff scheme was predicated on a full-cost recovery. This situation prevailed until the middle of 2001, with no explicit subsidies to the electricity rates. When Mr. Toledo took office in July 2001 announced legislation for establishing a social tariff for electricity consumption (the so called FOSE, Fondo de Compensacih Social Electrica ). The subsidy was approved by congress in August 2001, and began to be applied in November 2001, with a temporary duration of three years. The subsidy consisted of 25% and 50% tariff reduction for monthly consumption up to 30 kwh, for users supplied by the interconnected system (ICs) and by isolated systems (IS), respectively. For consumption between 31 and 100 kwh, the reduction was gradual from a maximum of 25% to a minimum of 7.5%, in the case of ICs users and double this percentage in the case of IS users. Consumption above 100 kwh per month would pay a surcharge in proportion to energy consumption above 100 kwh/month to finance the subsidy. In July 2004, the Congress extended indefinitely the application of the subsidy, increasing the levels of tariff reductions (increasing the amount of the subsidy). The new tariff subsidy for residential consumers with the FOSE is shown in the table below. Users of Areas Tariff Reduction for consumptions lower or equal to 30 kwhimonth For consumption greater than 3o kwhimonth up to 100 kwhlmonth Interconnected System Interconnected System Isolated System Isolated System Urban 25% of the energy charge A reduction of 7.5 kwldmonth A reduction of Urban-Rura1 and 50% of the energy charge Rural 15 kwwmonth Urban 50% of the energy charge A reduction of 15 kwwmonth Urban-Rural and 62.5% of the energy A reduction of Rural charge kwwmonth This new level of subsidy consists of 25% and 62.5% tariff reductions for monthly consumption up to 30 kwh, for urban users supplied by the interconnected system (ICs) and for rural users supplied by isolated systems (IS), respectively. For consumption between 31 and 100 kwh, the reduction is gradual, from a maximum of % to a minimum of 7.5%, for rural users supplied by IS, and for urban users supplied 23

30 by the ICs, respectively. Consumption above 100 kwh per month would pay a cross subsidy in proportion to their energy consumption above 100 kwmonth to finance the FOSE discount. The table below shows electricity tariffs, including the FOSE subsidy, for a residential user with monthly consumption up to 100 kwh: Table 1.3: Residential Subsidized Tariffs (S/kWh) Consump tion Lima Rural From 3 1 to 100 kwh Statistics shows that about 33% of all residential users consume less than 30 kwh per month and about 35% consume between 31 and 100 kwh per month. This means that 68% of all residential consumers receive some electricity price subsidy. This represents an increase of slightly more than 3% in the fullcost of electricity for the users providing the subsidy (the ones with monthly consumption over 100 kwh.). Background on Rural Electrification Electrification of rural and remote areas was not explicitly addressed in the new legal and regulatory framework. The rural electricity market in Peru is very small and dispersed. The distance and isolation of these communities make access to electricity in rural areas very difficult, which results in high installation, operation and maintenance costs for rural electric installations. These high costs discourage, private investment in rural electrification. Furthermore, the inhabitants of rural areas generally have very low income levels, which make their demand for electricity and ability to pay tariffs very low. Due to these factors, there is little incentive to invest in rural electrification without government subsidization. Consequently, only 32% of rural households in Peru have access to electricity, the second lowest electrification coverage in Latin America after Bolivia. Although no clear strategy or policy was established, the Government has invested a considerable amount of public funds in expanding electricity service to ruralhemote areas, and in non-served areas in the periphery and poor zones that surround the largest cities. In parallel with the reform program of the energy sector, in 1993, the Ministry of Energy and Mines established the Direccidn Ejecutiva de Proyectos (DEP), as an entity in charge of implementing electrification projects, to complement the investment activities of the privatized distribution companies. The main centralized development strategy pursued by DEP was to extend the grid and increase levels of rural electrification. Therefore, rural electrification in Peru has been thus far limited to direct investment by the central government - there is no adequate framework to mobilize investments from communities, regional governments and the private sector in the current centralized strategy. The activities of the electricity distribution companies within their concessions, and of the DEP and social funds such as FONCODES in rural areas and areas outside of concessions have increased national coverage levels from 57% in 1993 up to 76% in Over this period, rural electrification increased from 5% to about 32%. The total investment by the DEP during this period was just over US$600 million, with an annual average of about US$50 million. The DEP completed 608 projects during this time period. According to statistics from the DEP, about 4.8 million people were benefited by these projects (close to one million households). The average amount of kilowatt-hours consumed per month by each household, which were beneficiaries of the DEP projects, was around 20 kwh. 24

31 While progress has been made, there remain significant challenges in access and consumption of electricity in Peru. Today, significant differences exist between urban and rural areas, leaving about six million inhabitants without access to electricity, almost exclusively in rural and remote areas of Peru. In addition, the levels of investments have dropped significantly since the 1996 figure (around US$135 million) with investments in rural electrification in 2002, representing only 13% of the high in In 1995, the DEP executed 171 projects, while in 2003 only 23 projects were implemented. Many of the early projects targeted provincial and district capital cities, with the objective to improve services andor connect urban populations to the grid. Most of the remaining communities without electricity are highly dispersed and the difficult geography makes electrification much more costly. Currently, the DEP/MEM prioritizes rural electrification proposals based on technical criteria (project design status, existing electricity infrastructure, and provincial electrification index), economic criteria (socio-economic NPV, required investment per capita), and social criteria (poverty index, geographic location) and provides a 100% investment subsidy for the selected projects. However, the weighting factors result in priority being given to areas with low provincial electricity coverage and high incidence of poverty over other criteria such as economic efficiency, minimum subsidy and maximum economic benefit, undermining the long-run sustainability of these projects. Although the impact of MEM s activities in improving the electrification level of the country is recognized, limitations of fiscal budget allocations and experience with the existing approach indicate that an overhaulhmprovement of the existing model is required, to promote the involvement of the private sector, and broaden the active involvement of additional actors in rural electrification project development. Several attempts have been made to change the existing institutional and legal framework for rural electrification. Two laws have been passed by Congress in recent years, but not implemented because of conflicts with provisions of other laws (Law for Electrification of Rural and Isolated or Frontier Areas in 2002, and Law to Regulate the Promotion of Private Investment in Rural Electrification in 2004). Both initiatives, while incomplete, contained a number of positive elements, including incentives for private investment, increased role in planning for regional governments, and the creation of a Rural Electrification Fund. MEM recently reiterated its commitment to reduce the electrification gap, aiming to increase rural coverage from 32 per cent to 75 per cent by With this goal in mind, the MEM is contemplating the development of a modern institutional, financial, legal and regulatory general framework for rural electrification (rural electrification - including for urban poor, remote and isolated areas) that would address the following main shortcomings of the present situation: Lack of incentives to electricity service providers to invest in rural electrification Inadequate electricity tariffs for a sustainable development of rural electrification Low levels of electricity consumption in rural areas Centralized planning and selection of projects based on social criteria, that results in unsustainable projects. Lack of a legal and regulatory framework for small and isolated systems, including renewable energy systems Background on Renewable Energy As usage levels of electricity in rural areas are low and the costs of grid extension are high in Peru s difficult terrain, it is expected that there is potential for renewable energy to play a significant role in See the Rural Electrification Plan of This is estimated by MEM to require about US$860 million (US$86 million annually). 25

32 supplying rural electricity. Renewable resources abound: (a) in the highlands, the average solar radiation levels reach 5 kwm2/day, with small seasonal variations; (b) the wind velocity measurements in the coastal zone indicate average velocities of 6 d s at 10 m level; (c) the hydroelectric potential is vast, especially in the highlands and higher parts of the jungle; and (d) the potential for biomass projects in the upper zone of the jungle is very promising. Groups such as the Intermediate Technology Development Group have carried out small-scale donor-financed projects to promote rural electrification using small hydropower, wind and solar energy, creating experience that the project can flu-ther build upon. Work has been done by the MEM to investigate the potential of renewable energy and promote its use within Peru. With the assistance of the UNDP/GEF assisted Solar Photovoltaic Based Rural Electrification Project, MEM has investigated solar resources, prepared a solar map, and is in the process of developing a GIS system that will contain information on solar resources and the populations that could be served by PV systems. MEM has also prepared norms for the design, operation and maintenance of PV systems. A preliminary evaluation has been made of geothermal energy and there is a map of potential locations. A preliminary investigation has been made of wind power potential, and there are two turbines installed in the coastal areas of Malabrigo and Marcona (the latter is inoperative), Although recently the Congress has passed a general law for the promotion and utilization of renewable energy sources (Law No of June 16,2005), this law does not contain details of how it would work, leaving most of its application to future specific regulations. Also, there i s a law to promote geothermal energy, but it has never been made operational due to lack of regulations. The Direccidn General de Electricidad (DGE) is carrying out a study on how to promote use of renewable energy for electricity generation, but MEM has not yet developed an overall strategy for renewable energy utilization. With respect to rural electrification, the majority of rural electrification projects implemented thus far have been main grid extensions and in more isolated rural areas, the construction of local diesel generators. Thus there has been little diffusion of renewable energy systems in rural areas. The UNDP/GEF Project mentioned above is expected to result in the installation of about 7330 solar home systems in Peru, and to remove some of the barriers to the use of solar PV systems such as lack of resource information, norms and capacity of technicians. However, many barriers to rural electrification using renewable energy remain, including a lack of specific regulations by DGE and OSINERG to govern operation of renewable energy systems, lack of capacity in regional governments and in distribution companies and suppliers to develop renewable energy rural electrification projects, a lack of data and information on renewable energy resources other than solar, a lack of systematic policy for renewable energy promotion in the MEM, and a lack of promotion of potential productive uses of electricity from renewable energy. New Proposed Rural Electrification Strategy Including Renewable Energy The estimated required amount of annual investments to achieve the goal of increasing rural coverage from 30% to 75% by 2012, is US$86 million. The central government has been providing about US$40 million from the limited treasury hnds for this purpose; clearly not enough to achieve the indicated goal. The proposed Project will test a new strategy, in parallel with DEP activities, aimed at leveraging the treasury funds and increasing economic efficiency in the sector and attract broader participation and financing from communities, regional governments and private enterprises. Such a strategy would need to: (a) encourage planning and implementation of demand driven projects; (b) introduce rural electricity concessions with specific regulations to ensure the economic and financial viability of projects; (c) create incentive mechanisms for efficient rural electrification investments by existing and new distribution companies, and for local and regional governments to contribute toward subsiding investments; and (d) expand the use of new technologies to serve remote populations, especially renewable energy. 26

33 In parallel to the preparation of the proposed Peru Rural Electrification Project, the World Bank is assisting MEM to prepare proposals to reform the Rural Electrification Sector in Peru. Under assistance from the Public Private Infrastructure Advisory Facility (PPIAF), a new general framework for rural electrification was proposed and agreed with major stakeholders at a workshop in January 2005, Propuesta para un Nuevo Marc0 General para la Electrificacidn Rural en el Peru. The general framework is being used to assist preparation of a new model law and regulatory framework for rural electrification, with PPIAF support. The new proposed strategy reflected in the general framework would encourage planning and implementation of demand driven projects. Regional and local governments would support demand evaluation and project planning at the regional decentralized levels. The strategy also aims to mobilize investments from communities, regional governments and the private sector to help co-finance these new rural electrification projects. Consequently, the new strategy would help address the current need for more efficient and decentralized planning and selection of projects. The strategy would create subsidy incentive mechanisms for rural electrification investments by existing and new distribution companies. To provide incentives for investment in rural electrification, the strategy proposes to create a Fund for National Rural Electrification, which would be an entity specifically created to manage the mobilization, management and disbursement of funds for rural electrification. The Fund for National Rural Electrification would be designated to provide a minimum subsidy for rural electrification projects, and mobilizeicatalyze other funds for project financing. Electricity service provision companies would propose rural electrification projects to the fund. The projects would compete for the subsidy, and would be evaluated on economic efficiency criteria such as minimum capital cost subsidy and maximum economic benefit. The electricity companies, together with local and regional governments, would identify, design, and propose projects to the fund. The electricity company also would provide an equity investment on the rural electrification project in order to be eligible for the subsidy. The capital cost subsidy would therefore provide incentive to companies to participate in rural electrification projects, including companies in the private sector. This approach has been successfully used in several countries with diverse distribution models, including El Salvador and Chile (private sector distribution) and Ecuador (public sector distribution). The new strategy will also promote the participation of small private sponsors/concessionaries, ensuring long-term financial sustainability and adequate rate of return on project equity contribution to these new rural electrification projects. Nevertheless, theoretical analysis and empirical evidence show that cost functions in electricity distribution exhibit important economies of scale, increasing returns to scale and 12 economies of output and customer density. Therefore, existing distribution companies, already serving l2 The costs of a distribution system are the costs of building and operating and maintaining the system of service lines, mains and transformers. These costs depend upon: (i) the total number of customers served; (ii) the maximum demand on the system; (iii) the size of the distribution area; (iv) the capacity of the transformers; (v) the length of distribution lines; (vi) the total kwh sold; (vii) the price of labor; and (viii) the price of capital. Cost functions showing economies of scale in the electricity distribution industry are well documented theoretically and in empirical research; see for example: Salvanes, K.G. and Tjotta, S.,1994, Productivity Differences in Multiple Output Industries: An Empirical Application to Electricity Distribution, The Journal of Productivity Analysis, 5, 23-43; Power Technologies, Inc., 1966, An Approach to Define the Smallest Viable Distribution Company with the Perspective of Restructuring, Commissioned by The World Bank, LAC Technical Department, Washington, DC; Thompson, H.G., 1997, Cost efficiency in Power Procurement and Delivery Service in the Electric Utility Industry, Land Economics, 73, ; London Economics, 1999, Efficiency and Benchmarking Study of the NSW Distribution Businesses, Commissioned by the Independent Pricing and Regulatory Tribunal of New South Wales, Sydney, Australia; Adonis Yatchew, Scale Economies in Electricity Distribution: A Semiparametric Analysis, Journal of Applied Econometrics, Vol. 15, No. 2, 2000, pp ; T. Jamasb and M. Pollitt, Benchmarking and Regulation of Electricity Distribution and Transmission Utilities: Lessons from International 27

34 relatively extensive territory with an established customer base, have a natural economic efficiency advantage in expanding their service to new areas. Then, it is expected that most of the new rural electrification project proposals will come from existing distribution companies. Another objective of the proposed new rural electrification strategy is to introduce rural electricity concessions with specific regulations to improve the economic and financial viability of projects. A new institutional framework and regulations for grid-connected and off-grid rural electricity service are needed to improve the economic and financial efficiency of the sector, including procedures for issuing rural concessions norms for electricity provision and service quality. Furthermore, to ensure the economic and financial viability of the new projects, the proposed new rural electrification strategy will focus on encouraging the distribution companies to extend their existing grids organically, focusing first on those projects that are nearer existing grids that have existing or potential productive uses. These areas would be more densely populated than isolated rural areas and would have higher demand due to the current or potential productive activities in these areas. Part of the sub-project selection criteria will take into account the number of connections (households) and the maximum economic benefit of the project. This new approach would not only be more economically and financially viable, but also address the issues of low electricity densification and low rural electricity consumption. The final objective of this new strategy is to expand the use of new technologies to serve remote populations, especially using renewable energy. The strategy recognizes that given the low usage levels in rural areas, it would be more economically efficient to serve some of the remote and isolated areas of the country, or areas where the population is dispersed, using off-grid renewable energy technologies such as solar PV systems, or isolated grids where the electricity is generated using renewable energy, e.g. small hydropower, wind power, or biomass power alone, or in combination with diesel. The strategy proposes to include fully renewable energy in all aspects of development of the institutional framework, new concessions and regulations, to ensure that renewable energy technologies will be used for provision of electricity where these technologies would be more economically viable than grid extension or diesel mini-grids. Work under the PPIAF grant on the general framework, the model law and the detailed framework still to be developed integrates fully renewable energy in all aspects. Experience, in DAE Working Paper. Cambridge, U.K.: Department of Applied Economics, Univ. Cambridge, 2001; and M. Filippini, J. Wild, and M. Kuenzle, Scale and cost efficiency in the Swiss Electricity Distribution Industry: Evidence from a Frontier Cost Approach, in CEPE Working Paper 8. Zurich, Switzerland,

35 Annex 2: Major Related Projects Financed by the Bank andor other Agencies PERU: Rural Electrification Sector Issue: Rural Electrification Renewable Energy in the Rural Market (P006043) Electricity Services for Rural Areas Project (P085708) Rural Electrification and Transmission Project (PO7 1591) Rural Power Project (P066397) Offgrid Rural Electrification (PERZA) (P073246) Rural Energy Project (P074688) System Efficiency Improvement, Equitization & Renewables Project (P066396) Power and Communications Sectors Modernization and Rural Services Project (PROMEC) (P063644) Decentralized Infrastructure for Rural Transformation (P073367) Energy Services Delivery Project (PO10498) Renewable Energy for Rural Economic Development (P077761) Rural Energy I1 (P074688) S- Sati, Country OED Rating Last ISR Date Argentina Senegal Cambodia Nicaragua Vietnam Vietnam ictory MS-Moderately Satj Latest Supervision (ISR) Ratings Development I Implementation Objective Progress MS MU S S S MS MS S MS MS S S S S IADB Projects Code Country Year Approval PPP Support to Rural Electrification and to the Energy Sector Rural Electrification Program H00224 Honduras 2004 CHO 1 74 Chile

36 Annex 3: Results Framework and Monitoring PERU: Rural Electrification Results Framework Ns: As this is a fully integrated World Bank-GEF Project, the results framework presented below concerns the whole Project, The Project Development Objective outcome indicators refer to the overall Project. However specijic outcomes and indicators on the GEF components are presented below and indicated by an asterisk (*). PDO I I Increase access to efficient and sustainable electricity in rural areas o f Peru Global Environment Objective: (*) Reduction of greenhouse gas emissions through provision of electricity using renewable energy. Intermediate Outcomes r Electricity distribution companies invest in sustainable rural electrification projects. Project Outcome Indicators Vumber o f new electricity :onnections [ncrease in MWh o f electricity :onsumed for productive uses in target areas (*reported separately for projects using renewable energy) (*) Number of new electricity connections using renewable energy (*) MW Renewable energy based electricity generation capacity connected to grid (*) Reduction in tons of COZ emissions Intermediate Outcome Indicators Total investments by distribution companies in rural electrification Use of Project Outcome Information YR 1 YR2 Measure effectiveness o f xoject in leveraging financing for mral electrification and improving zfficiency of service delivery YR 3 Mid-term review of approach on subsidy provision and renewable energy promotion. YR 5 Inform the rural electrification strategy o f the country and development o f legal and regulatory framework Use of Intermediate Outcome Monitoring YR 1 YR2 Measure effectiveness o f project in leveraging financing for rural electrification and renewable energy YR 3 Mid-term project review Regulations, norms and guidelines developed under Project are adopted for all rural electrification projects, including (*)specific provisions for renewable energy Issuance o f regulations, norms and guidelines and their adoption in all rural electrification projects YR 5 Project completion report YR1 YR2 Measure effectiveness of technical assistance component of the project YR3 Mid-term review of effectiveness in cost reductions and efficient service delivery 30

37 PDO Communities, Municipal and Regional Governments collaborate with distribution companiesiproject sponsors to develop rural electrification projects Project Outcome Indicators Number of proposals approved for financing by the project Use of Project Outcome Information YR1, YR2 Measure effectiveness of capacity building for stakeholders YR 3 Mid-term review of technical assistance YR 5 Inform country s rural electrification and renewable energy strategy Rural populations in targeted project areas (* including renewables) use electricity for productive activities provide funds for small hydro generation investments Number of enterprises adopting electricity in targeted areas Investment in electricity consuming equipment made by enterprises. (*) MW of small hydropower installed; MWh o f renewable electricity produced by these plants YR1 YR2 Measure effectiveness of productive uses component YR 3 Mid-term review of components design and implementation YR 5 Inform rural electrification strategy that would contemplate specific productive uses promotion activities YR 2 Measure effectiveness o f small hydro financing facility YR 4, YR 5 Measure effectiveness of refinancing mechanism 31

38 .- 0 E L c +.c E s + c : P L h + U E : E I L a 9 F cu '0 m v! 0 0 F 3 d hl 0

39 2 3 3 m 0 m * - a * 0 0 CQ 2 r z 3 0 m

40 Annex 4: Detailed Project Description PERU: Rural Electrification The project seeks to increase access to efficient and sustainable electricity services in rural areas of Peru. To achieve this objective the project would actively engage all stakeholders while allocating to the electricity service providers a central role of responsibility in the scheme. To ensure sustainability and efficiency, electricity providers would be responsible for the identification, design, investment cofinancing, and long-term operation of projects under the existing -or any future, specifically adapted to rural areas- electricity concession system. Communities, local and regional governments would: (a) coordinate with electricity providers in the identification, prioritization and planning of specific subprojects, and (b) possibly provide co-financing for sub-projects. The central government through the Project Executing Unit would be responsible for the competitive selection of projects and the provision of capital investment subsidies under transparent procedures. The regulatory body fosinerg), together with the Directorate General of Electricity (DGE) of the Ministry of Energy and Mines, would be responsible for appropriate norms and guidelines for rural electrification projects, as well as monitoring the service delivery. The project components are aligned with the above project design and the allocation of roles among different stakeholders: Component I refers to the specific investments for rural electrification subprojects; Component 2 refers to technical assistance activities for stakeholders; Component 3 aims to enhance the economic and financial sustainability of electrification by promoting productive uses for electricity; Component 4 addresses a key barrier in the implementation of small hydropower generation investments -- lack of appropriate financing in the early risk stage of projects; and Component 5 concerns project management needs. Component 1 - Rural Electrification Sub-projects (Estimated cost US$ million, US$ million IBRD, no GEF): Overall Description. The investment component of the Rural Electrification Project is financed by a World Bank loan, counterpart funds from the government of Peru, investments by electricity service providers, and grant contributions by regional and local governments. The component provides capital cost subsidies for part of the investment cost of rural electrification sub-projects that would be implemented by qualified electricity services providers to extend services to rural consumers. Rural electrification sub-projects are defined as projects to provide service to new customers in rural areas outside of existing concession areas, where the obligation to serve i s not mandatory. Examples of such projects would be extension of the existing grid to serve new customers grid (from the interconnected system or isolated networks), establishment of new isolated systems with diesel or small hydro generation, or provision of service to customers with individual renewable energy systems such as solar PV systems. Other types of projects that meet the definition would be considered. Prior to receiving a subsidy, the service provider would need to have an electricity concession, which ensures adequate experience and technical, commercial and financial capacity. The geographical scope of the Project is national; a service provider can make an application for a subsidy for any project that meets the eligibility criteria described below. Project Procedures. The Project would provide a grant of up to 90% of the capital cost of the rural electrification sub-proj ect. The electricity service provider must also invest. The subsidy would be 34

41 determined as the amount needed to provide a 12% rate of return on the share of the investment provided by the electricity service provider at current tariffs. Any regionalaoca1 government grant contribution would reduce the subsidy required from the central government and increase the likelihood of sub-proj ect selection. The service provider must have an electricity concession to receive the subsidy. The service provider would present a detailed profile of the Project including financing plan, with evidence of commitment with application for subsidy. Other Project components would support preparation of feasibility studies for the first sub-proj ects proposed using renewable energy. Training and capacity building would also be provided to MEM, electricity service providers, regional and local governments for project implementation and supervision. Productive use pilots, including in health centers, schools, etc., would be promoted through targeted technical assistance. MEM would sign a sub-project agreement with the electricity service provider, governing rights and responsibilities of all parties. The sub-proj ect installations would be owned by the electricity service provider. There would be two types of criteria for sub-projects to be financed under the Project. All projects would be required to meet a set of eligibility criteria. If the amount of subsidy required for eligible sub-projects is greater than the amount available in a given evaluation period (two or three times per year), there would also be criteria for prioritization. Criteria would be specified in the operational manual and then adjusted with experience, based on mutual agreement between GoP and Bank. Illustrative criteria are supplied below. Eligibility criteria for sub-proj ects to receive a subsidy are: - profile sub-proj ect document is complete, including safeguards screening; - sub-project connects at least 1000 new electricity customers; - sponsor makes a minimum investment of 10% of total capital cost; - economic rate of return is above SNIP requirement (currently 14%); - subsidy required is no more than US$SOO per connection. To maximize the impact of central government funds, the principal prioritization criterion for subprojects is minimum central government subsidy per connection. The above procedures would apply to both public and private sector projects. However, the lack of a legal framework for the direct provision of investment subsidies, or the transfer of funds or assets (and some taxation implications), is the principal outstanding issue for private sector participation. In the case of public companies, this situation could be solved by considering the subsidy as a capital infusion by the Government, or the transfer and holding of assets by ADINELSA. In countries such as Chile and El Salvador, specific legal provisions have been adopted to overcome these problems and allow the Governments to provide these subsidies for rural public infrastructure. TA i s underway and would be continued within the Project to obtain similar exemptions in Peru. In'order to prevent inordinate delays in private sector participation, the fallback option of proceeding through bidding of concessions would be adopted within a year of effectiveness if no private sector proposals have been financed under the Project. Component 2 - Technical Assistance for Rural Electrification (Estimated cost US$3.75 million of which US$O.75 million IBRD and US$2.5 million GEF): Overall Description. This component is designed to provide the technical support and build the capacity of all project participants, in order to ensure that the Project is successful. It includes sub-components to improve the regulatory environment, build capacity of project participants, promote private sector investment and promote renewable energy as described below: 35

42 a. Regulations and norms. The electricity concessions law of Peru, and the subsequent development of regulations, has focused primarily on provision of electricity in urban areas. As a result, standards of design, construction and quality when applied to rural areas cause over-sizing and over-designing of systems which in turn tend to rise per unit costs and hinder the economic viability of projects. Furthermore, the lack of a legal framework for the direct provision of investment subsidies and the transfer of assets of rural electrification projects implemented by the DEP, forced the creation of ADINELSA as a public company with the sole objective of holding the ownership of the assets created by these public investments. ADINELSA has no mandate to operate and maintain the systems, therefore they sign management agreements with municipalities and other institutions to administer the assets and provide electricity service. Some DEP projects were transferred to public distribution companies as equity contribution, causing complaints from these companies, considering the non profitability of the projects. This arrangement is considered unsatisfactory and the Government is searching for an adequate solution. In addition, the option of using renewable energy in electricity provision remains largely underused and its potential is not sufficiently exploited. Taking into consideration the above situation, this component aims to address these issues through the provision of technical assistance to develop and implement appropriate norms and guidelines for rural electrification including specific treatment of renewable energy. The component is expected to include activities such as: 0 Legal and regulatory arrangements for direct investment subsidies and transfer of rural electrification assets; Concessions Regulations for Electricity Service Provision in Rural Areas; 0 Regulations for Monitoring and Supervision of Electricity Service Provision in Rural Areas; 0 Tariff System for Grid-Connected and Off-Grid Renewable Energy Project; 0 Product and Service Quality Regulations for Rural Electrification; 0 Design and Construction Guidelines for Grid Extension Rural Electrification; 0 Design and Construction Guidelines for Off-Grid Rural Electrification with Renewable Energy Sources. b. Capacity building for stakeholders. Rural electrification has been so far mainly organized and delivered through the largely centralized mechanism of the DEP. This component therefore aims to assist the various stakeholders that would have to work together under the proposed Project design. This component would strengthen the capacity of local and regional governments to identify, plan and prioritize adequate projects in cooperation with the electricity service providers who would be ultimately responsible for the construction and operation of projects. The Project would also strengthen the capacity o f service providers to propose projects, especially projects using renewable energy. The Project would assist the selection of appropriate, least-cost technologies --such as renewable energy-- to electrify remote areas, or regions with dispersed populations, where grid extension would not be economically viable. The component i s expected to include activities such as: Development and Implementation of a GIs-Based Project Information System; Development of Sectoral Institutional Structure in Regional (and Local) Governments; Capacity Building and Training in Sub-Proj ects Development Procedures in Regional (and Local) Governments; Capacity Building and Training for Development of Electricity Distribution Business Plans for New Sub-projects Sponsors; 36

43 0 0 0 Capacity Building and Training for Sub-projects Technical Development for Existing Service Providers; Capacity Building and Training for Development of Renewable Energy Sub-Projects; Computer Hardware and Software Support for Regional (and Local) Governments. c. Promotion of Private Sector Participation: While the distribution companies serving Lima are currently private, the majority of the existing distribution companies serving rural areas are in the public sector. This component aims to catalyze the participation of new private entities in rural electricity distribution. This could include private distribution companies from Lima or other countries, or companies in other sectors such as mining. It is expected to include activities such as the following: Definition of Legal and Regulatory Measures for Provision of Capital Cost Subsidies to Private Sector Service Providers; Development of a Project Bidding Mechanism for Private Participation in RE Projects; Preparation o f Bid Packages for Concessions; Capacity Building and Training for Development of Electricity Distribution Business Plans for New Private Sub-projects Sponsors; Public Awareness and Promotion of the Project's Renewable Energy Financing Facility; Development of Electrification Projects as Part of Private Investments in Other Sectors Like Mining, Agribusiness and Others; Business Development Activities for Identifying Potential Private Investors in Electrification. d. Renewable Energy Promotion: Annex 15 contains an analysis of the barriers to introduction of renewable energy to Peru. The various components of the Project are designed to remove a number of barriers for renewable energy in Peru. Each of the above components addresses selected barriers. This component would address specifically the lack of reliable renewable energy data and information, specific policies to promote renewable energy in the country, and awareness among the general population and stakeholders. This component would focus on renewable energy for rural electrification and supply to the rural grid, especially using small hydropower due to the resource availability in many areas of Peru. This component would include support to specific activities such as the following: Development of Capacity within MEM/DGE for Renewable Energy Promotion; Measurement and Other Technical Equipment for Evaluation of Renewable Energy Sources; Complementary Evaluation of Potential of Renewable Energy Sources for Electricity Generation (mainly small hydropower); Development of Policy and Regulatory Incentives and Overcoming Barriers for Renewable Electricity and Distributed Generation; Development of Pre-Feasibility and Feasibility Renewable Electricity Projects; Development of Financing Mechanisms for Renewable Electricity Projects Implementation; Development of Public Awareness and Promotional Printed Material Regarding Renewable, Clean and Sustainable Energy Development; Public Conferences, Seminars and Technical Presentation on Renewable Energy. 37

44 Component 3 - Pilot Program to Promote Productive Uses of Electricity (Estimated cost US$3.95 million of which US$2.0 million IBRD and US$1.5 million GEF): There is almost unanimous agreement that energy plays an important role in increasing productivity of enterprises and in improving livelihoods. In the context of rural areas, this generally implies productive use of energy for the provision of power for agricultural and small industrial or commercial uses. For example, motors are used to grind grain, operate power tools, irrigate farmland, process agricultural produce, and facilitate many commercial activities. Electric power can result in productivity gains and economic growth, thus transforming the underdeveloped rural landscape - if ancillary services such as market access, human and enterprise capacity, financial services, and resources/raw materials are available. From an electricity service company viewpoint, productive uses are essential to establish the long-term economic viability and sustainability of rural electrification. Load factor and capacity utilization in rural areas of Peru are currently low. Power demand peaks usually occur at night while daytime loads are minimal, indicating that electric power is mainly used for domestic lighting and appliances (e.g. radio, TV). Load factors are often under 50%, and sometimes under 25%. For example, Electrosur reports that in its rural service areas, the load factor i s only around 25% with a two hour evening peak from 6-8pm. Many hydro grids have similar low load and capacity factors. According to MEM data, 50% of the hydropower plants with total installed capacities of 580 MW have capacity factors less than 60% (implying that daytime loads are typically less than 50% of peak generation capacity). Achieving increases in productive uses of electricity in rural areas confronts constraints on both the supply (electricity service company) and demand (enterprise) side. On the enterprise side these have included: (i) lack of knowledge on adopting electricity to improve productivity; (ii) inadequate access to investment financing to obtain an electricity connection and electric equipment; (iii) lack of trained personnel; (iv) uncertainties or difficulties with regard to increased availability of raw materials or access to larger markets; and (v) lack of knowledge in dealing with the electricity service company. On the electricity service company side, these have included: (i) the selection criteria for rural electrification areas, whch in the past did not explicitly include existing or potential productive uses; (ii) the lack of 24- hour service in some isolated systems (particularly true in the case of municipal isolated grids in Peru); (iii) service quality, particularly outages and voltage fluctuations; (iv) delays in responding to business requests for connections and upgrading of contracted power; (v) the tariff structure which hinders both initial connection and the expansion of installed capacity; and (vi) an incentive structure which does not encourage electricity service company staff to promote productive uses. The component concept is based on several successful productive uses promotion projects in Peru, including the Marenass Project and the Incagro Project (by the Ministry of Agriculture); the Corredor Puno-Cusco Project (by FONCODES and MIMDES); as well as the Rural Business Services component in the Indonesia Second Rural Electrification Project financed by the IBRD. Principal lessons from these projects are that targeted marketing interventions and price incentives which address information constraints and business needs of small enterprises in rural areas are effective in load promotion. Furthermore, for success, cooperation and support from the local electricity service company is essential to facilitate grid connections. Access to investment resources are also needed to finance the switch to electricity. The objective of this Productive Uses Promotion component is to contribute to increase the productivity of rural businesses by promoting a more intensive use of electricity, which would in turn improve living conditions in rural areas of Peru, as well as improve the utilization of electricity supply infrastructure and electricity service company revenues. Priority would be given to those energy intensive operations that 38

45 currently employ diesels or other power sources, and those with strong potential for electricity use if additional value-added processing is done in the region. Since this component is financed both by IBRD and GEF, the component would focus on two distinct market segments: (a) isolated hydroelectric grids or hydroelectric-dominated grids where GEF assistance would be offered; and (b) other rural grids, isolated or interconnected where IBRD resources would be deployed. Target areas would be selected based on four criteria: (i) low load factor in the grids serving the regions due to underutilized capacity, and not due to supply side constraints, and an electricity service company with interest and commitment to support productive uses promotion; (ii) presence of a significant potential for energy intensive productive activities in farm and off-fann enterprises that might benefit from a shift to electricity; (iii) existence of basic supporting infrastructure; (iv) for the renewable energy-focused market segment, service areas predominantly supplied with renewable energy-based electricity. Screening of candidate areas based on the four criteria noted above is being undertaken during preparation. The MEM would approve the target areas. The proposed approach for this component relies on providing cost-shared and targeted technical assistance to entrepreneurs, associations or communities in rural areas interested in expanding their businesses through the use of electric energy. The proposed approach is broadly one of capacity building. It is a marketing approach in the broadest sense - identifying target markets and segments; increasing awareness and skills, assisting potential productive users, user groups and communities to identify opportunities, barriers and solutions; working closely with the electricity service suppliers to ease access; and facilitating access to other necessary services, including financing. The proposed core steps in designing a marketing-based productive uses program could be as follows: (i) conduct diagnostic to screen for promising areas/communities with significant opportunities for increased productive uses of electricity where there are no electricity supply constraints; (ii) identify constraints to productive uses in these areas and develop approaches to mitigating the barriers; and (iii) test them out in several marketing pilots, evaluate, adjust, reiterate, replicate. The implementation approach proposed is that the productive uses capacity building activities be implemented on a campaign-like basis in the different areas that would include: (i) having the PEU lead the effort with support from an organization (either an NGO or private company), to administer the program, and supervise and coordinate the work of a number of regionally-based consultants; (ii) giving the beneficiaries key decision making authority in selecting services and service providers, with appropriate guidance and ensururing the cost sharing of services; (iii) using locally based implementers as much as possible, with guidance and support as necessary from others. They would use locally appropriate promotional and instructional materials, and standardized material; (iv) working collaboratively with and building alliances with the critical facilitative services and with the electricity service company to resolve issues and ensure support services are available. Component 4 - Small Hydropower Financing Facility (Estimated cost US$15.0 million, of US$5 million is from the GEF): which Peru is a country with significant hydroelectric resources due to its geography (Andean mountain range) and climatic conditions. In addition, various irrigation projects and water resources management projects have already created civil engineering structures that could result in competitive hydroelectric generation in small and micro schemes. Through its carbon financing activities in the country, the World Bank has reviewed a significant number of privately sponsored small hydro schemes that would be viable and could likely provide least-cost solutions for supply of electricity in Peru. Nevertheless, although the financial system in Peru is relatively liquid, commercial banks are not experienced, and in general are unwilling to provide financing on a project recourse basis. Project sponsors, therefore, have to finance projects fully 39

46 on equity, borrowing on their balance-sheet, or pledging other assets for collateral. This has created significant financing barriers to investment in small hydro plants for sale to the grid, despite the viability of the potential projects. This project component would address the above barriers by using GEF funds to leverage private and commercial debt financing for small hydro generation plants to supply electricity to the grid. The project would provide bridge-financing for small hydro plants during the period of construction and initial operation, after which the loan would be refinanced by commercial banks. The project sponsor would provide an equity contribution (at a minimum of 30% of total capital cost) while the GEF funds (as well as other commercial financing) would provide debt finance for the remainder, during the period of construction and initial operation. The debt component of the GEF would then be refinanced by commercial financial institutions, after the construction risk had been eliminated. This component would not finance electricity connections or distribution grids, which would be financed only under Component 1. The facility would include an investment decision-making function and a separate revolving loan facility under a financial administrator-- to handle the disbursement and recuperation of specific project loans (lending back-office functions). A qualified company would be competitively selected to act as Fund Manager with responsibilities that would include: marketing and promotion of the facility, preliminary screening of project proposals, detailed evaluation and due diligence on projects, negotiation of conditions and terms for specific loans and supervision of investments. A separate three-member Investment Committee would be appointed by the Project Directory Committee to approve investments proposed by the Fund Manager. For approved investments, the disbursement and repayment of the loans would be handled through an administrative financial agreement with a qualified bank. Project sponsors would present hydro projects to the facility which would evaluate them on the basis of their financial, technical and economic soundness. Qualified projects would be presented to the Investment Committee for final approval. Once investments are approved, the financial management functions of the lending operation would be handled under an administrative financial agreement. At the end of the construction and initial operation period, the debt would be financed by commercial financial institutions. The financing of small hydro would be possible because an already constructed and operating hydro system is a valuable asset, which can be used as collateral to comply with the requirements of commercial banks. Because of the minimum equity requirement under ths financing scheme, an operating plant would have a value of about 140% of the debt component to be refinanced. The facility would continue its operations after the project is completed for another five years under similar rules aiming to continue leveraging financing. The costs of the administrative financial agreement would be covered after the initial operation period through revenues from interest payments. It is estimated that during the ten years of the operation of the facility, at least 30 MW of small hydro projects would be thus financed, while it is expected that as the scheme proves the concept of project financing for small hydro systems, financial institutions would increasingly start to provide funds for such schemes assuming earlier project risk. At the end of the period, after financing about 30 MW of renewable energy projects, it is expected that funds would still be available in the facility. At that time, the GoP and the World Bank, in consultation with the GEF Secretariat, would agree on the further use of any remaining funds in accordance with GEF Climate Change Mitigation objectives. 40

47 Component 5 - Project Management (Estimated cost is US$6.4 million of which US12.75 million is IBRD and US$I million is GEF): This component would include support for overall management of the proposed Project including the Project Executing Unit which would consist of a Project Manager; an administrative unit with staff to handle procurement and financial management; a technical unit that would evaluate sub-proj ect applications and oversee the functioning of the finance facility and the productive uses component; and a monitoring and evaluation unit. It is expected that the actual administration of the subsidy and the renewable energy finance facility would be carried out by a qualified bank under an administrative financial agreement. 41

48 Annex 5: Project Costs PERU: Rural Electrification 42

49 Annex 6: Implementation Arrangements PERU: Rural Electrification General Institutional and Implementation Arrangements The project would be implemented over a five-year period by the Ministry of Energy and Mines (MEM). Project implementation includes partnership among MEM, MEF and the regulator, OSINERG in a Project Directory Committee, which would approve the subsidies for sub-proj ects. Implementation also includes a partnership with a bank that would assist in implementation of the renewable energy finance facility and NGOs that would assist in implementing productive uses technical assistance activities, as well as with distribution companies and regional governments. The project would have an implementation organization, under the Ministry of Energy and Mines, guided by a Project Directory Committee, and executed by a Project Executing Unit (PEU). The Directory Committee would be presided over by the Vice-Minister of Energy, and it would have two other members, the Vice-Minister of Economy and the President of OSINERG, the energy regulatory entity. A Project Manager would direct PEU activities. The PEU would be organized in three basic units, the Technical Unit, the Administration, Financial and Procurement Unit, and the Monitoring and Evaluation Unit. As explained before, the main function of the Technical Unit is the evaluation of sub-projects for subsidization. Other activities of the Technical Unit would include technical support to the local and regional governments, and to the distribution companies or projects sponsors, on sub-project formulation, and management of the technical assistance and productive uses promotion components of the Project. The Administrative Unit would be in charge of general administration, financial management and procurement activities for all Project components. The Monitoring Unit would be in charge of Project progress evaluation, reporting and other follow up activities. Figure 6.1 shows the specific project implementation institutional arrangement. Figure 6.1: Project Organization Setup Project Directory Committee Executing Unit 2I Technical Unit Administration, Financial Management, Procurement Unit Monitoring and Evaluation Unit 43

50 Rural Electrification Sub-projects Public intervention in rural electrification requires interactions between different institutions, from the central government to the final beneficiaries. In the case of a particular project its institutional organization must manage and guide these interrelations. The implementation of the proposed Project reflects this situation at different levels. First, rural electrification sub-proj ects would compete for the subsidy. Sub-projects to be presented for financing under the project would be prepared, starting at the community where the demand for electrification is manifested. The community may request electricity service either directly from the service provider, or from the local or regional government. If requested from the local or regional government, these requests would be initially screened by the local (municipalities) and regional governments that would define regional priorities and interest in project cofinancing. The local or regional government would coordinate with the existing regional distribution company or with a qualified project sponsor (hture service provider/distribution concessionary), for project preparation and submission to the Project Executing Unit for evaluation. The Project would be open to, and would promote the participation of newly created private sponsorsiconcessionaries, while ensuring sub-proj ects long-term financial sustainability and adequate rate of return on project equity contribution. Sub-projects selected for subsidy would be contracted for construction and subsequently operated and maintained by the service provider. Figure 6.2 shows the overall institutional arrangement, Figure 6.2: Overall Rural Electrification Sub-project Implementation Arrangements Project Executing I '+' Unit Participating I Contractors Existing or Potential ' Electricity Service 4 Provider Government Regional Government Community /Users I I I The second institutional arrangement deals with sub-proj ect preparation, evaluation, prioritization, selection and subsidy allocation by the Project. For the proposed sub-project, the electricity service providers would prepare documentation following standard guidelines, at the level of a detailed profile, including an analysis of demand and estimation of length of distribution lines. The Technical Unit of the PEU would be in charge of carrying out a detailed technical, economic and financial evaluation of subprojects, preparing a prioritized list of selected projects and estimating the initial amounts of sub-projects' subsidies. The Technical Unit would prepare an evaluation and recommendation report to be considered by the Directory Committee. The Directory Committee would approve the selected sub-projects and the subsidy amount. To implement the selected sub-projects, a sub-project agreement would be signed between MEM and the electricity service providers that would carry out the sub-projects. To ensure economic efficiency in sub-proj ect implementation, their construction would be bid out by the service providers. Details of the roles and responsibilities are given below. Figure 6.3 shows the sub-projects' processing cycle. 44

51 Figure 6.3 Sub-project Cycle: Rural Electrification Project Pro.ject Request Gov t or Qualified Service Provider &provides basic data Qualification of Service Provider and funds Eligibility of Sub-pro,jects determined by PEU TU of PEU determines the sub-project OPI/SNIP System PEU submits report Basic Engineering Completed & Safeguard Reauirements Met Service Provider continues with project preparation for bidding Bidding Following Bank Procedures Service Provider bids out sub project turn-key construction Construction Contract Between Service Provider and Contractor Subsidy will be provided according to sub-project agreement Evaluation & I Final Payment on Construction 1 45

52 Project Executing Unit of MEM: The PEU is responsible for: 0 Creation of awareness among communities, provincial authorities, other national agencies and other donors; 0 Capacity building of regional and local governments, electricity service providers, communities; 0 Evaluation of subsidy proposals according to criteria set forth in Section 3, and presenting the selected projects to the Directory Committee; 0 Ensuring that each sub-project conforms to GoP and Bank environment and social safeguards, as required; 0 Preparing a sub-project agreement for each sub-project, between MEM, the electricity service provider and third party investors, if any; 0 Supervising bidding procedures by service providers to ensure they comply with Bank procurement procedures and rules; 0 Review of financial performance of sub-projects on an annual basis; 0 Monitoring and evaluation of sub-proj ects impacts. Participating Bank The participating Bank would have the following responsibilities, under an administrative financial agreement with PEU: 0 Payment of subsidy to electricity service provider; 0 Financial management and reporting with respect to subsidy funds. Electricity Sewice Provider: The electricity service provider would: 0 Receive request from community or regional/local government for electricity project; 0 Coordinate with regionauloca1 government and community, including arrangements for their grant contributions; 0 Prepare and submit proposal for subsidy including profile sub-proj ect proposal, financing plan, and preliminary safeguards screening; 0 Have or obtain an electricity concession; 0 If successful, sign sub-project agreement with MEM; 0 Carry out detailed engineering and safeguards studies; 0 Conduct tendering process for turnkey construction of sub-proj ect according to Bank procedures; 0 Sign contract with construction contractor; 0 Supervise construction and authorize payments against progress; 0 Evaluate and accept asset; 0 Operate and maintain system, providing electricity service to rural customers that meet quality requirements. Regional/Local Government 0 Coordinate with community and service provider; 0 Prepare indicative rural electrification plans; 0 Participate in prioritizing by optionally providing grant that reduces central government subsidy. Community 0 Make request for service to electricity service provider and/or local or regional government; 0 Provide necessary information on demand, potential connections, identifying special loads, etc.; 0 Provide contribution in kind or cash and commit to pay electricity tariffs. 46

53 Implementation Arrangements for Technical Assistance and Productive Uses Promotion Activities The TU would contract out technical assistance activities under Component 2 to national and international consultants that would carry out the required investigations, studies, workshops and capacity building activities. The PEU would administer the Productive Uses Promotion Component which would be implemented through a number of regionally-based consultants with assistance from a Support Services Contractor. The regional offices would be contracted separately. The organizational relationships are shown in Figure 6.4. The PEU would have overall responsibility for implementing this component, including administration, production of training and capacity building materials, establishing operating procedures, and financial management. Each regional consultant would implement the Productive Uses Promotion Component in its regional area of responsibility under the supervision of the PEU. Capacity building and promotional services would be conducted by regional consultants. Cost sharing with the beneficiary would be required where individualized assistance is provided to a specific enterprise. Specific responsibilities are shown below. Figure 6.4 Productive Uses Component Organization I ; Contracts I-- -r I I Project Execution Unit Promotion Support Services I L I I-- I I I r I Regional Regional Regional Regional Contractor 1 Contractor 2 Contractor 3 Contractor 4 I I Regional Contractor N Associations/Communities Assisted m. The PEU would have overall responsibility for implementing this component, including the following: (i) Overall management responsibility of the Productive Uses Component; (ii) Approve the target regions for focusing the work of this component; (iii) Update the Operations Manual and prepare the detailed Implementation Plan; (iv) Direct and supervise the performance of the support services contractor(s) and the regional consultants; (v) Overall fiduciary responsibility; (vi) Monitor and evaluate performance of regional consultants and program effectiveness; (vii) Issue quarterly and annual report to the Steering Committee and World Bank, as required; 47

54 (viii) Help build relationships and liaise with partner organizations, including financing institutions, electricity service companies, training and capacity building organizations, and trade and marketing associations; and (ix) Organize technical and financial support through alliances with existing programs with similar objectives. Support Services Contractor(s). Specific tasks would include the following: (i) Assist the PEU to supervise the performance of the regional consultants; (ii) Assist PEU update the Operations Manual and prepare the detailed Implementation Plan; (iii) Lead the diagnostic work and recommend to the PEU any changes to the priority geographic areas and priority sector/application to support; (iv) Prepare standardized marketing brochures, leaflets, advertisements, posters, training videos and all other instruments; (v) Organize training sessions for regional branches and subcontracted institutions on the wide range of businesses that could be helped to shift from manual and/or diesel source of energy to electricity; (vi) Help build relationships and liaise with partner organizations, including financing institutions, electricity service companies, training and capacity building organizations, and trade and marketing associations; (vii) Arrange to leverage technical and financial support through alliances with existing programs with similar objectives (e.g., Peru Emprendedor, SENATI); (viii) Assist PEU monitor and evaluate regional consultants and program effectiveness; and (ix) Prepare quarterly and annual report to the PEU, as required. Regional Consultants. Each regional consultant would be responsible to implement the Productive Uses Promotion Component in its regional area of responsibility under the supervision of the PEU. The responsibilities would encompass the following: Conduct a diagnostic of specific energy intensive opportunities to increase productive loads and of constraints faced by local entrepreneurs towards more electricity intensive operations or switch to electricity from using diesel or other power sources; Conduct targeted promotionallmarketing campaigns to inform the local Communities about the advantages of switching to electricity use and of the availability of cost-shared assistance; Facilitate access to information on electrical equipment, performances and costs; Using facilitators, visit potentially energy intensive enterprises, associations or communities to encourage their participation and assist interested organizations in seeking assistance. Priority would be given to those energy intensive operations that currently employ diesels or other power sources, particularly those needing electricity during the daytime; Screenievaluate requests for assistance and select promising proposals for cost-shared assistance; Provide direct assistance and advice in the most cost-effective manner possible, e.g. providing standard documentation, advice and training, or group advisory services. In exceptional cases, it may be necessary to support the implementation of the proposed work by assisting beneficiaries to select and contract for technical assistance. The funds available under the project along with a 10-20% contribution from the beneficiary would pay for technical services where individualized assistance is provided to an enterprise or association. It is expected that during the period of implementation, about 15,000 rural enterprises would be assisted; Establish relationships/partnerships with local electricity service companies as well as regional organizations that can provide supplementary services and investment financing and assist beneficiaries in obtaining such services. This may include assistance in preparing loan applications and electricity connection applications; (viii) Conduct baseline and post-assistance surveys to determine effectiveness of services provided. Monitor electricity consumption changes and other key performance indicators; and 48

55 (ix) Monitor and supervise the provision of services, manage finances and report to the PEU on a regular basis. Implementation Arrangements for Financing Facility for Renewable Energy Projects The Facility includes an Independent Investment Committee, a Fund Manager (investment advisor) and an Administrative Financial Agreement where financial administration would be handled. The Facility would be managed by a competitively selected qualified Fund Manager. The Fund Manager would be responsible for: 0 Promoting the Facility to prospective sponsors and financial institutions; 0 Analyzing potential projects proposed by sponsors; 0 Performing due diligence for short-listed projects (technical design assessment including resource assessment, costing and timing of works, and operational requirements; financial and economic assessment; compliance with environmental and social framework; risks assessment); 0 Actively seeking co-financing and closure of refinancing upon end of construction and initial operation period; 0 Preparing necessary documentation and presenting investment recommendations to the Independent Investment Committee; 0 Advising the PEU on issuing instructions for loan disbursements under the Administrative Financial Agreement for approved projects; 0 Supervising the project sponsor as necessary during the investment period. The Fund Manager would be rewarded based on proportion of co-financing that i s brought to the deal and successful refinancing of the hydropower facility after its commissioning and operation for a period of time. The Independent Investment Committee would be composed of three adequately qualified members, to be appointed by the Project Directory Committee. The Independent Investment Committee would review investment recommendations provided by the Fund Manager and provide its approval for worthy investments. The Participating Bank would operate based on an administrative financial agreement with PEU, as instructed by the PEU (disbursement of funds as necessary to ensure project completion and costs minimization) issuing invoices and receiving loan repayments from project sponsor company, recordkeeping and management of legal documents. 49

56 Figure 6.5 Implementation Arrangements for Small Hydropower Generating Financing Facility Independent Investment Committee (Appointed by PDC) 4 w Fund Manager Trust Fund (Investment Advisor) Revolving Loan Small Hydro Facility b 50

57 Annex 7: Financial Management and Disbursement Arrangements PERU: Rural Electrification A Financial Management Assessment was performed in accordance with OPiBP and the Guidelines for Assessment of Financial Management Arrangements in World Bank Financed Projects. The evaluation was initiated jointly by the FM and Procurement teams, on June 24, 2005 and performed, in the offices of the Ministry of Energy and Mines (MEM) with a team led by the Project Preparation Manager and the Coordinator. Executive Summary and Overall Conclusions Project design and implementation require a robust financial management system, which at the time of the assessment are not yet in place, since according to local regulations the Project Executing Unit (PEU) can only be established after the signing of the loan agreement and the participating institutions and private enterprises have not yet been selected. Nevertheless, as one of the products of the preparation grant, a draft operations manual has been prepared, which, along with the proposed FM action plan, will bring together planning, budgeting,.accounting, financial reporting, internal control, auditing, disbursement, physical performance for the project, and will, finally, determine the necessary steps to achieve adequate resources management and to reach the project development objectives. Currently, the overall inherent and control risks have been assessed as moderate. More specifically, at the country and entity level the risks are moderate, while at the project level the risk profile is high. However, successful implementation of the FM action plan, highly qualified professionals in key positions and adequate capacity building would generate acceptable financial management arrangements, resulting in moderate residual inherent and control risk ratings at the project level, too. Risk Assessment Overall:- both inherent and control risks have been assessed as moderate. At the country level, CFAA findings and experience with the existing country portfolio in the areas of financial accounting, reporting, audit quality and compliance, and the quality of the FM profession, indicate that country risks are m~derate. ~ At the entitv level, the MEM has traditionally operated acceptable financial management arrangements, based on national control norms, and MEM is staffed with high level professionals with excellent capacity in planning, budgeting and financial management as well as internal controls. Entity level risk is therefore assessed as moderate. At the project level, the risk profile is high, due to the relative size of the loan, the multiple actors described in Annex 6 Implementation Arrangements, the flow of funds mechanism, including a participating bank, which would make payments for Components 1 and 4, through an Administrative Financial Agreement comisidn de confianza, the need for robust coordination in planning and budget preparation, and technology capacity that would allow timely and accurate consolidation and reporting of financial and disbursement information. l4 See the Country Financial Management Strategy note for a fuller description of the country context. 51

58 In order to mitigate the risks posed by the lack of an established PEU and lack of recent engagement with the Bank, the following will be required: (a) highly qualified professionals in key positions (profiles in the Operations Manual); (b) a highly qualified and experienced Financial Manager (profile in the Operations Manual); (c) considerable degree of technical assistance and capacity strengthening measures (to be provided by the financial management and disbursement Bank teams); (d) successful implementation of the FM action plan; and (e) close supervision by the Bank FM team, during the first year of project implementation. Full analysis and development of financial management issues will be included in the Financial Management Assessment, included in the Project files. Disbursement Arrangements and Flow of Funds Disbursement Arrangements During project implementation, disbursements may be transaction based (ie against Statements of expenditure (SOEs), full documentation, direct payments or special commitments) or Report-based. The Bank and client have discussed the use of report-based disbursements for all components. However, given that the Project team will be newly created and the IT systems are not yet operational, the Project will use the transactions based disbursements mechanism (SOEs), during the capacity building period. Indeed, report-based disbursements call for a substantial amount of technical assistance to the PEU in the design of the Financial Monitoring and additional disbursement required reports. Satisfactory IT systems that will produce the reports and staff technical capacity will be necessary for timely disbursement and satisfactory flow of funds. On the client side, the key elements for successful implementation of reportbased disbursements are the following: 1) the ability to make projections of cash flow requirements; 2) synchronization with the annual operating plans, procurement plans; and 3) finalization of the interinstitutional arrangements to ensure: (i) accountability in the different project levels; and (ii) timely transfers of funds to the bank accounts of the participating bank for payments and loans. The project will have access to funds advanced by the Bank to two Special Accounts in US dollars (one for the loan and one for the GEF), for processing disbursements to beneficiaries for those eligible expenditures under project activities. The Special Accounts (SA) will be opened by the Borrower in the Banco de la Nacion (Government commercial bank) and will be managed by the central PEU, established within the MEM, responsible for implementing the project. Designated accounts will be set up in coordination with Credit0 Publico and will consist of both USD and Local Currency accounts, Counterpart funds will be financed from the National Treasury and the Peruvian system is set up to force two payments from the two sources of funds. Funds will be deposited into the Special Account as advances and will follow the Bank s disbursement operating policies and procedures. In the case that withdrawals of loan proceeds are made using Report-based Disbursements, the Bank will deposit into the Special Account an amount, which the Bank has determined, based on the reports submitted (FMRs and additional reports for disbursement purposes), required to finance eligible expenditures during the next period (no more than 9 months) following the reporting period of such FMRs. The disbursement of up to 9 months cash flow needs to the sub-accounts managed by the Participating Bank was deemed necessary to provide contractors sufficient payment assurances. 52

59 Transaction-based disbursements may include direct payments to consultants and service providers, reimbursement to the Government for the Bank s share of pre-financed expenditures and Bank advances. Report-based disbursement would be used almost exclusively for Bank advances to the project. The counterpart funds from MEF and possibly from Regional Governments, that will be used for the current project in the percentages stipulated in the Legal Agreement will be monitored by the PEU according to the Operations Manual. The project should design detailed procedures for the opening of Bank Accounts, which include acceptable internal controls, as well as procedures for the transfer of resources from the Special Accounts to the Rural Electrification Designated (sub) account and to project local currency accounts (Second Generation Special Accounts, or SGSAs), established by the PEU in a commercial bank acceptable to the Bank. Financial management capabilities of the Participating Bank should be a criteria of selection. The Bank FM team will assess the Participating Bank to ensure that it is capable of managing Bank and GEF resources and that it meets minimum Bank FM requirements. Flow of Funds Both sources of external financing (IBRD loan and GEF grant) will be managed by the PEU. Funds will flow from the World Bank Loan account to a USD Loan Special Account and from the GEF Grant Account to a USD Grant Special Account. Both USD special accounts will have corresponding project local currency accounts for disbursements. The PEU will make disbursements to suppliers and contractors from the special accounts for Components 2, 3, and 5. The PEU will transfer funds from the Loan Special Account to the Rural Electrification Designated (sub) account managed by the Participating Bank, under the Administrative Financial Agreement, for expenditures to be made under Component 1. The PEU will similarly transfer funds from the GEF Grant Special Account to a second designated sub-account managed by the Participating Bank for loans to be made under Component 4. Counterpart funds will be transferred from the Peruvian Treasury to the Project s counterpart account, managed by the PEU for the Government s share of project expenditures, according to the percentages established in the Loan and Grant Agreements. 53

60 More specifically, the flow of funds will pursue the following schema for each component: 1. Component One: Selected rural electrification service providers, under PEU s supervision, will sign contracts with construction contractors. They will make payments corresponding to their co financing share, while the Participating Bank will pay directly the construction contractors the remaining part, corresponding to the subsidies (loan, and counterpart and other funds) form the designated sub-account, upon PEU s instructions and under the conditions of the Administrative Financial Agreement against bills and construction progress. Initial payments and progress payments made by the Participating Bank will be reported or summarized on SOE s to be presented to the Bank by the PEU for the Special Account replenishment on (at least) a monthly basis. World Bank b Project Special Account (Banco de la Naci6n) I National Budget Allocations Counterpart Funds Executina Rural Electrification Designated Account (in the name of PEU, Banco de la Nacion) (managed by Participating Bank) 4 Regional Government Funds Others (Donations, Grants to the Project) Rural Electrification Sub-project Agreement Electricity Service Provision Company Contract for Contractor for Rural Electrification Sub-project 2. Component Two: The technical unit, within the PEU will handle this component s activities, contracting out technical assistance activities to national and international consultants. The PEU will make payments from the Special Account and the Counterpart funds account, and will keep all original documentation. 3. Component Three: The PEU will lead the implementation of this component with the support of a service contractor and regional consultants. The PEU will make payments from the Special Account and the Counterpart funds account, and will keep all original documentation. 54

61 4. Component Four: A Fund Manager will select and propose to the Independent Investment Committee (within the PEU), renewable energy projects, according to a Facility Agreement. The Participating Bank will finance selected projects with GEF grant funds, under the conditions of an Administrative Financial Agreement. It will provide loans to the selected small hydro projects, based on the instructions received from the PEU and receive and administer repayments (including interest). Upon signing a small hydro project loan agreement, the Participating Bank will send an original copy of the loan agreement to the PEU for filing. The PEU will determine the amount of loan disbursements and make monthly or biweekly transfers from the GEF special account to the Participating Bank GEF account. Loan disbursements reported by the Participating Bank will be considered eligible expenditures for purposes of the GEF grant and will be reported or summarized on SOE s to be presented to the Bank by the PEU for the Grant Special Account replenishment, on (at least) a monthly basis. The loan repayments will be deposited into the Participating Bank GEF reflow account and be used for additional small hydro project loans. Original documentation corresponding to loan repayments will then be sent to the PEU s archives. Finally, the Participating Bank is expected to send to the PEU a GEF bank account statement, on a monthly basis. I I I I I World Bank Project GEF Grant Special Accoun (Banco de la Naci6n) I Unit I I Proiect Executing Rural Electrification GEF Grant Designated Account (in the name of PEU, Banco de la Nacion) (managed by Participating Bank) 1 Participating Bank Small Hydro I Agreement iall Hydro Sub-project an Agreement Contractor Payment: I I Contractor for Rural Electrification Sub-project 5. Component Five: The PEU will carry out this component, make payments from the SA and the Counterpart funds account, and will keep all original documentation. The budgeting process necessary for Project s implementation and disbursements would use in many cases a bottom-up approach, while the final budget would have to be consolidated by the PEU, for the 55

62 final approval from the MEF. The information would flow from the service providers, the TU, the Participating Bank and the Fund Manager to the PEU for consolidation. Accounting The PEU will maintain all Project records, consolidated accounts and financial statements, for disbursements and reporting. Therefore, the accounting function should be centralized at the PEU, making sure that: (i) all the participating entities maintain adequate accounting systems in order to operate all the sub-accounts, and (ii) adequate charge codes are attributed to the upcoming expenses, harmonized among the implementing entities, thus identifying the origin and use of the funds by category and by component. This is necessary, in order to build three series of financial statements for: 1) the IBRD loan; 2) the GEF grant; and 3) the consolidated or Project s financial statements. Information Systems At present, the MEM is using the Sistema Integral de Administracidn Financiera (SLAF) and the GESTOR, a parallel system compatible with SIAF, which allows the registration of more detailed accounting information. Those systems will be used by the PEU for project financial statements consolidation, reporting and disbursements. Audit Arrangements hzternal Audit: Project transactions undertaken by the PEU will be subject to review by the Internal Audit Department of the MEM. This Department is independent and reports the findings of its ex-post control directly to the country s supreme audit institution ( Contraloria General de la Repziblica). However, as the rhythm of implementation increases, the PEU will need to ensure that its own internal control structure is sufficiently strong, and the FM function is adequately staffed with professionals conversant with Bank policies and procedures in order to: (i) avoid ineligible expenses and delays in the flow of hnds and Project implementation; (ii) safeguard of Project s assets; and (iii) avoid misuse of funds. External Audit: The PEU will be responsible to provide the Bank annually with consolidated financial statements for the Project, including funds from the World Bank loan, GEF Grant and counterpart funds (including funds from loan repayments), audited by an independent auditing firm acceptable to the Bank and under terms and conditions satisfactory to the Bank, which will include an opinion on the project financial statements and a management letter on the internal control structure. The auditors should have access to all supporting records and make on site examination of all participating companies and institutions (including the Participating Bank). Annual audit reports with the related statements will be submitted to the Bank within six months of the end of the Borrower s fiscal year. All supporting records would be maintained at the Project and at all participating companies and institutions sites for at least one year after submission to the Bank of the audit report covering the year in which the final project expenditure was incurred. The Bank s audit guidelines will be used by the Borrower in determining the format and content of the annual financial statements and in preparing the audit terms of reference (TORS). The costs of the Project audits may be subject to financing from loan proceeds. Auditors would perform at least one interim inspection per year in order to promptly identify areas that require attention of the Project s management. Such reviews will identify problems related to accounting or/and internal control in a timely manner. After each interim visit, a memorandum on internal controls (management letter) would be produced to ensure that corrective actions are addressed prior to year end. 56

63 Annual project financial statements will be audited in accordance with International Standards on Auditing (ISAs) issued by the International Federation of Accountants (IFAC), by an independent firm acceptable to the Bank. The audit will be performed in accordance with terms of reference (TORS) approved by the Bank, and the audit opinion should cover the project financial statements, Special Account, Statement of Expenditures (SOEs), compliance with Loan Agreement and applicable financial laws and regulations. Financial Management Supervision during Implementation During the first year of implementation, supervision intensity will be increased, considering the overall risk profile, and will take the form of technical assistance to the project, and will review controls and transactions as appropriate. This will be complemented by desk reviews of the Financial Monitoring Reports and annual audit. Thereafter, in addition to the main annual supervision mission, visits may be scheduled to follow up on the findings o f the desk reviews, as appropriate. Financial Management Action Plan The Financial Management Assessment concluded that the Project arrangements will not meet minimum Bank requirements at signing as the PEU will not exist. As a result, the Action Plan that follows was proposed by the Bank FM team to strengthen institutional capacity. The action Plan was agreed with the Borrower during negotiations. In the discussions with the Project task team, it was decided that all important considerations for Financial Management should be included in the Operations Manual. A Draft Operations Manual was submitted for the Bank s Review during negotiations. While FM conditions of effectiveness are not proposed, as part of fiduciary due diligence leading up to effectiveness, the Financial Management team will visit the project and confirm that financial management capacity is in place to ensure that the Operations Manual can be effectively implemented. Activity 1 1 Responsible Target Date 1-7 Negotiations Legal Preparation of the standard institutional and operational arrangements between the PEU, Privet Electricity Providers, Fund Manager, Participating Bank (for Loan and Grant). Flow of Funds Flow of Funds Design Flow of Funds Chart (Comp. 1 & 4) Training in financial management, including planning and budgeting using country systems and Report-based Disbursements. Organization and Staffing PEU Organization Chart Preparation and submission of TOR for staff of the PEU to Bank for non objections. Formal nomination of the Project Preparation General Manager Formal nomination of the Project Preparation FM PEU Negotiations Accomplished PEU During appraisal Accomplished WB Before negotiations Accomplished WB Project Launching I PEU Inclusion in Operations Manual Accomplished PEU Inclusion in Operations Manual Accomplished MEM Prior to negotiations Accomplished MEM Prior to negotiations Accomplished 57

64 I Activity Full staffing in place Internal audit staff in Bank Disbursement, Procurement Responsible PEU PEU IBRD/PEU Target Date Three months from effective date (Dated covenant, under Article 111, Section 3.04 of the Legal Agreement) Condition of disbursements for Category 4 (Schedule 1, A3(h)(ii) of the Legal Agreement - Loan and Grant) Project launching; Status at Negotiations including institutional arrangements, flo~ of funds design, staff functions, accounting policies and procedures, basis of accounting, chart of accounts tailored to include project components. disbursement catcgories and financing source, internal controls, segregation of duties, fixed assets and records management procedures. Pro\,ision of comments and recommendations. PEU IBRD PEU Prior to negotiations Accomplished =- Prior to effectiveness Prior to effectiveness Preparation of draft TORS for audit and submission to Bank for no-ob'ection. Submission of approved TORS to the CGR to initiate the process of selection and contracting of external auditors. Obtain waiver from the CGR for hiring of the external auditors. Appointment of external auditors. Internal Controls Establishment of own internal control mechanism PEU PEU CGWPEU PEU Prior to negotiations Within three months after effectiveness Within six (6) months after effectiveness To be reviewed bv external auditors I Accomplished Safeguard over Assets (physical and information) Imolementation of Fixed Asset Policics and Procedures I inkding physical inventories, storage/transfer/ distributionhetirements of assets etc. PEU PEU collection and report generation of same, for the Bank to provide its no-objection. Integrated Financial llanagement System Implementation of Integrated Information systems. PEU PEU (attached to the minutes) Three months after effectiveness I 58

65 Annex 8: Procurement Arrangements PERU: Rural Electrification General Procurement for the proposed project would be carried out in accordance with the World Bank's "Guidelines: Procurement Under IBRD Loans and IDA Credits" dated May 2004; and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" dated May 2004, and the provisions stipulated in the Legal Agreement. The various items under different expenditure categories are described in general below. For each contract to be financed by the Loan, the different procurement methods or consultant selection methods, the need for pre-qualification, estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank in the Procurement Plan. The Procurement Plan will be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. Procurement of Works: Works to be procured under this project would include construction of infrastructure to extend the scope of grid-connected electrification services and to develop off-grid electricity services in isolated communities with use of renewable energy sources in rural settings. Procurement processes would be managed directly by awarded electricity distribution companies -under close monitoring of the PEU- using Standard Bidding Documents under NCB procedures acceptable to the Bank. Procurement of civil works will be carried out in 12 rounds throughout project implementation. At each round, contracting packages will be sub-divided in seven contracts, each one estimated to cost US$1.2 million on average, to be procured under NCB. Whenever service providers are not available, the sub-proj ects could be proposed by communities or localhegional governments. In these cases, bidding processes for contracting of civil works and operational activities required for the provision of electricity services will be managed directly by the PEU staff following the procurement methods described above. Details on procedures to be followed in cases where community participation is expected shall be described in the procurement chapter of the project Operations Manual. Procurement of Goods: Goods to be procured under this Project would include office equipment and supplies, technical equipment for evaluation of renewable energy sources, computer hardware and software support for the PEU and regional and local governments. Procurement will be carried out by using Bank Standard Bidding Documents under ICB procedures, and National SBDs proposed by the PEU and agreed with or satisfactory to the Bank. Procurement of non-consulting services: Expenses related to training activities for capacity building purposes -other than consultants- would be procured as non-consulting services. Under this sub-category, expenses such as rental of facilities, purchase or reproduction of training materials, food and other relevant expenses would be financed by the project. Also, contracts for administration of GEF funds by financial institutions in support of small electricity supply companies would be procured under this contract category. Non-consulting services with estimated values less than US$50,000 per contract will be procured with the use of price comparison (shopping) procedures of at least three quotations obtained from qualified local suppliers. For the use of this procurement method, the PEU will submit project standard procurement documents to be acceptable to the Bank. Selection of Consultants: Consultant services to be provided by firms and individual consultants under the project would include advisory services, technical assistance and training in activities related to the development of institutional frameworks and regulations for grid-connected and off-grid rural electricity services, capacity building of service providers and regional governments for development of grid and off-grid sub-projects, promotion of private sector investment and renewable energy, design and 59

66 implementation of promotional/marketing campaign for productive uses of electricity, assistance in business development for purchase of electricity using equipment, and consultant services of a technical and project administrative nature to enable project management and coordination and the carrying out of project administrative tasks in support of the PEU. Short lists of consultants for services estimated to cost less than US$350,000 equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. Consultant firms will be employed with the use of QCBS; QBS, FBS, LCS, CQS and SSS procedures. Contracts for employment of firms to be procured under FBS and LCS methods may not exceed a ceiling of US$200,000 equivalent per contract. Individual consultants will be employed for assignments meeting the requirements established in para. 5.1 of Section V in the Bank Consultant Guidelines and selected on the basis of their qualifications for the assignment required under TOR agreed with the Bank team. Such consultants will be competitively selected through the comparison of at least three candidates among those approached directly by the project agency or who have expressed interest, as the case may be. Operating Costs: Under this cost category, the Project would finance expenses needed to support project management and coordination tasks and monitoring, including rental of the PEU facilities, utilities, operation and maintenance of PEU computer and office equipments, travel, per diem, supervision costs and local contractual staff salaries but excluding salaries of non-proj ect staff of the Borrower s civil service at the national and regional levels. Except for local contractual staff salaries, expenses to be financed under this category will not have to be included in the procurement plans. Implementation of proj ect procurement shall be systematically monitored on the basis of yearly-submitted procurement plans that will include the particular contracts and proposed methods for procurement of works, goods and consulting services, consistent with the ones agreed in the Loan Agreement. Therefore, aggregated amounts for project financing under each type of contract are not necessary to include. A detailed description of the particular methods for procurement of works, goods and non-consulting services, and selection of consultants agreed for project implementation shall be included in the Operations Manual. Project standard procurement documents will be also incorporated in a specific Annex to the Manual. The procurement methods and prior review conditions proposed for the project are indicated in Table 8.1 below. Assessment of the Agency s Capacity to Implement Procurement Procurement activities will be carried out by the Ministry of Energy and Mining -through a dedicated Project Executing Unit- and awarded distribution companies. This Unit will closely oversee the procurement processes managed by service distribution companies. The PEU will be staffed with a total of 14 professionals headed by a Project Manager acting as Project Team Leader; 1 Administrative- Financial Coordinator supported by 1 Procurement Officer; 1 Accounting Officer; 1 Treasury Officer; and 1 Budget Officer; 1 Technical Coordinator assisted by 2 Technical Specialists; 1 Economist; 1 M&E Specialist; 1 Legal Specialist; and 1 Internal Auditor to be provided by MINEM. The procurement function will be staffed by 1 Procurement Officer who would coordinate procurement planning and oversight tasks and provide technical assistance to MEM s line units involved in specific component implementation and Distribution Companies participating in the project. An assessment of the capacity of the Implementing Agency to implement procurement actions for the project has been carried out on June 24, The assessment reviewed the organizational structure for implementing the project and the interaction between project staff responsible for procurement and the Ministry s relevant central unit for administration and finance. 60

67 The key issues and risks concerning implementation of project procurement have been identified and include: i) an organizational structure not yet defined for the PEU by MEM; ii) lack of prior experience and skilled staff in both MEM and in potential electricity service providers to implement Bank-financed project procurement; iii) some degree of uncertainty around the choice of provision of physical space, and computer and office equipment to enable the PEU s full operation and; iv) lack of an integrated project information system necessary to enable timely project monitoring, control and reporting. The corrective measures to be taken by MEM are: i) submission of an organizational structure and a staffing list, and its final decision on the physical location; ii) hiring of a procurement consultant with experience in MDBfinanced projects to provide project procurement coordination, supervision and technical assistance to MEM s executing units and staff, and electricity service companies participating in the project; iii) incorporation in sub-project agreements to be entered into by MEM and Electricity Service Providers in rural areas whereby the latter will adhere to the Bank rules for procurement of civil works and to close oversight and monitoring of the PEU s designated procurement specialist; and iv) full implementation by MEM of an integrated PMIS with the capability of recording timely information and monitoring procurement and FM related transactions not later than the end of first year of project implementation. Bank basic procurement training to both PEU staff and Electricity Service Provider s will by provided by Bank Procurement Specialists not later than project launching mission. The overall project risk for procurement is moderately HIGH. Procurement Plan The Borrower, at appraisal mission, developed a procurement plan for project implementation which provides the basis for the review of proposed procurement methods. This plan has been agreed between the Borrower and the Project Team and is available at the offices of the Vice-Ministry of Energy and Mining (MEM) in Lima. It will also be available in the project s database and in the Bank s external website. The Procurement Plan will be updated in agreement with the Project Team annually or as required to reflect actual project implementation needs and improvements in institutional capacity. Frequency of Procurement Supervision In addition to the prior review supervision to be carried out from Bank offices, the capacity assessment of the Implementing Agency has recommended one annual supervision mission to visit the field to carry out post review of procurement actions. Table 8.1: Thresholds for Procurement Methods and Prior Review* Contract Value Contracts Subject to Expenditure Category Threshold Procurement Method Prior Review (US$ thousands) (US$ thousands) 1.Works Contract = > 3,000 ICB All Contract >250 NCB Contracts = > US$l.O mill; the first 2 contracts; and annual review of procurement plan. Contract < = quotations (Shopping) Post-review: Random sample of contracts First 2 contracts and 61

68 Contract Value Contracts Subject to Expenditure Category Threshold Procurement Method Prior Review (US$ thousands) (US$ thousands) annual review of procurement plan. Post-review: sample of contracts 2. Goods and Non-Consulting Contract = > 250 ICB All Services 250 > Contract 7 50 NCB Contracts = > 200; the first two contracts; and annual review of procurement plan Contract < = 50 National Shopping First 2 contracts and, annual review of procurement plan. 3. Consulting Services and Training 3.1 Firms Contract = > 100 QCBS, QBS, FBS, LCS Post-review: Random sample of contracts All contracts, including TOR, RFP, shortlist of firms, full review of technical and final evaluation reports, and final negotiated contract. Contract < 100 QCBS, QBS, LCS, CQS, FBS or SSS TOR and annual review of the selection plan. 3.2 Individuals Contract = > 50 IC Post-review: Random sample of contracts All contracts, including TOR, CVs, and Form of Contract Contract < 50 IC, and SSS TOR, and annual review of the selection plan Post review: Random sample of contracts Thresholds generally differ by country and project. Consult Operational Directive (OD) , Review of Procurement Documentation, and contact the Regional Procurement Adviser for guidance. Total value of contracts subject to prior review: [US$ million] 62

69 Details of the Procurement Arrangements Involving International Competition 1. Goods, Works, and Non Consulting Services Ref. No. Contract (Description) None Estimated Procurement P-Q Domestic Review Expected Comments. Cost Method Preference by Bank Bid- (yesho) (Prior / Post) Opening Date (b) ICB awarded contracts estimated to cost above US$3.0 million for procurement of works; and NCB awarded contracts above US$1.O million for procurement of goods per contract; and all direct contracting will be subject to prior review by the Bank. 2. Consulting Services (a) List of consulting assignments with short-list of international firms, Ref. No. 2.b.l Description of Assignment Estimated cost Development and Implementation of a Gis-Based Project Information System 0.23 Evaluation of Selection Method OB S Review by Bank (Prior / Post) Expected Proposals Submission Date Comments Prior 2.d Jan b. 1 3.a.l.l krm) Region 1 Office & Promotional Consultancy 1 Services 0.46 Region 2 Office 3.b.2 & Promotional 0.46 Prior Prior Prior May-06 Aug-06 Aug-06 63

70 Ref. No. Description of Estimated Selection Review Expected Comments Assignment cost Method by Bank Proposals (Prior / Submission Post) Date Consultancy Region 3 Office I QB S Promotional Consultanc y 3.b.3 Services 0.46 Region 4 Office & Promotional Consultanc y I 3.b.4 Services 0.46 Region 5 Office I QB S & Promotional Consultancy I 3.b.5 Services 0.46 Region 6 Office I & Promotional QBS Consultanc y 3.b.6 Services 0.46 Dec-06 Fund Prior Management 0.27 QCBS Jun-06 (b) Consultancy services estimated to cost above US$lOO,OOO for employment of firms; and US$50,000 for employment of individuals per contract; and single source selection of consultant firms and individuals will be subject to prior review by the Bank. (c) Short lists composed entirely of national consultants: Short lists of consultants for services estimated to cost less than US$350,000 equivalent per contract, may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. 64

71 Annex 9: Economic and Financial Analysis PERU: Rural Electrification A. RURAL ELECTRIFICATION SUB-PROJECTS Background The main economic objective of the project is to improve the cost-effectiveness of the Government s rural electrification program presently implemented by MEM. In the past, MEM s project selection was largely based on social criteria (to serve the poorest in the most remote communities), with little regard for costeffectiveness. As a result, many such schemes have low electricity consumption, and some, following population migration to urbanized areas, have been effectively abandoned. Rural electrification (RE) schemes built by MEM have been handed over to distribution companies for operation, an unpopular arrangement since these often inadequately designed schemes typically incur high financial losses, Table 9.1 shows MEM s existing Rural Electrification Plan. Average connection costs over the plan period are US$940/HH (household): in the past, this entire amount has been provided as a subsidy since the full construction cost was borne by MEM. Table 9.1: Average US$/connection in each year of MEM s existing Rural Electrification Plan Year Investment Households $HH Cumulative Cumulative US$ million connected Investment, HH US$million connected ,124 59, ,124 59, ,050 62, , , ,502 17, , , ,835 67, , , ,392 38, , , ,O 12 62, , , ,533 61, , , ,324 72, , ,359 total 472, , Source: MEM, Plan Nacional de Electrificacion Rural A new approach is proposed by the project. Its emphasis will be to provide rural electrification to rural areas adjacent to existing distribution company franchise areas (where demand levels will generally be higher, and investment costs per household lower), and to ask the distribution companies themselves to design (and construct) rural electrification schemes for which they will be responsible for operating. This is expected to improve the prospects for financial sustainability, and provide higher rates of economic return than under the existing approach. Outline of the Analysis The economic and financial analysis consists of five steps: 1. Preliminary screening: 49 proposals submitted by the distribution companies to MEM in May 2005 were evaluated for general economic and financial feasibility: this resulted in the selection of a short-list of 16 sub-projects. l5 This is a summary taken from the detailed report on Economic and Financial Analysis. It reflects the preliminary analysis of results of the Rural Energy Survey conducted in June-July. It is unlikely that the main findings would change significantly when survey results are finalized, 65

72 2. Detailed analysis of the short-list, including comparison of key assumptions (e.g. for monthly consumption per household) against the results of the survey, and discussions with the distribution companies to verify technical assumptions. 3. Extrapolation of the of the initial sub-project results to the entire program, again using survey results, for example to assess the market size of potential grid-based rural electrification (RE) projects. 4. Estimating the ERR for the project as a whole. 5. Comparison of the proposed project against the project alternative (Le. a continuation of the existing approach to RE). In the sections that follow we first present the financial and economic model used to assess each subproject: key assumptions on assessing economic benefits are described in Attachment 1. We then present the main conclusions of each step enumerated above. Financial Analysis A standard project finance model was applied to each project proposal to assess the amount of capital subsidy necessary to enable the implementing institution (the majority of which are distribution companies) to obtain a 12% pre-tax financial rate of return.i6 Table 9.2 shows the demand forecast that is the basis for the subsequent revenue projections for a typical sub-project. In most cases, the initial rate of connection is substantially below the rate achieved in the final year, especially in growing regions. The critical assumption for establishing financial sustainability is the consumption rate per household (to ensure that tariff revenue exceeds the (largely fixed) costs of O&M plus energy expenditures. All calculations are at constant 2005 prices. l6 These financial calculations are from the perspective of the distribution companies, and therefore exclude the cost for the house connection and meter, which is assumed financed by the distribution companies, and recovered from consumers over the first year of service, as is present practice. These connection costs are of course included in the economic analysis. 66

73 Table 9.2: Demand Analysis Consumption Project 3 Company I NW 0 I I1 Connexions domestic [#I "on-domesric [#I a genenl [#I small indusrty [#I rpcrlal loads [#I to tal Monthly Consumption domestic kwhlmer non-domesri< general small induitv speclal loads Annual consumption domerrk non-domestic genenl small in6ustry special loads Annual ronsumptlon public lighting ntc public lightlng kwhlmes kwhlmes kwhlmes kwhlmes <I5kWhlm MWh MWh 0 >30 MWh MWh MWh MWh MWh MWh MWh TOSl MWh PI IOSlCS energr required [MWhl enem 'OSt IUS$lkWhl m i m I o 00 0.o o 0.o 0.o I I % I % nowdomesti< ronsurnption IO9 115 a5 fnitlon 0ftoS.l 3% 3% 3% 3% 3% 3% 3% 3% 3% 3% 3% connexlon ate 47% 49% 51% 53% 56% 58% 60% 62% 65% 68% 70% Note: Calculations are for the entire 20-year planning horizon: in the interests of clarity, only first 11 years of operation are shown here. The results of the survey have been used to cross-check the plausibility of the electricity demand assumptions presented by the distribution companies. Average national consumption per household (in rural areas) is 26 kwh/month (with 95% confidence limits as shown). Table 9.3: Electrification Rates and Average Consumption Total HH Electrified HH % electrified k Wh/HH/ 95% month confidence limit Costa Norte 156,419 54,584 35% Costa Centro 75,3 I5 45,378 60% Costa Sur 27,787 19, % Sierra Norte 362,029 80,261 22% I.56 Sierra Centro 634, ,084 52% Sierra Sur 565, ,561 44% Selva 383,403 68,990 18% National Average % Table 9.4 illustrates the financial analysis for a typical project. As indicated in the project summary, the costs and subsidy per household vary according to the year chosen. For purposes of determining eligibility for subsidy, set at US$800iHH, subsidy per households connected in the first year is used (US$571/HH in the example shown). The subsidy itself is calculated as that contribution necessary for the distribution company to achieve a 12% pre-tax rate of return. 67

74 Table 9.4: Financial Analysis Economic Analysis For the economic analysis, costs were adjusted for duties and taxes, while benefits are based on estimates of willingness-to-pay (WTP) derived from survey results: the methodology and a summary of the derivation of the specific values used are provided in Attachment 1. For the first 15 k W H tranche of high-valued electricity used for domestic lighting and TV, the average WTP is estimated at 2.3 Soles/kWh, and 1.4 Soledkwh for the next 15 kwh/hh/month. Beyond 30 kwh/hh/month the WTP is assumed at the tariff. Average use in non-domestic enterprises is 90kWh/month, for which the average WTP is estimated at 3.20 Soledkwh (and at the average tariff thereafter). These are quite conservative assumptions (both in comparison to those encountered in other countries, as well as to past estimates, such as the 4.2 soles/kwh estimate by NRECA). We test below the robustness of the ERR estimates with respect to this uncertainty. Moreover, it should be noted that the quantification of benefits by estimating WTP for given end-uses such as lighting and TV-viewing represents only a lower bound of the actual benefits, which include increased returns on education and wage income; improved access to modern communication and information devices (computers, fax); social benefits to the community (street lighting increases safety allowing women to participate in community life at night); health benefits (reduced burn injuries from kerosene lamps), time savings (e.g. avoiding trips for battery charging). These are difficult to quantify and incorporate into the ERR calculation, but they nevertheless represent a significant part of the social benefits of rural electrification. In one of the few studies to have attempted quantification of education, income generation and time saving benefits to rural electrification (for the Philippines)17, these were estimated at US$95/year, compared to US$56/year for the directly estimated benefits (lighting, TV, etc.) World Bank, Rural Electrification and Development in the Philippines: Measuring the Social and Economic Benefits, ESMAP Report , Washington, D.C. 68

75 The table on distribution of costs and benefits displays the lifetime impacts on stakeholders (expressed as lifetime NPV at 14%, in US$lOOOs). Rows of this table represent individual transactions, and columns represent the costs and benefits incurred by each of the stakeholders. The negative impact on the distribution company (-US$104,000) arises because of the difference.in discount rates and income taxes: if the calculations were at the 12% discount rate, and at zero income tax, then the net impact on the distribution company in NPV terms would be zero (since at the 12% pre-tax FIRR, the NPV is exactly zero). The net economic benefit is simply the sum of the entries in each row with transfers, taxes and duties netted out. 8 Consumers with less than 100 kwh monthly consumption benefit from a crosssubsidy provided by the Fondo de Cornpensacion Social Electrica (FOSE), with equalization at the national level: this adds about 3% to the subsidy providers average electricity bill (and appears in the table of distribution of benefits and costs as other consumers ). Public lighting is similarly crosssubsidized by a complicated scheme equalized at the distribution company level: most of the cost is paid by large consumers with consumption greater than 5,00OkWh/m0nth. ~ Screening and Project Selection Forty nine subprojects were submitted to MEM in May 2005 for potential funding under the proposed project. These were subjected to a preliminary screening for general economic and financial feasibility. About 20 of these were resubmissions of earlier proposals submitted to DEP, most of which failed the SNIP hurdle rate for ERR (14%) and had O&M costs in excess of probable tariff revenues. A short-list of 17 projects was selected for more detailed analysis, that included extensive discussions with the distribution companies to verify technical assumptions. The following screening criteria were used to select projects from the short-list: 0 Financial sustainability, which requires that tariff revenues must exceed the costs of O&M and energy purchases; 0 Minimum project size of 1,000 HH (connected in the first year); Maximum subsidy of US$800/HH (based on the number of HH connected in the first year); 0 Minimum ERR of 14% (as currently required by the SNIP). * The GoP funds include those borrowed from the World Bank. The presentation ignores the additional transaction costs o f the loan (fees, charges and interest charged on the amounted loaned to GoP). However, these are relatively small amounts. l9 Most of the distribution companies are VAT neutral (Le. VAT levied on construction costs are offset by VAT receipts from electricity sales), so the financial and economic costs are a little different. Such differences as remain relate to import duties on imported equipment: the shadow-priced economic costs are 97% o f the financial costs. However, there is a VAT exemption for the Selva, where electricity is classified as a service free o f VAT. However, a distribution company must still pay VAT on that portion of equipment imported from other parts o f the country, without the ability to recover it on electricity sales. This has led to significant losses, and the affected distribution companies have launched a court action in an attempt to change the rules. 69

76 Table 9.5: Economic Analysis Economic Analysis Project 3 Company I NW( I 4%) 0 I IO II costs connexions added [#I connexion cost3 [$IOOO] investment [$IOOO] energy [$looo] O& M [$ I to-1 cos- [$looo] eiierits 0 domestic flrst I5kWt[$lOOO] kwh [$1000] >30 kwh [$1000] non-domestic first90 kw [$1000] >PO [$ small Industry [$ IO special loads [$ I public lighting [$ I 68.4 neteconomicflows [$looo] ERR 1b.5cs TO~I consumption [MWhlYr] levelired economii cost [$US/kWh] 0.32 levelized net economic bent [$US/kWh] 0 51 [Soles/kWh 1.78 Distribution of costs and benefits INW@I4%, $USIOOOs1 8 proleit beneficiaries domestic now otherdbtributton consumers domestic consumers company GoP net benefit benefits Lil 8 - Electriciq Benefla Publlc Llghting = 4 - costs? Meters Ppoject cost O&M -890 ago z' ' P $ In r I n Table 9.6 shows the results of the financial analysis screening, on the basis of which 10 projects meet all of the first three (financial) criteria. Projects 20, 19 and 43 show distribution company contributions that are negative: these projects require a subsidy greater than the construction cost to make up for future revenues that are below O&M costs (i.e. they fail the test of financial sustainability). These projects also fail on grounds of a subsidy requirement>us$800/hhh. Project 23 is financially (and economically) attractive, but the beneficiaries are owners of groundwater irrigation systems rather than HH, and therefore lie outside the scope and objectives of the project (which is to electrify rural households). Overall, among the projects that meet the criteria, the average distribution company contribution is 25.3%. The nine sub-projects have an average subsidy of US$457/HH, which would take up US$l5.2 million of the available subsidy funds. 70

77 Table 9.6: Results of the Financial Analysis Screening [I] [3] [4] [5] [6] D1 PI [IO] accepted I Project I Company I I 5 8% 3 Project3 Company I I 15 I% 4 Project4 Company I I3 3% 54 Project 54 Company 2 I % 14 Project 14 Company % 21 Project21 Company4 I % 46 Project46 Company I % 47 Project47 Company I % 49 Project49 Company 2 I % toed (average) accpeted propch % repcted, rubr1dy~800$ HH 5 Project 5 Company I 2 Project2 Company I 20 Project20 Company6 19 Project 19 Company8 43 Project43 Company 3 repcted. less dtvt 1000 HH 23 Proiect23 Company % % % I % I I % 0 0 I I % Table 9.7 shows the corresponding economic analysis. We note the close alignment of the results of the economic analysis with the financial analysis. Projects with ERR less than the 14% hurdle rate also fail one or more of the financial criteria; and three out of four projects (2, 19, and 20), rejected on grounds of too high a subsidy, also have ERRS only marginally above the hurdle rate ( %). Whatever may be the uncertainty in estimating WTP, one may be confident that strict adherence to the financial screening criteria will also select the best sub-projects from the standpoint of economic returns. Because the economic costs include connection costs, even when taxes and duties are omitted, the average cost per HH (US$644/HH) remains higher than that shown in Table 9.5 (US$612/HH). Table 9.7: Results of the Economic Analysis Screening 3 Project 3 Company I 4 Project4 Company I 54 Project 54 Company2 14 Project 14 Company 3 21 Project21 Company4 46 Project45 Company 5 47 Project47 Company % I % I % I I IO I % 436 I % % 49 Project49 Company 2 I % I I % rejected, sribsidy>8001~hh 5 Project 5 Company I % 2 Project2 Company I I % 20 Project20 Company % 19 Project19 Company 8 I % repcted, less than IO00 HH 23 Project23 Company 7 35 Project35 Company I 0.1 I 40.4% % repcted, ERR< 1.1% hurdle rate 43 Prolect43 Company I90 II % (I) including connexton cost excludingwes and duties 71

78 Criteria for Selection of Projects The criterion of minimum size of 1,000 HH is based on a judgment of transaction costs, and the likely ability of the Project Implementation Unit (PIU) to process applications. In the first 49 proposals received from the distribution companies, 15 were for small projects of less than 100HH, for which clearly the transaction costs for evaluation, approval, management and monitoring do not warrant consideration. The target number of HH to be electrified is 154,000, in projects ideally to be identified over four years, say 40,000 per year. If the average size is 4000, that means that 10 subprojects must be processed per year. Clearly if too large a proportion of these were below 1000 HH, the workload on the PIU would be unreasonable. The specific choice of 1,000 HH therefore represents the judgment of the Steering Committee of what is a reasonable minimum size. The principal selection criterion of minimizing subsidy per HH corresponds to the main objective o f the program, which is to maximize the number of rural households that can be connected with the available funding. Subsidy per HH and economic rate of return are closely correlated, as shown in Figure 9.1, In other words, projects with the lowest subsidy per HH are highly likely to have the highest economic rate of return (ERR). Figure 9.1: ERR v. Subsidy per HH, Projects in the Short List o'8 1 E accept reject c 0.4 E w 0.2 L reject subsidy/hh, 1 OOO$ One could of course introduce multiple objectives (minimize subsidy per HH, maximize ERR or economic NPV, etc), but these would then require weighting schemes to produce rankings whose resulting rank order would be sensitive to the (subjective) weights chosen. However, the precision that results from such a weighting summation scheme is judged spurious, and is offset by the simplicity and transparency of a single objective. In any event, no project less than the 14% SNIP hurdle rate will be implemented. In sum, there is high certainty that choosing the projects with the lowest US$ subsidy per HH also corresponds to a selection of projects that maximizes total economic benefits. Environmental Benefits Most of the projects have negligible environmental effects: there i s some local air quality benefit to the displacement of kerosene for lighting and diesel for battery charging, and some small increment to GHG 72

79 emissions from grid-based thermal generations2 The only sub-projects that have more significant environmental impacts are those with significant industrial loads that displace diesel self-generation: however, many of these projects would be financially viable without subsidy (and therefore did not enter the short-list). Reconciliation of Financial and Economic Flows Table 9.8 shows a reconciliation of the aggregate financial and economic flows of the nine accepted projects of Table 9.7. The Government of Peru (GoP) funds include those borrowed from the World Bark2 The distribution of costs and benefits follows the general pattern observed in individual projects. The ERR is 3 1.7%, and the NPV (of economic benefits at 14%) is US$25.8 million. project beneficiaries 40 domestic non- other distribution consumers domestic consumers company GoP net benefit benefits Electricity Benefits $ 30 Public Lighting t CWtS ; 20 Metem ,G Project cost O&M Energy cost Tariff metee - I902 I902 = consumption s public lighting ; Transfer Pxyni ents = -10 FOSE Investment Subsidy VAT ; I - Overall Program and Risk Assessment While the economic returns and financial sustainability of the nine projects selected from the shortlist may be confidently assumed, these account for only US$15.2 million in subsidy and electrify only some 33,235 HH (in the first year), and take up only 16.5% of the US$92.5 million available for subsidy. Therefore three additional questions must be answered: 0 Are there a sufficient number of additional rural electrification schemes -- that all meet the required SNIP criterion for ERR, and are financially sustainable -- to justify a US$92.4 million subsidy program? 0 If there do in fact exists a sufficient number of additional projects, what is the likely ERR for the project as a whole (which must meet the SNIP criterion no less than must individual projects)? 0 How does such an overall program compare to the business-as-usual alternative (Le. to MEM s current approach to rural electrification)? 2o These are preliminary calculations based on general assumptions. Carbon emissions are valued at US$20/ton carbon equivalent. Local air emission damage costs are based on Lvovsky et al., Environmental Costs o f Fossil Fuels: A Rapid Assessment Method with Application to Six Cities, World Bank Environment Department. October The Economic Analysis Report provides hrther details. 21 The additional transaction costs of the loans (fees, charges and interest) are sufficiently small to be ignored in this summary. 73

80 Is there likely to be a sufficient number ofprojects to warrant a $92.4 million program? From the preliminary screening it was observed that the key issue in both economic and financial feasibility is monthly consumption, whose average was 22 kwhh/month for satisfactory projects, but only 16 kwh/hh/month for projects that failed the ERR criterion, Therefore, a narrower question can be posed, namely whether there are a sufficient number of projects whose monthly consumption is 22/kWHH month or more. The survey results can be used to answer this question. First, we hypothesize an average reference project based on the characteristics of the projects submitted to MEM to date. If we assume a representative subproject size of 4,000 HH, and an average subsidy of US$600iHH, then we need to identify a total of 39 projects to justify a US92.4 million in total subsidy. As shown in Table 9.9, the assumptions are more conservative than those of the average project that passed the short list. Table 9.9: The Reference Project Reference Passed project Shortlist (Table 9.7) Key assumptions Typical consumption [ KWhiHHimonth] Average distribution company share [ ] 20% 25% Average subsidyihh [$IHH] Costs per HH [$IHH] HH per project [HHI ,690 Total Projects to be identified Subsidy amount [$million] $92.4m $15.2m Number of HH connected [# HHI ,235 Number of subprojects [#I 39 9 The survey results are easily aggregated by conglomerate (the basic unit used by INEI), each of which represents some 4,900 HH. The universe of unelectrified HH is 2.2 million. The average consumption in each electrified conglomerate is readily calculated, and is distributed as shown in Figure 9.2A: from this figure it is evident that 70% of all conglomerates have consumption of 22 kwh/hh/month or more. However, this includes conglomerates that are in Departments already heavily electrified (such as Lima and Tacna). These are likely to have a disproportionate number of high consumption HH, and represent Departments not likely to be targeted by the proposed program. Therefore, if Departments with present overall electrification rates greater than 80% are excluded (Arequippa, Junin, Ica, Lambayeque, Lima, Moquegua, Tacna and Tumbes), then the universe of unelectrified HH reduces to 1.19 million, and the number of potential projects (at the reference project size of 4,000 HH) reduces to 298 potential projects. How likely is it that 39, or 13% of these, have consumption of 22 kwhwmonth? 74

81 Figure 9.2: Percentages of Conglomerates (villages) with Monthly Consumption Greater than a Given Value A. All conglomerates B. Excluding Departments with high electricity coverage * a e n average kw hlhhlmonth average kw hlhhimonth From the recalculated probability curve shown in Figure 9.2B, 52% of (electrified) conglomerates have average electricity consumption of 22 kwwhwmonth or more. Therefore 52% of 298, or 155 projects, are likely to have the necessary consumption. Since 9 projects are already identified, 145 projects remain, out of which the remaining 30 must be identified. Provided that consumption in unelectrified areas is similar to consumption in electrified areas (captured by the survey), then there are over four times as many actual projects with 22 kwhwmonth as we need to find to consume US$92.4m in subsidy. In fact, this condition is met, because in the past, MEM s RE program emphasized electrification of areas of high poverty (but this also meant in areas of low consumption). As shown in Figure 9.3, the distribution of rural electrification by expenditure decile is flat. In other words, the presently electrified areas (captured by the survey) have roughly similar average incomes as the unelectrified areas, Thus there is no reason to suppose that potential consumption in the presently unelectrfzed areas (i.e. the market for the proposed project) would be any lower than in the presently electrified areas (which are represented in the curve of Figure 9.2). 75

82 Figure 9.3: Electrification Rates of Conglomerates by Expenditure Decile 22 % m I 5 I 6 I lo[hig l] 42% I 40% 1 34% 1 37% I 40% I 34% 1 42% Thus we may reasonably conclude that: 0 The risks of not finding 30 additional projects over the next three years, among 145 projects that are likely to have more than 22 kwh/hh/month, is small. The market effort required to find these is surely within the capabilities of the project implementation unit; 0 0 The risk that consumption in the presently unelectrified areas will prove lower than in the presently electrified areas (whose actual electricity consumption is known from the survey) is very small; The risk of not consuming US$92.4million in subsidies, on projects that meet the SNIP and financial sustainability criterion, is extremely small. Aggregate ERR of the entire program The reference project, based on the assumptions of Table namely a cost per connection of US$750, and 22 kwh/hwmonth, has an ERR of 20.5%. If the additional 30 reference projects are assumed implemented in years 2 to 5 of the project, then the aggregate ERR of the overall program is 23.8%. The plausibility of the reference project, and the use of 22 kwhwmonth as its monthly domestic consumption, may be confirmed by a simple calculation of sustainability. Even without non-domestic consumption, a project of 22 kwhh/month would still be financially viable, as shown in Table 9.10: this project has an average net revenue to the distribution company of 30 soles/hh/year. This is clearly not true of a project with an average of only 11 kwhh/month. 22 Use of income deciles would be preferred, but these are still in preparation from the survey database. However, INEI data show high rank correlation between average income and expenditure aggregates (the Department with the highest average income also has the highest average expenditure, etc.), so the effect on decile classifications is not expected to be significant. 76

83 Table 9.10: Illustrative Minimum Revenue Calculations (assuming residential loads only) consumption kw h/hh/month 22 II kw hlhhlyear variable charge SoleslkWh fixed charges I.9 I.9 revenue soleslmonth soleslyear connexion cost $lh H soies/h H &M as % of connexior 2.5% 2.5% solelyeadhh Energy cost US$lkW h soles/kwh public lighting as%ofhh 4.6% 4.6% kw hlyear I public revenue so ledyear tom1 consumption [kw hlyr] losses [I energy requirement kw hlyear energycost soles/year Tom1 COSG Net (Tariff rev.-o&m-energy) Figure 9.4: Switching Value for Aggregate ERR s Risk analysis cc cc w 0.2 REFERENCE PROSECT 0.1 ERR=20.5% 22 kw hlh Hlrnon h SWIT F HINGVALUE irr= 4%13 kw hlhhlmonth kwhih Hlmonth The estimate of ERR for the aggregate US$92.4million subsidy program is subject to several uncertainties, notably in the assumptions for WTP and the actual monthly domestic consumption. The uncertainty in construction and O&M costs is lower, given the consultations with the distribution companies. The robustness of the aggregate ERR estimate has been tested with a Monte Carlo risk assessment, in which these key input assumptions are specified as probability distributions rather than as deterministic values; by repeating the analysis several hundred times, at each step drawing input assumptions from these probability distributions, the ERR is turn generated as a probability distribution, 77

84 as shown in Figure The probability that the program does not meet the 14% SNIP hurdle rate is simply the area under the curve to the left of 14%, which is estimated at 4.6%. Figure 9.5: Probability Distribution of the Aggregate Project ERR 0 3 I 0.25 sr 94.- s 0.2 m 0.15 P e n I Comparison to the project alternative (continuation of the MEM program) MEM makes no estimate of the aggregate ERR on the projects in its Plan, and therefore direct comparison of ERRS is not possible. However, the overall savings achievable from the new approach are readily demonstrated by a few simple comparisons. In Figure 9.6 we start with the present MEM plan: the curve shows the (cumulative) number of HH connected (Y-axis) as a function of the (cumulative) investment (X-axis). For the US$92.4 million that is actually likely to be available over the next five years, we see that the MEM program would provide electrification of around 100,000 HH (recall Table 9.1 for details on MEM s plan). Now if all that were done is to re-sequence MEM s program in strict least-cost order - i.e. if no new projects of the type anticipated were forthcoming - then assuming an average 100% subsidy, around 150,000 HH could be electrified under the new approach, rather than 100,000 households in MEM s original plan. (One could state this in a different way by comparing probable costs for electrifying a given number of HH: to electrify the first 150,000 HH under the proposed approach costs US$92.5 million (with 100% subsidy), as opposed to US$130 million under MEM s existing program). With an average 20% contribution from the distribution companies, the number of HH that can be electrified with the US$92.5 million of central government. funds increases to around 175,000. Thus these savings may be taken as the lower bound of the aggregate impact of the proposed new approach: it is the lower bound simply because it supposes that no additional projects would be forthcoming. Since the MEM s existing inventory of candidate projects are generally in remote (and very poor) areas, this analysis does not include the many potential projects in the areas immediately adjacent to the service areas of the distribution projects, few of which were considered for MEM implementation, and 23 See the detailed Report on Economic and Financial Analysis for a full presentation of methodology and assumptions. 78

85 which are likely to have lower capital costs (per connected household) because they have higher load densities, and are more likely to have productive uses. Figure 9.6: Comparison of the Proposed Program with the MEM Alternative MEM PLAN RESORTED IN LEAST COST ORDER, 80% MEM PLAN RESORTED IN LEAST COST ORDER, 100% cumulative investment, $million 200 B. SMALL HYDRO Peru has significant potential for small run-of-river hydro schemes, both as adjuncts to existing irrigation schemes (in the coastal regions), as well as in the hydro-rich Selva. Table 9.11 shows a sample of identified projects, the first of which, Santa Rosa, is currently being implemented (with carbon sales to the Community development Carbon Fund). Most have satisfactory ERRs in the range of 14-22%; only one (El Sauce) fails to meet the hurdle rate. When carbon emission reduction benefits are valued at US$5/ton C02 (the purchase price obtained by the Santa Rosa project), ERRs increase by 1-1.5%. Table 9.11: Small Hydro Schemes Tarucani Moche CMulato El Sauce Graton Tanguche Quitaracsa I Santa Santa Z&ZZ zz Rita R~~~ Data Installed capacity [MW] capital cost [$USml construction time [years] costikw [MWI annual O&M cost [$USm] [as%of capital] [ ] 4.7% 3.0% 2.8% 1.8% 2.6% 2.7% 1.7% 2.3% 3.0% load factor [ ]. 85.7% 55.5% 69.1% 48.1% 63.2% 80.3% 63.5% 66.4% 83.5% Generation [ GWhgiyear] Economic returns ERR 16.6% 14.7% 16.0% 8.6% 14.3% 21.9% 13.5% 18.3% 22.6% ERR with carbon 17.7% 15.7% 17.1% 9.3% 15.3% 23.3% 14.3% 19.4% 24.0% 79

86 As shown in Figure 9.7, the estimated ERRS are strongly correlated with load factor: those with load factors above 70% are typically associated with irrigation schemes that benefit from upstream regulation. Figure 9.7: ERR v. Annual Load Factor 025 I I %t;fata C.MuIil0 0 Moche 1811 Grdon 0 Quitaaza I 8auca annual load factor The critical assumption is the assumption for valuation of economic benefit: the calculations shown above use the Santa Rosa PPA price (based on the busbar price of the interconnected system at the Huacho substation namely power: US$lO/kW-month, and energy 3.86 UScentdkWh peak, and 2.85/kWh offpeak). This matches well the average (energy only) spot market price of 3.35 UScentdkWh, used as the baseline benefit estimate. The ERR is robust with respect to this assumption, as shown in the sensitivity analysis of Figure 9.8. One estimate of LRMC (that pre-dates the recent increases in international oil and gas prices) is somewhat lower, at 2.27 UScentdkWh; the resulting ERR is still 18.8%. Indeed the switching value is 2,05UScents/kWh, which implies world oil prices below US$25/bbl. One may therefore be confident that there exist many small hydro projects with good economic returns, that warrant support from the proposed small hydro finance facility. Figure 9.8: ERR v. Benefit Assumption (for Tanguche 11) O3 025 I m Eco~ion~ic I,rncfit, UScc~its/l~WI~ 80

87 Financial Cashflow to the Small Hydropower Facility Table 9.11A below contains a cashflow for the proposed facility. It is an excerpt from a larger financial model for the Small Hydropower Finance Facility that is available in the Project files. This analysis shows that the revenues from interest payments would be more than sufficient to cover the costs of the facility, after the first two years. 81

88 N 00

89 Pv SOLAR HOMES The economic cost of a 50 Wp PV system, (based on quotations for 1,000 systems, including retail margin, but excluding all taxes and duties) is estimated at US$564. Operating and maintenance costs are as shown in the economic and financial analysis of a representative system shown in Table The general business model would be analogous to that proposed for grid extension, with enterprises bidding for subsidy on similar criteria. Table 9.12: Economic and Financial Analysis, PV Systems RMefitS KWhhonth [KWhhnonth] IO 10 BWhMW I1013 I2013 I2013 I WTP 389 [SolaskWh] 1.1 I WWh] [U~*wl corn Capid Cost [Bus Battery 60 [8US] Reglators PUS1 45 Li$?tc WJSI Balance of maintenance co[bus] 121) I213 I I I tota costs w Net economic flows ERR 18.1% The economic benefits are based on the PV system delivering the same level of service as a grid customer consuming 10 kwh/month (sufficient for lighting, radiohound equipment, and possibly even for B&W TV) - a pattern of use verified by the survey results. The capital costs include the costs of two 1 1 W CFLs for each HH. This consumption is valued at the WTP for lighting (US$1.1 l/kwh for the initial tranche of kwh consumption, see Annex below), and which results in an ERR of 18.1 %. The financial analysis, and the determination of financial cost, is complicated by VAT, the business model that applies, and the region in question. One of the difficulties is the VAT exemption that applies in the Selva, but only provided the company in question is headquartered in the Selva. Electricity service is VAT exempt in the Selva, which as noted above creates problems even for conventional gridbased service. Three cases may be considered, as indicated in Table Table 9.13: Business Models (1) (2) (3) Region Costa/Sierra Costa/Sierra Selva Implementing entity Distribution Other Distribution company company company (e.g.tenesoi) Consumers pay VAT on electricity Yes No existing No, VAT service customers exempt Effective financial cost of system USS591 USS708 USS618 83

90 Table 9.14 shows the financial analysis for Business Model 1, which involves a VAT neutral distribution company. The distribution company requires a 49% subsidy, US$292/HH, to obtain a 12% rate of return. The incremental VAT revenue collected by the Government occurs only once customers are billed for their monthly service charge: this is analogous to the grid extension case, which is similarly VAT neutral in the construction phase. Table 9.14: Financial Analysis, Business Model 1 NW 0 I IO II I2 &clbdil5 Monthlychay 20 [Soleshonth] 531 [BUShonth] Relenue [BUS Cor6 Capital Cost Wl Battery 60 BUS] Replaton [BUS] II 45 Li*o [BUS] G M olerheads [BUS] I2 12 I2 I I2 I2 I2 I1 total cos8 [BUS] I2 I2 I I2 I I1 87 Net financial flow I FlRR no subsidy 29 % Subsidyrequired to achiew 12% FlRR IS %of capital cost 49 % Disbibution company equity 51% clolrrrllnrl carlrn4wr connefion cost monthlysenice chay 70 l2d I1D 12D 12D I1D I1D 12D VAT tot4 cost 83 OD Govr Rcveirnr Sub s id y VAT tot If there is no VAT exemption (business model 2 of Table 9.13), the subsidy required increases to 58% (US$41O/HH). However, overall, the Government is better off (in NPV terms), with a net cost (subsidy and VAT) of US$267 (as opposed to US$243 in business model 1). Finally, in the case of business model 3 (distribution company in the Selva), the subsidy required is US$320/HH, and the net cost to the Government is US$280. The influence of VAT regime differences will need to be considered in any competitive solicitation for PV subsidy. A metered tariff is not meaningful for a PV system, and therefore the business model requires a flat monthly charge (that would be set according to the size of the panel, here assumed at 50Wp). The subsidy requirement will then be inversely proportional to the value of this flat monthly charge as shown in Figure 9:9 (The amount actually paid by the consumer is reduced by FOSE to 50% of this). For a 15 Sole/month charge, the distribution company would require a 75% subsidy contribution (US$508/HH, which is lower than the subsidy proposed for grid electrification in four of the nine projects shown in Table 9.5). Clearly the subsidy requirement would be further reduced by whatever up-front contribution is made by the household: for the sake of equity (compared to households charged for a grid connection) and in the interest of motivating due care and attention to the system, some such contribution should be made. 84

91 Figure 9.9: Subsidy Requirement for PV System v. Monthly Charge 120 I ' loo s -0- :, 80 3 E v) 40 ' 20 ' 01 I I I Fixed monthly charge, Soles 40 85

92 Attachment 1 to Annex 9: Methodology for Estimating Willingness to Pay (WTP) The methodology adopted for the economic analysis to establish WTP follows that used in a number of other countries for rural electrification projects (Philippines, Bolivia, Vietnam, among others). Section 4 o f the economic analysis report provides a complete description of the methodology. Willingness-to-pay is the area under the demand curve, as illustrated in Figure 9.10; for the case of lighting (similar curves may be drawn for other services such as TV viewing). The demand curve is downward sloping, and typically has a shape that is concave (with respect to the origin). This shape frequently emerges where more than two points on the curve can be plotted (here only the points x and y are assumed known). The concave shape also follows from the (convenient) assumption of constant elasticity (an assumption often made in econometric models). price Figure 9.10: Demand curve for lighting Before electrification, these services are typically provided by a mix of kerosene, candles, dry cells and car batteries (for lighting) and dry cells and car batteries (for radio and TV). In this example, for simplicity, assume that the only service provided is lighting provided by kerosene lamps: the quantity of services so consumed is QKERO, at the price PKERO. The total household expenditure on lighting is therefore QKERo x PKERo, equal to the area B + D. The total willingness to pay (WTP) for the service at level QmRo is the total area under the demand curve to that level of consumption, Le. areas A + B + D. This is the total benefit to the consumer. However, the cost is area B + D, and therefore the net benefit, also called the consumer surplus, is the difference between the two, namely the area A. After electrification, the level of service (in the case of lighting, the number of lumen-hours) typically increases substantially; consumption increases from QKERo to QE, but the price paid for the electrified service also falls (typically) from PKERO to PE. Now the household s expenditure for electricity is PE x QE, equal to the area D+E. At this level of consumption, the total area under the demand curve to QE, i.e. the total benefit, is now the area A + B + C + D +E. Therefore the net benefit, or consumer surplus, after subtracting the cost D +E, is A + B + C. Thus it follows that the net economic benefit of electrification is the increase in consumer surplus, which is the area B + C. Areas B, D and E are readily calculated from knowledge of consumption before and after electrification, from the household budget for kerosene (and battery charging), and from the tariff of electrified service: i.e. given knowledge of the two points on the demand curve x and y, the areas B, D and E are immediately calculable. But area C is more 86

93 difficult to estimate, since it requires knowledge of the shape o f the demand curve between points x and y. The most convenient assumption- and therefore the one most frequently encountered -- is that the demand curve is linear. Unfortunately such an assumption will lead to an overestimate of the area C, and of the net benefits of electrification, because the empirical evidence is that in fact the demand curve is much more likely to have a concave shape, as shown in Figure Given some functional form for such a demand curve, the area C is readily calculated as the definite integral: here we use a standard functional specification with constant elasticity p r Dip L 'JJ whose corresponding area C (e.g. between QKERo and QE) easily calculates from the corresponding definite integral. TV viewing TV viewing is one of the most desired aspects of electrification, and many non-electrified households devote significant money and time for auto-battery charging. In Peru, the survey estimates that 17% of non-electrified households use car-battery charging, the main use of which is for TV. The cost can be calculated from surveyprovided information about appliance wattage and appliance use, and from expenditure data on the cost of batteries, and the costs of recharging. The average HH using auto-batteries spends 15.3 Solesimonth on this TV viewing (including some use of radios, sound equipment). Calculations show that on average, auto-batteries provide 4.2 kilowatt hoursimonth, from which point x in Figure 9.11 calculates to 3.61 solesikwh (US$l.O4ikWh). Once electrified, on average, kilowatt-hour use for TV (and related equipment) increases to around 11 kwh (in consequence of increased use o f color TV and higher-wattage appliances and to a greater number of TV-watching hours. The average price of electricity of course falls dramatically to about 0.61 SolesikWh. The total area under the demand curve(areas B + C + D + E in Figure 9.10) then calculates to 24.9 solesihhimonth, and hence the average WTP (over the 11 kwh consumed for TV-viewing) is 2.26 SolesikWh. Figure : Demand curve for N-viewing '2 - v) 0 B=I? D=? 5 El kwh 'nboiitli Lighting Table 9.15 shows the assumptions for the derivation of WTP for lighting, which is estimated at US$1.1 likwh for HH making the transition from kerosene lighting to electricity. 24 Recognising this problem, some studies (e.g. the World Bank's Solar Homes project in Bolivia) take the area Cas one third o f the area determined by a linear demand curve. 87

94 Table 9.15: Lumen consumption Peru Bolivia Philippines Laos Assumptions QKERO klhimonth QELEC klhimonth PKERO $ per klh PELEC $ per klh Results Elasticity [I ** B $US C $US D $US E $US I.25 total WTP (per HWmonth) $US average kwh KWh 14.5 average WTPlkWh $USkWh 1.11 klh = kilo-lumen-hour Bolivia data from Annex 9, ERTIC Project PAD, Philippines data from ESMAF', Rural Electrijkation and Development in the Philippines: Measuring The Social and Economic Benejts, Report , May Laos data from PAD, 2"d Southern Provinces Rural Electrification Project, 2004 ** Based on linear demand curve! Table 9.15 also shows the comparable results from three other studies, Bolivia, Laos and the Philippines. The Peru results are consistent with those in Bolivia and Laos, but significantly lower than those of the Philippines. This is due to the latter's use of a linear demand curve: when the constant elasticity demand curve is used, the Philippine result reduces to a total benefit of US$7/HH/month. As can be seen from Figure 9.12 which shows the lumen-hour demand curve for Peru, the benefit is almost entirely determined by the area C, and hence the assumption made for the shape o f the demand curve is critical. Figure 9.12: Demand curve for lighting (lumen-hours) zoo 250 Idll, IllOlltll Table 9.16 shows the estimates o f average WTP for lighting by region. Table 9.1 6: Estimates of WTP for lighting, by region (US$/kWh) Peru Costa Costa Costa Sierra Sierra Sierra Selva Norte Centro Sur Norte Centro Sur average WTP/kWh

95 Attachment 2 to Annex 9: Summary for Typical Rural Electrification Sub-project Project 3 Company 1 PROJECT CHARACTERISTICS First-year domestic connexions 6583 FINANCIAL VIABILITY Avenge domestic load per connxion 30 Project FlRR before subsidy -4.2% Produductive use [MWhlyr] 70.2 Distribution company equity share 15.1% [as%toul] 3% (92 1 %) domestic (2 9%) non-domestic (5 0%) public lighting E CON OM IC VI AB1 LlTY Summary investment, s u bsidyl ERR 26.5% HH Investment HH subsidy HH ieveiized economic cost [BUSlkWh] 0.32 first year HH connected i ieveiized net economic benefit [BUSlkWh] 0.51 at end of project (5th year) Foles/kWh i.78 avenge numberofhh economic cost per [first year HH connexion) [BIHH] 703 end of planning horizon I Diroibution ofrora ondbenefia I subsidyas % ofinvestment cost 8 5% 02 hurdle rate: FIRR=12% er -4 ~ --u- I -0.1 I doinertic other coiisiiiiiers OoP tion domertic Dirtr. Co. Net Benefit Distribution coiiiyany equity share 89

96 Annex 10: Safeguards Policy Issues PERU: Rural Electrification Environment The Project is expected to have a positive environmental impact due to the reduction of COz emissions through the use of renewable energy in rural areas for provision of electricity. This is a National Project with specific locations for projects that were determined during project preparation and others expected to be identified during implementation. Such locations include rural areas of Peru currently without electricity service. An environmental assessment has been undertaken, identifying any possible negative environmental effects due to the installation of equipment and other minor works proposed by the project. The assessment has concluded that the probability of negative environmental effects is very small. The Project is classified as Environmental Category: B (Partial Assessment). The Environmental Assessment (EA) includes: (i) a brief summary of the potential for renewable energy projects in Peru; (ii) a proposal for screening criteriaiguidelines and management procedures for all investment sub-components, ensuring compliance with the Bank's safeguard policies and the local legislation; (iii) an outline of the main environmental issues, and (iv) main environmental aspects to be included in the bidding documents. What are the main features of the EMP and are they adequate? Each investment activity will be screened using the environmental framework, and Environmental Management Plans (EMPs) will be developed consequently using the environmental guidelines provided in the Environmental Assessment. EMP will be developed as an inherent part of the preparation of each transaction, and its conclusions and recommendations will be integrated into the contracts with private sector providers that will be responsible to install, operate and maintain the electricity systems. The appropriate procedures will be described in the Operational Manual. Both the environmental framework and guidelines include specific provisions mandated by OP 4.37 Safety of Dams for the construction of new small dams (<lorn), i.e. the design and construction of a new dam has to be supervised by experienced and competent professionals and requires the adoption of certain dam safety measures for the design, bid tendering, construction, operation, and maintenance of the dam and associated works. How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EA report on the environmental impacts and proposed environ,ment management plan? Describe mechanisms of consultation that were used and which groups were consulted? The main stakeholders were consulted as a part of the process of the preparation of EA and guidelines. Additional consultations (rural communities) are planned during the implementation of the Project, as a part of the preparation of EMPs. The EA is available at the offices of the Project Management Unit (PEU) and in World Bank's Infoshop. Future EAs and EMPs will similarly be made available to the public. What mechanisms have been established to monitor and evaluate the impact of environment? Do the indicators reflect the objectives and results of the EMP? the Project on the 90

97 Mitigation measures will be included in the contractors' bidding documents and environmental indicators will be monitored by the PMU. The overall impact of the Project on greenhouse gas reduction will be monitored as a key output indicator. Social The Project could trigger the two social safeguard policies (OD 4.20 and OP 4.12), depending on site characteristics and specific subprojects designs. Because the Project is demand-driven, we do not know before implementation the locations where it will be implemented. In order to comply with these policies and to avoid unnecessary adverse impacts as well as to ensure that the most poor and vulnerable peoples benefit from project implementation, the borrower has prepared two frameworks that have been reviewed by the social safeguard specialist in the team who have found them acceptable to the Bank: an Indigenous Peoples Development Framework (PDF) and a Resettlement Policy Framework (RPF). The PDF depicts the process and the principles by which Indigenous Peoples Development Plans would be prepared if the policy is triggered due to its implementation in lands owned or used by Indigenous Peoples in the highlands and the upper selva regions, or whenever P become beneficiaries of the Project. The PDF also provides an assessment of the social, economic and cultural traits of the Indigenous Peoples in these regions, as well as demographic information; and assesses the impacts, both adverse and positive ones that the Project might have in these communities. It includes a thorough legal framework, both national and international, that supports Indigenous Peoples rights in Peru. The PDF has been submitted to a preliminary consultation. One consultation was held in the highland city of Huancavelica, on July 20, 2005 with participants representing peasant communities, producers associations and local authorities. A second consultation was held in the central upper selva, in the town of Pichanaki on July 24, 2005 with participants representing indigenous communities, indigenous organizations and members of the electrification district committee. These consultations have provided useful feedback regarding the kind of productive activities that these communities would like to develop when having access to electricity. The provision of electricity to rural communities in the highlands and upper selva in Peru could have the following positive outcomes that would contribute to reduce poverty levels: 0 Implementation of productive activities for transforming agricultural and forest produce and optimize their use; 0 Improvement in health and education services; 0 Creation of employment due to the diverse productive uses of electricity; Improvement in family income due to new productive opportunities; 0 A better and more balanced link of Indigenous Peoples to the market; 0 Improvement of infrastructure for tourism; and 0 Better links between the rural areas and isolated areas through communication systems. Both in the highlands and the upper selva, the people consulted welcomed the idea of having electricity but the indigenous peoples in the upper selva expressed concern about the payment of tariffs. Andean peasants and selva settlers are more prone to make productive uses of electricity for their economy is more linked to the market than the one of the indigenous peoples of the selva region. The latter will require more time to adapt as well as more capacity building support to take advantage of the use of electricity. Those consulted were also more inclined to favor conventional energy sources rather than offgrid alternatives. They also expressed their willingness to support the Project with the implementation of forest management and water usage in the case of small hydropower facilities. 91

98 It is worth noticing that the indigenous communities of the upper selva are mostly found in the departamentos of Amazonas, Cusco, Junin and Pasco. While those departamentos with the higher number of Quechua and Aymara speakers are Apurimac, Ayacucho, Huancavelica, Cusco and Puno. The IPDF also provides information on those rural areas where access to electricity is most marginal or does not exist. Finally, the PDF explains the institutional arrangements that according to the Peruvian legal framework are needed for the implementation of PDPs. It has identified two institutions for this purpose: INDEPA, which has been recently created and still lacks adequate budget and personnel, and the Project Management Unit within the MEM, which will be responsible for the preparation of PDPs. This unit will include a social specialist to manage all social issues related to the project. A Resettlement Policy Framework for Rural Electrification Sub-Proj ects and Small Hydropower Facilities has been prepared by the Borrower in case the policy is triggered due to civil works, rights of way for transmission lines and water usage for hydropower facilities. Due to the small sizes of the required works, it is very unlikely that the policy will be triggered regarding physical displacement of affected populations. It is more likely though that the policy will be triggered due to land acquisition, rights of way or water usage. Nonetheless, the RPF details the process, the criteria and the principles to be followed for the preparation of site specific Resettlement Plans as required by the policy. This framework also depicts the legal framework and explains the role of the various institutions involved in resettlement activities in the country such as CONATA, PETT, etc., and identifies the Project Management Unit as the entity responsible for the preparation of RAPS and the DGAAE as the unit in charge within the MEM for the supervision and monitoring of these activities. Both frameworks were disclosed prior to appraisal in the country and in the Infoshop and will be included in the Operational Manual for the project. 92

99 Annex 11: Project Preparation and Supervision PERU: Rural Electrification Planned Actual PCN Review 08/03/2004 Initial PID to PIC 08/06/ /08/2004 Initial ISDS to PIC Appraisal 08/09/ /09/ /2005 Negotiations 09115/ /04/2006 BoardIRVP Approval Planned Date of Effectiveness Planned Date of Mid-Term Review Planned Closing Date 03/09/ /01/ /2012 Key institutions responsible for preparation of the project: Ministry of Energy and Mines Bank staff and consultants who worked on the Project included: Name Title Unit Susan V. Bogach Sr. Energy Economist, Task Team LCSFE Demetrios Papathanasiou Isabella Micali Drossos Patricia Mc Kenzie Regis Cunningham Robert O Leary Keisgner Alfaro R. Ani1 Cabraal Alonso Zarzar Casis Douglas French Barnes Malcolm Cosgrove-Davies Iris del Valle Oliveros Eduardo Zolezzi Luis M. Vaca Soto Roberto Gabriel Aiello Nicolas Drossos Peter Meier Laura Wendell Berman Albert0 Didoni Chris Rathnayake TTA and IM3, Spain Leader Energy Economist, Co-Task Team Leader Senior Counsel Sr. Financial Management Specialist Sr. Finance Officer Sr. Finance Officer Sr. Procurement Specialist Lead Energy Specialist Sr. Social Scientist Sr. Energy Analyst, Peer Reviewer Sr. Energy Analyst, Peer Reviewer Task Team Assistant Consultant Consultant Consultant Consultant Consultant Consultant Consultant Consultant Consultants LCSFE LEGLA LCOAA LOAGl LOAGl LCOPR EWDEN LCSEO EWDES AFTEG LCSFE LCSFE LCSFE LCSEN LCOAA LC SFE LCSFE LCSFR 93

100 Bank funds expended to date on project preparation: 1. Bank resources: US$447, Trust Funds: (US$l06,000 Spanish CTF); (US$29,000 Italian CTF); (US$74,800 PHRD); (US$40,000 GEF PDF) Sub-total Trust Funds: US$249, Total: US$696,950 Estimated approval and supervision costs: 1. Remaining costs to approval: US$17, Estimated annual supervision cost: US$120,000 94

101 Annex 12: Documents in the Project File PERU: Rural Electrification A. Bank Staff Assessments Mission Aide MCmoires Project Concept Note Procurement Capacity Assessment Financial Management Assessment B. Other Documents Plan de Electrificaci6n Rural 2004, Departamento Ejecutivo de Proyectos, Ministerio de Energia y Minas Propuesta Para un Nuevo Marco General para Electrificacion Rural en el Ped, NRECA, January 2005 (PPLAF assisted) Ley Modelo de Electrificacih Rural, Junio, 2005 (PPIAF assisted) Informe de Evaluacih de 10s Sub-proyectos, Trama-Tecnico Ambiental con IM3 Ingenieros Emetres, S.L., Agosto 2005 Economic and Financial Analysis Draft Operational Manual including Policy Frameworks for Environment, Resettlement and Indigenous People s Management Plans Results of National Rural Energy Survey (forthcoming, with support from ESMAP) 95

102 Annex 13: Statement of Loans and Credits PERU: Peru Rural Electrification Original Amount in US$ Millions Difference between expected and actual disbursements Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm Rev d PO PE Regional Transport Decentmlization 5 5 PO PE Inst. Capacity for Decent. TAL PO PE Vilcanota Valley Rehab & Mgmt PO Project PE (APL2)Agric Research and Extension PO PE-(CRL1)ACCOUNT. F/ DECENT PO SOC.SCTR PE LIMA TRANSPORT PROJECT PO PE Justice Services Improvement PO PE LIMA TRANSPORT PROJECT PO GEF PE PARTICIPATORY MGMT PROT PO AREAS PE Trade Facil. and Prod. Improv. T. A PO PE NATIONAL RURAL WATER PO SUPPLY AND PE Lima Water Rehab Add1 Financing PO PE- Rural Education PO GEF PE Indigenous Management Prot PO Areas PE SECOND RURAL ROADS PROJECT PO PE-HEALTH REFORM PROGRAM PO PE IRRIGATION SUBSECTOR PROJECT Total: PERU STATEMENT OF IFC s Held and Disbursed Portfolio In Millions of US Dollars FY Approval Company Loan 1999 Alicorp 2005 Corp. Drokasa EDYFICAR FTSA Gloria ISA Peru, SA ISA Peru, SA Inka Terra 5.00 Committed IFC IFC Disbursed Equity Quasi Partic. Loan Equity Quasi Partic oo

103 ~ Disbursed IFC FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic Interbank-Peru lnterseguro Interseguro lnterseguro Laredo Laredo Latino Leasing MIBANCO Milkito Miraflores Norvial S.A. Paramonga Peru OEH Peru Prvtzn Fund Quellaveco Quellaveco Quellaveco Quellaveco RANSA RANSA Tecnofil S.A. USMP Y anacoc ha oo '00 5.oo OS Total portfolio: IFC Approvals Pending Commitment FY Approval Company Loan Equity Quasi Partic UPC I Drokasa PCG 2004 CMAC Arequipa 0.01 Total pending commitment:

104 Annex 14: Country at a Glance PERU: Peru Rural Electrification Latin POVERTY and SOCIAL America Peru &Carib Population, mid-year (millions) GNipercapita (Atlas method, US$) 2,360 3,600 GNI (Atlas method, US$ billions) ,946 Average annual growth, Population ('37) 1.5 Labor force (%) 2.7 Most recent estimate (latest year available, ) Po vert y (77 of po pulatio n beio w natlo nai poverty line) Urban population (%of totalpopulation) 74 Life expectancyat birth (pars) 70 lnfa nt mortal it y (per 1000 live births) 26 Child malnutrition(%ofchildrenunder5) 7 Access to an improved water source (%ofpopulation) Literacy (%of population age 159 Gross primaryenrollment (%of school-age population) Male 18 Female P3 I26 P2 Lowermiddleincome 2, , Development diamond' Life expectancy Gross per t- * primary capita enrollment._ -I i Access to improved water source Peru Lower-mrddle-income gro UP KEY ECONOMIC RATIOS and LONG-TERM TRENDS GDP (US$ biiiions) Gross capital formation/gdp Exports of goods and serviceslgdp 8.3 T2.8 Gross domestic savings/gdp Gross national savings/gdp Current account baianceigdp Interest paymentslgdp Total debt/gdp Total debt service/exports Present value of debt/gdp Present value of debtlexports (average annual growth) GDP GDP per capita Exports of goods and services li n Economic ratios' Domestic savings _-I.-.per" Trade T 1 -$- 1 1 Indebtedness Capital formation Lo wer-middle-income orom STRUCTURE of the ECONOMY (% of GD P) Agriculture industry Manufacturing Services n Growth of capital and GDP (%) $37 Household final consumption expenditure General gov't final consumption expenditure Imports of goods and services (average annual growth) Agriculture Industry Manufacturing Services Growth of exports and imports (%) 2o T Household final consumption expenditure General gov't final consumption expenditure Gross capital formation Imports of goods and services I Exports -imports I Note: 2004 data are preliminaryestimates. *Thediamonds showfourkeyindicators inthecountry(in bo1d)comparedwith its income-groupaverage. If data are missing, thediamondwiil be incomplete. 98

105 Peru PRICES and GOVERNMENT FINANCE Domestic prices (% change) Consumer prices Implicit GDP deflator Inflation (%) 1 Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeficit *iiy.. GDP deflator -4-CPI TRADE (US$ millions) Total exports (fob) Copper Fishmeal Manufactures Total imports (cif) Food Fuel and energy Capital goods Export price index (2000=100) Import price index (2000=100) Terms of trade (2000=100) , ,199 5, , ,091 1, ,620 8, ,376 1, ,617 2, ,476 9, ,754 2, Export and import levels (US$ mill.) 1llrOO T Exports W Imports O4 I I BALANCE of PAYMENTS (US$ millions) Exports of goods and services Imports of goods and services Resource balance ,817 3, ,662 7,161-1, ,786 10, ,531 12,581 1,950 Current account balance to GDP (Oh) 1 Net income Net current transfers -1, , ,144 1,221-3,421 1,461 Current account balance , Financing items (net) Changes in net reserves ,614-3,059 1, ,362-2,352 Memo: Reserves including goid (US$ millions) Conversion rate (DEC, local/us$) E-6 7, , , EXTERNAL DEBT and RESOURCE FLOWS (US$ millions) Total debt outstanding and disbursed IBRD IDA , ,510 1, ,822 2, ,991 2,834 0 omposition of 2004 debt (US$ mill.) G: 2,525 A Total debt service IBRD IDA 1, , , , Composition of net resource flows Official grants Ofkiai creditors Private creditors Foreign direct investment (net inflows) Portfolio equity (net inflows) , ,182 1, , World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers j ~ IBRD E - Bilateral 1 -IDA D - Other multilateral F -Private ; ~ IMF G -Short-term Dewlopment Economics 9/9/05 99

106 Overall Context for Rural Electrification in Peru Annex 15: Incremental Cost Analysis PERU: Rural Electrification More than six million people in the predominantly poor rural areas of Peru do not have access to electricity. At 30% coverage, this is one of the lowest rural electrification rates in Latin America (only Bolivia has worse coverage in rural areas). Together with scarcity of other infrastructure services, lack of electricity results in a lower quality of life, poor medical care and education, and limited opportunities for economic development. In Peru, power sector reform has not touched rural electrification issues. The existing electricity distribution companies hold concession areas concentrated in small areas around urban centers. Their obligation is to meet service requests only within 100 meters of the existing network. Therefore, to expand coverage, the Government of Peru (GoP) has been investing US$40-50 million per year for the last ten years in direct subsidies for the capital cost of rural electrification. All of the investments were carried out and financed by agencies of the central government. Investments were made through social funds (e.g. FONCODES) and more importantly by the Executive Office for Projects of the Ministry of Energy and Mines (MEMDEP). From Lima, the MEMiDEP identifies designs, constructs and transfers the rural electrification sub-projects to the distribution companies or to ADINELSA, a public holding company. There is currently no mechanism to mobilize investments for rural electrification from communities, regional governments and the private sector. MEM recently reiterated its commitment to reduce the electrification gap, in the National Rural Electrification Plan (Plan), aiming to increase rural coverage from 30% to 75% by The 2004 Plan states that the objective is to broaden the coverage of rural electrification, using technologies that minimize the cost of investment, in order to accelerate socio-economic development and improve the quality of life of people living in isolated and rural areas of Peru. In order to realize this commitment, the Plan shows an estimated investment of US$860 million, or US$86 million per year, to provide service to an additional 860,000 households or 4.3 million people. While the Plan contains ambitious goals, foreseeable financing is inadequate to realize these goals. Given limitations on funding from the treasury, funding for rural electrijkation subsidies at national level is unlikely to exceed US$40 million per year. Therefore, the GoP requested assistance from the World Bank to develop a new rural electrification framework that would increase economic efficiency in the sector and attract broader participation and financing from communities, regional governments and private enterprises. The GoP s request to the World Bank for assistance with the rural electrification program specifically emphasized the potential role of renewable energy where it would be cost-effective. As usage levels of electricity in rural areas are low and the costs of grid extension are hgh in Peru s difficult terrain, it is expected that there is potential for renewable energy to play a significant role in supplying rural electricitg5. Renewable resources abound: (a) in the highlands, the average solar radiation levels reach five kwh/m2/day, with small seasonal variations; (b) the wind velocity measurements in the coastal zone indicate average velocities of 6 m/s at 10 m level; (c) the hydroelectric potential is vast, especially in the 25 The Plan includes ambitious plans for renewable energy, including for the period, investments of US$30 million in small hydropower systems to serve 27,500 users, US$96 million in solar PV systems to serve 122,000 users and US$16 million to serve 27,300 users. 100

107 highlands and higher parts of the jungle; and (d) the potential for biomass projects in the upper zone of the jungle is very promising. Groups such as the Intermediate Technology Development Group have carried out small-scale donor-financed projects to promote rural electrification using small hydropower, wind and solar energy, creating experience that the project can further build upon. Proposed World Bank and GEF Support for Rural Electrification The proposed GEF Project is fully integrated into the Bank s Program to support rural electrification efforts in Peru. This Program began in 1999, with the Estrategia Integral de Electripcacidn Rural Study (NRECA). It continued with the ESMAP financed Peru: Rural Electrification Study in 2001, and the Peru Rural Infrastructure Strategy completed in The GoP formally requested Bank investment program support for rural electrification in May Following this, the Bank and MEM initiated several on-going activities in parallel. The first is a technical assistance activity with PPIAF support to develop a new legal and regulatory framework, Design of Enabling Framework for Public-Private Participation Models in Rural Electripcation. With ESMAP support, the Bank and MEM are conducting a national Rural Energy Survey to provide data on energy demand, willingness to pay and electricity pricing issues. Most importantly, MEM requested World Bank and GEF assistance for the hlly blended investment operation under preparation, the proposed GoPIIBRDIGEF Rural Electrification Project, that would demonstrate key elements of the new rural electrification framework. As well as bringing substantial financing for investment, the Bank would bring its knowledge of rural electrification legal and regulatory frameworks and experience with private and public sector partnerships. GEF resources are required to develop the policy, institutional, financial and regulatory framework for renewable-hydro, or biomass, based community-scale isolated grids and for electrification projects using individual renewable energy systems. In addition, GEF resources are required to increase the availability of financing for investments in grid-connected renewable energy generating plants, especially using small hydro. By fully incorporating renewable energy into the GoP/Bank Project framework, the GEF Project aims not only to promote investments in renewable energy under the Project, but more importantly to shape the overall national rural electrification program. The new approach would enable a significant share of the overall rural electrification investments, estimated at a total cost of US$856 million, to be in renewable systems. This program could realistically be achieved in about 20 years, given the expected level of financing of US$40 million per year. Assuming a 10-20% share of renewable energy, this would mean that a successful GEF project could facilitate investments of US$ million in renewable energy, over 20 years, as part of the overall rural electrification program in Peru. Baseline Scenario for Rural Electrification In the Baseline Scenario, the GoP would continue to implement rural electrification projects through the MEMIDEP, in parallel with a new project that would be implemented by the Bank, without GEF support, As noted above, annual funding for rural electrification subsidies at national level over the next five years can be expected to be no more than US$40 million per year. Over the five-year period , this would result in total investments of US$200 million. Of this investment, about half or US$lOO million would be dedicated to a continuation of the existing program by MEM through the MEMIDEP, the other half or US$lOO million would be implemented through the new GoP/Bank Project. Continued Activities by MEMDEP. The MEM/DEP would continue its top down approach. It would continue to identify, select, and design sub-projects. It would then bid out construction and transfer ownership of the sub-project to either existing public distribution companies or the public holding company ADINELSA. The criteria for sub-proj ect selection would continue to be primarily social--low 101

108 coverage rates of electricity and high poverty in the project area. Assuming that MEMDEP s budget would be approximately US$lOO million over , based on average costs in the 2004 plan of US$830/connection, MEMDEP would provide electricity service to about 120,000 households, including about 10,000 households that would receive service using PV systems. Some of these projects would require not only capital subsidies, but also operating subsidies that would be managed through AD INEL S A. Part of the MEM/DEP s activities in the Baseline Scenario would be the completion of the UNDP Photovoltaic-based Rural Electrification Project, according to the restructuring proposed. The results are expected to include: (a) establishment of a data base including data on solar energy and the target population, in the form of a GIS database; (b) establishment of norms for installation, maintenance and operation of solar PV systems; (c) selection of target communities for installation of PV systems under the UNDP Project; (d) installation and operation of about 7,000 PV systems to serve households and institutions in rural areas; (e) capacity building for professionals, technicians and users of solar PV systems; and (0 information available from monitoring and evaluation of the Project. It is expected that this would be the most significant renewable energy activity carried out by the MEM/DEP, over the period, in the baseline. Baseline BanWMEM Project--Without GEF Support. The Baseline Rural Electrification Project would aim to introduce a decentralized, demand driven approach to rural electrification, where the service providers in collaboration with local and regional governments would propose and co-finance sub-projects. It is considered that the electricity service providers have the best knowledge of subprojects with low costs, and high economic benefits including productive uses, which would result in more efficient provision of electricity in rural areas. The objective of the proposed Project would be to provide sustained and efficient electricity services to rural consumers. The Baseline Project would have four main components as shown in Table 15-1: (a) investment by private and publicly owned enterprises to provide electricity to about 160,000 new connections including households, public facilities and businesses; (b) technical assistance to support the demand driven approach rural electrification (projects proposed by service providers); (c) a pilot program to promote productive uses through an information campaign and access to business development services; and (d) project management. The Project is expected to deliver rural electricity services more efficiently than the current system. Rural electrification sub-proj ects proposed by service providers, in collaboration with regional governments, would compete for the subsidy. Project selection would be based on criteria such as minimum subsidy provided by the central government andor maximum economic benefits. Sub-projects would be financially viable based on the proposed subsidy and tariff-there would be no subsidies on operation. The Project would focus on encouraging the distribution companies to extend their existing grids organically, focusing first on those projects that are nearer existing grids that have existing or potential productive uses. For this reason, the average cost assumed per connection is less than in the case of the MEMIDEP, at about US$700 per connection26. Also, the subsidy funds provided by the central government are assumed to be leveraged by the funds of the distribution companies/regional governments, in the ratio of 80/20. The result is the ability to connect 160,000 households and businesses using subsidy funds from the Project of approximately US$92 million. 26 If the projects in the PNER are sequenced in order of lowest to highest cost, the PNER contains sub-projects that would result in 160,000 connections at an average cost of less than US$640. An average cost of US$700 is therefore considered conservative. 102

109 While the subsidy funding would in principle be available for both grid-connected and renewable projects, the focus of both the MEM and the distribution companies would inevitably be on development of grid-connected electrification projects. In the absence of GEF support, the Bank Project would theoretically offer financing to renewable energy projects, but in fact would finance almost entirely gridextension projects, or diesel-based generation, because of the barriers noted below.27 Barriers to Rural Electrification Using Renewable Energy. As noted above, the UNDP-assisted Photovoltaic-based Rural Electrification Project is expected to build experience and develop capacity in Peru with respect to use of solar PV technology for rural electrification. However, even after completion of this project, a number of barriers to development of renewable energy will remain, including: Lack of Regulations SpeciJically for Renewable Energy Systems. Neither the DGE, responsible for concessions, norms and standards nor OSINERG, responsible for tariffs and oversight of operation of concession, have developed regulations specifically designed for renewable energy systems, either for rural electrification or connection to the grid. Lack of Capacity in Regional Governments, Distribution Companies and Suppliers To Develop Sub-project Proposals. There is little capacity in regional governments, distribution companies or other potential service providers to identify, select, design and propose renewable energy subprojects for the subsidy. Lack of Data and Information on Renewable Energy Resources. For resources other than solar energy, including small hydropower, geothermal energy and wind, there has only been very preliminary work done on estimation of resources. There is a need for systematic information 27 Electricity supply for these rural households would come almost entirely from thermal generation, since rural demand occurs mainly in the early morning and evening hours, coinciding with the system peak load. 103

110 and data gathering and dissemination, in a form that could be used reliably for project development. 4. Lack of Systematic Policy for Renewable Energy Promotion in MEM. Peru has no effective policies for renewable energy promotion. A law to promote geothermal energy was passed by Congress, but never implemented. There is no law or policy that provides a basis for promotion of renewable energy, or use of financial incentives to encourage its development. 5. Lack of Promotion of Potential Productive Uses of Electricity. As is the case with provision of grid-connected electricity, it is expected that use of renewable systems will likely be limited to a few lights, radio and TV, with little promotion of opportunities to take advantage of possible increases in economic benefit by carrying out income generating activities. 6. Lack of Financing for Renewable Energy Generating Facilities. While definitive data is not available, Peru has considerable potential for development of small hydropower and possibly geothermal, biomass and wind energy, to supply electricity to the grid. However, commercial banks in Peru do not provide project financing. Debt financing of small hydropower plants, for example, would require both a hgh proportion of equity (30-50%), and guarantees to cover the debt financing provided by commercial banks. Under such conditions, it is difficult to put financing packages together even for plants that have high financial rates of return. The most fundamental barrier is the aversion of commercial banks to construction risk. It has been reported that the requirement for guarantees has been waived once a plant has been constructed and is in operation. Other activities, including the GEF-assisted UNDP Photovoltaic-based Rural Electrification in Peru and bilateral efforts, would result in electrification of 10,000 households, using SHS, and would overcome some of the barriers above for this technology. However, in the absence of GEF support, the GoP would maintain a commitment on paper to the use of renewable resources, but would not mobilize the necessary resources to overcome fully the lack of an institutional, financial and technical framework for implementation of rural electrification using renewable technologies (which require different design guidelines, standards for quality of service and tariffs). Service provision and extension of new service in rural areas would continue to take place using isolated diesel, gasoline, generation systems. GEF Project Alternative Rural Electrification The GEF Project would be fully blended with the GoP/Bank investment operation that would demonstrate key elements of the new rural electrification framework, through the proposed GoP/IBRD/GEF Rural Electrification Project2*. The GoP would bring its commitment to the introduction of a new framework, as well as substantial investment financing. The Bank would bring investment financing, as well as its knowledge of rural electrification legal and regulatory frameworks and experience with private and public sector partnerships. GEF resources are required to develop the policy, institutional, financial and regulatory framework for renewable-hydro, or biomass, based community-scale isolated grids and for electrification projects using individual renewable energy systems. In addition, GEF resources are required to increase the availability of financing for investments in grid-connected renewable energy generating plants, especially using small hydro. The objectives of the GEF Project under the blended operation would be to: 28 The Bank is executing in parallel a TA activity with PPIAF support to develop a new legal and regulatory framework, Design of Enabling Framework for Public-Private Participation Models in Rural Electrification. 104

111 a) provide electricity services to about 20,000 households, businesses and public facilities such as schools and health clinics, using renewable energy sources to serve remote and dispersed populations; b) provide technical assistance to ensure that renewable energy options are fully incorporated into electricity provision in rural areas of Peru; c) pilot a program to increase productive uses of electricity from renewable sources that would increase opportunities for income generation in rural areas; and d) provide an estimated 15 MW of renewable energy generation for sale to the grid, mainly from small hydropower, during the Project life and 30 MW over the ten-year lifetime of the financing facility. Support from the GEF Project would enable MEM to incorporate renewable energy fully into each of the components of the proposed IBRD/GoP Rural Electrification Project. The total incremental cost o f GEF support is estimated at US$10 million, as described below and shown in Table Component I: Rural Electrification Sub-projects. There would be no GEF support to the investment cost of provision of electricity services (Component 1). However, GEF support to the other components would enhance the capability of all participants to identify, design and propose renewable energy-based sub-projects for subsidies using BRD and GoP funds under the Project. It is estimated that, with GEF support, about 20,000 (12%) of the connections to be financed under the project would utilize renewable energy, mainly small hydro micro-grids or solar photovoltaic household systems, or solar photovoltaic/diesel hybrid grid systems. This ratio is based on the projected investments shown in renewable energy in the Plan 2004, where about 15% of the projects to be financed use renewable energy. Therefore, this component is expected to enable provision of electricity services to remote areas or dispersed areas that would otherwise not be served under the rural electrification program of the GoP. Component 2: Technical Assistance for Rural Electrijkation. Technical assistance would be provided by GEF to support the implementation of renewable energy sub-proj ects including: a. Development of institutional framework and regulations for grid-connected and off-grid rural electricity service, including renewable energy service provision, specifically designed to improve the economic and financial efficiency of the sector, such as procedures for issuing rural concessions; norms for electricity systems design and construction appropriate for rural areas; norms for operations; procedures for calculating rural tariffs; and norms for rural quality of service (addresses Barrier 1 above). b. Capacity building for identijkation and development of sub-projects using renewable energy, is effectively linked to regional development plans. The Project would strengthen the capacity of electricity service providers to prepare and propose sub-proj ects, as well as strengthen the capacity of regional and local governments to coordinate planning and management of electrification projects with other rural development activities. The Project would assist the selection of appropriate, least-cost technologies --such as renewable energy-- to electrify remote areas, or regions with dispersed populations, where grid extension would not be economically viable (addresses Barrier 2 above). c. Promotion of renewable energy, including: (i) development of appropriate policies and incentives; (ii) cost-sharing of preparation of sub-proj ects; and (c) carrying out technical studies such as resource assessments. This component would focus on renewable energy for rural electrification and supply to the rural grid, especially using small hydropower, geothermal and biomass energy and wind power (addresses Barriers 3 and 4 above). (Incremental cost US$2.5 million GEF.) 105

112 Component 3: Pilot Program for Productive Uses of Electricity. This project component would promote productive uses of renewable electricity, such as tailor shops, hair cutting, entertainment businesses using TV, small refrigerators, etc. It would include a promotional/marketing campaign, as well as business development assistance in deep rural areas. This project component would be tested first in areas that had been electrified by isolated small hydropower plants, and then expanded to project areas, including those using renewable energy. Since power from renewable energy systems is often limited, and the remoteness of the population limits economic activities, specific programs are needed for areas served with such technologies (addresses Barrier 5 above). (Incremental cost US$1.5 million GEF.) Component 4: Small Hydro Financing Facility. There is considerable potential to lower costs and improve service through provision of grid-connected small hydropower to rural networks. Peru is a country with significant hydroelectric resources due to its geography (Andean mountain range and climatic conditions). In addition, various irrigation projects and water resources management projects have already created civil engineering structures that could result in competitive hydroelectric generation in small and micro schemes. Through its carbon financing activities in the country the World Bank has reviewed a significant number of privately-sponsored small hydro schemes that would be viable and could likely provide least-cost solutions for rural electrification. Nevertheless, although the financial system in Peru is relatively liquid, commercial banks are not experienced and in general unwilling to provide financing on a project recourse basis. Project sponsors therefore have to finance projects fully on equity, borrowing on their balance-sheet, or pledging other assets for collateral. However, because small hydropower generation projects are unfamiliar to commercial banks in Peru and the construction risk is considered unacceptable, banks in Peru have been reluctant to finance such projects. The GEF would facilitate commercial debt financing of small hydro generating plants by providing bridging financing during construction and initial operation, after which the loan would be refinanced by the participating bank at agreed terms, subject to satisfactory financial operating performance of the project. A revolving loan facility would be operated, with an estimated turn-around period of two to three years. Project proponents would be asked to propose projects for financing by the facility. An estimated 15 MW of projects would be financed during the five-year life of the project, but the facility would continue to operate and would be expected to finance to finance 30 MW over ten years before it would finally close (addresses Barrier 6 above). This facility would not finance connection costs or distribution systems. (Estimated incremental cost US$15.0 million of which US$5.0 million is GEF and US$I 0 million is from investors.) Component 5: Project Management: This component would include support for incremental cost for management of the GEF components of the Project, including a share of the time of the Project Manager; an administrative unit with staff to handle procurement and financial management; a technical unit that would evaluate sub-project applications and oversee the hnctioning of the finance facility and the productive uses component; and a monitoring and evaluation unit. (Estimated incremental cost US$I million is GEF.) 106

113 ovemments for development o f grid and off-grid sub- financial management) b. Technical unit to evaluate investment sub-projects c. Monitoring and evaluation unit, including safeguards d. Administrative financial agreement fee Coordination of Implementation with UNDP Photovoltaic-Based Renewable Energy Project. The Bank/GEF Project would build upon the experience of the UNDP/GEF Project. Outputs of the UNDP/GEF Project would be useful to the Bank s Project including the solar data base and GIS system; norms for solar PV systems; analysis of alternative management models for service provision; and monitoring and evaluation of PV systems installed under the UNDP Project. During the expected year of overlap in implementation in 2006 and early 2007, the Bank project will closely coordinate any installation of solar PV systems to ensure that there is no geographical overlap with the UNDP/GEF project, which would be expected to have selected the sites for installation of most of its systems by the time that the Bank Project starts operation in early Benefits Expected. As shown above, US$2.5 million of GEF support would be used for technical assistance for promotion of renewable energy projects, US$1.5 million would be used for TA to support promotion of productive uses in areas where electricity is provided by renewable energy, and US$5 million of GEF support would go directly to a revolving fund for bridge financing for the construction phase grid-connected renewable energy projects, mainly small hydropower. Together, GEF support is expected to leverage: (a) US17.5 million (from the GoP, the World Bank and enterprises) for renewable energy rural electrification investments, benefiting thereby around 20,000 households and institutions such as health centers, schools and community centers; and (b) US15 million over the five years of the Project or US$30 million over the life of the Renewable Energy Finance facility, from enterprises and banks in grid-connected renewable energy generating plant investments (mainly small hydropower). It is 107