A-A 3c2'0 - /-VL) Document of The World Bank FOR OFFICIAL USE ONLY. Repon No IND

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY A-A 3c2'0 - /-VL) STAFF APPRAISAL REPORT INDONESIA GAS UTILIZATION PROJECT MAY 8, 1990 Industry and Energy Operations Division Country Department V Asia Pegional Office Repon No IND This document has a restricted distribution and may be used by recipients only in the perfonnance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS Currency Unit = Indonesia Runiah (Rp) US$1.00 = Rp 1,750 Rp 1,000 = US$0.57 WEIGHTS AND MEASURES 1 barrel (bbl) = cubic meters (cu.m.) 1 standard cubic foot (cf) = cu.m. 1 British Thermal Unit (btu) G kilocalories (Kc) MCF = thousand standard cubic feet MMCF = million standard cubic feet MMCFD = million standard cubic feet per day MCM = thousand cubic meters MMCM = million cubic meters BCF = billion standard cubic feet TCF = trillion standard cubic feet Kl kiloliter toe = tons of oil equivalent (in heating value) boe = barrels of oil equivalent (in heating value) tpy metric ton per year bbl/d = barrels per day KWh = kilowatt hour (1,000 watts per hour) MW megawvtt (1,000 kilowatts) Km = kilometer HP = horse,ower ABBREVIATIONS AND ACRONYMS BAKOREN National Energy Coordinating Board BAPPENAS National Development Planning Board ERR Economic Rate of Return FRR Financial Rate of Return GOI Government of Indonesia HSD High Speed Diesel ICB International Competitive Bidding IDO Industrial Diesel Oil LIB Limited International Lidding LNG Liquefied Natural Gas LEMIGAS Research and Development Center for Oil and Gas Technology LPG Liquefied Petroleum Gas MIGAS Directorate General of Oil and Natural Gas, Ministry of Mines and Energy PERTAMINA National Oil and Gas Company PGN State Gas Corporation PLN State Electricity Corporation FISCAL YEAR (FY) April 1 - March 31

3 FOR OFFICIAL USE ONLY INDONESIA GAS UTILIZATION PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. Loan and Project Summary... i-iii I. THE ENERGY SECTOR AND GAS SUBSECTOR... 1 Introduction... 1 Primary Energy Resources... 1 Power... 3 Organization of the Energy Sector... 4 The Natural Gas Subsector Bank Role and Strategy... 9 II. THE BENEFICIARIES PGN (STATE GAS CORPORATION) Background Statutory Functions Organization Proposed Reorganization Technical Assistance Requirements Human Resource Requirements and Training.13 Accounts.14 Audit.15 Budgeting.15 Billing and Collection.16 Insurance.16 MIGAS AND LEMIGAS.16 III. THE PROJECT.17 Background.17 Market Gas Supply Project Objective and Rationale Project Description Project Costs Financing Plan Implementation Procurement Disbursement Environment Reporting Requirements This report was prepared by ilessrs. S. Khwaja (Sr. Gas Specialist), M. Sergo (Sr. Financial Analyst), and Ms. M. Manzo (Energy Specialist) on the basis of a field appraisal during May Ms. Rosa Lema assisted in the typing of this report. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

4 IV. FINANCIAL ASPECTS PGN's Margins on Gas Sales Past Financial Performance Present Financial Position Financial Projections Risks in Financial Projections Project's Financial Rate of Return V. PROJECT JUSTIFICATION AND RISKS. r.... _U Economic Evaluation of the Project.39 Project Risks.42 Fiscal Impact of PGN's Operations.43 Benefits from Institution Building Component.. 44 VI. AGREEMENTS REACHED ANNEXES 1.01 Estimated Gas Reserves 1.02 Historical Gas Production 1.03 Gas Production/Utilization Balance 1.04 Historical Gas Productior & Consumption By Region 2.01 Composition of Current Industrial Demndnd in Surabya and Medan 2.02 Gas Demand and Supply Projections for Medar and Surabaya 3.01 PGN's Existing and Proposed Organization 3.02 Organization of MIGAS and LEMIGAS 4.01 Implementation and Technical Assistance-Terms of Reference 4.02 Planning Study for Gas Technology Development Center-Terms of Reference 4.03 Regulatory System for Safe _Jilization of Natural Gas 5.01 PGN's Project implementation Sch lule 5.02 Phasing of Expenditure 5.03 Estimated Schedule of Disbursements 5.04 PGN's Progress Reporting Requirements 6.01 Notes and Assumptions on Financial Statements 6.02 PGN's Income Statement for FYs PGN's Balance Sheet for FYs PGN's Sources and Uses of Funds for FYs Efficiency Improvement Program for PGN 6.06 Income Statement for Medan Component of the Project 6.07 Income Statement for Surabaya Component of the Project 6.08 Financial Internal Rate of Return 7.01 Assumptions Underlying Economic Analysis 7.02 Economic Analysis - Internal Rate of Return 7.03 Domestic and International Prices of Petroleum Products 7.04 Economic Rate of Return Calculations based on Least Cost Alternative Fiscal Impact of the Project 8.01 List of Documents in the File Maps General IBRD Region-wise IBRD 21724R1, IBRD 21725R1

5 -i- INDONESIA GAS UTILIZATION PROJECT Loan and Project Summary Borrower: Beneficiaries: Amount: Lending Terms: On-lending Terms: Republic of Indonesia Perum Gas Negara (PGN) US$86 million equivalent Repayable over 20 years, including five years of grace, at the standard variable interest rate. The Government would onlend US$76 million to PGN at a rate of 13Z per annum, with repayment over 15 years including a grace period of five years. Project Description: The primary objective of the project is to accelerate the substitution of exportable petroleum product fuels in domestic consumption with non-exportable natural gas. This would be achieved through: (a) the provision of an assured supply of natural gas, at competitive prices, to power plants, manufacturing industries, and commercial entities in Surabaya and twelve other towns in its vicinity in East Java and in Medan in North Sumatra; (b) the integration of gas utilization plans and operations to facilitate balanced development; and (c) institution building, technology transfer and marketing studies to accelerate safe and efficient utilization of natural gas and to help plan for its long-term development. The project would consist of: (a) design and construction of a natural gas supply system for Surabaya and its environs and expansion of existing natural gas supply system for Medan; (b) technical assistance involving enhancement of PGN's skills in growth management and efficient expansion of its gas supply infrastructure, establishment of a Gas Technology Development Unit in LEMIGAS and upgrading of skills in MIGAS to facilitate the coordination of gas sector development plans and to institute a regulatory system for safe utilization of natural gas; and (c) feasibility studies for natural gas marketing in Palembang (South Sumatra), Jambi (Central Sumatra), Batam island (Riau) and Balikpapan (East Kalimantan). Benefits: The main benefits of the project are: (a) substitution of low value natural gas for high value petroleum

6 _4 i- products for power generation and manufacturing industry thus releasing more oil for export; (b) strengthening of institutions so as to improve the efficiency in the gas sector; and (c) reduction of environmental pollution and forest depredation with the replacement of polluting fossil fuels and wood by relatively clean natural gas. The project is expected to yield an economic rate of return of about 59Z for the Medan and Surabaya components combined. Risks: The potential risks to the project fall in four categories: (i) timeliness of gas supply; (ii) delays in market development; (iii) declining retail prices (in real terms) of the fuels to be substituted; and (iv) shortfalls in institutional capability to implement the project. These iisks are recognized and the precautions to minimize them have been built, as far as possible into the project design. The substantial benefits from the project far outweigh these risks. Estimated Costs: Local Foreign Total A. Natural Gas Transmission and US$ million----- Distribution Systems for Surabaaa & its environs Pipelines Regulator Scations Meter Stations & Service Lines Subtotal Medan Pipelines Meter Stations & Service Lines Subtotal Base Cost (A) B. Technical Assistance PGN Twinning Arrangement Staff Training Equipment (computers & software) Subtotal LEMIGAS (Gas Tech. Development Center) Consultancies Staff Training Equipment Subtotal

7 -iii-- MIGAS Staff Training Base Cost (B) C. Studies Marketing Feasibility Studies for Palembang Jambi, Batam Island & Balikpapan Base Cost (C) Total Base Cost (A+B+C) Physical Contingencies Price Contingencies Total Project Cost a/ Capitalized Interest During Const Total Funding Required a/ includes taxes and duties amounting to US$11.0 million equivalent. Financing Plan The total funding required (US$118.8 million equivalent) is expected to be financed as follows: Source Local Foreign Total US$ million z Proposed Bank Loan Bilateral Sources PGN Internal Cash Generation GOI Total Estimated Disbursements: IBRD Fiscal Year Annual Cumulative Economic Rate of Return: 59Z Maps: IBRD 21723, 21724R1, 21725R1

8 INDONESIA GAS UTILIZATION PROJECT I. THE ENERGY SECTOR AND GAS SUBSECTOR Introduction 1.1 Indonesia is endowed with large and diverse energy resources including oil, gas, coal, hydiopower and geothermal resources. Until recently, the energy sector was the main source of export earnings for the country, accounting for as much as 81% of total exports in FY1981/82. However, triggered by a lower international price of crude oil and OPEC production quotas, and with the coriconmitant promotion by the Government of non-oil exports, the share of energy exports has since steadily aeclined. In FY1987/88 and FY1988/89, the sector accounted for 48% and 39% of total export revenues, respectively. Although its export share has been reduced, the energy sector still remains the largest single source of foreign exchange earnings. To mitigate the decline in oil export earnings, the Government has adopted a two-pronged energy development strategy that calls for (a) maximizing the country's export of energy resources through development of tradeable energy resources including oil, coal and gas, and (b) the diversification of domestic energy consumption away from heavy reliance on petroleum products towards alternative fuels for which there are non-exportable surpluses (gas and coal) or which are non-tradeable (hydropower and geothermal). 1.2 Given the abundance of gas reserves and its relatively low marginal cost to develop, the natural gas subsector offers wide opportunities for pursuing Got's energy development.rategy. On the export side, LNG exports to Japan and Souch Korea represent 25Z of total energy exports and there are planned increases in exports with the commissioning of additional LNG facilities to meet supply commitments to Taiwan and additional contracts with Japan. On the other hand, the share of natural gas in domestic energy consumption is only 1Z, indicating a need for greater recognition of the prospects offered by gas as a more efficient and cheaper fuel for domestic use. Accordingly, GOI is promoting the expanded production and use of gas as substitute fuel for power generation and industrial manufacturing. Highest priority has been given to the regions of East Java and North Sumatra where recent gas findings have confirmed the adequacy of reserves accessible to the major economic growth centers of Surabaya and Medan. The avdilability of gas supply in these regions is expected to attract existing industrial users of more expensive liouid fuels to shift to gas, as well as promote more industrial development. Gas supply for power generation is likewise intended to meet the rising energy demand at a reasonable cost and thus sustain the regions' growth. Primary Energy Resources 1.3 Oil. Indonesia's proven and probable reserves have been estimated at about 70 billion barrels. Cumulative production as of 1988 has reached

9 billion barrels and the remaining proven recoverable oil is estimated at 8-10 billion barrels. Oil production reached a peak of 1.7 milli.- barrels per day (bbi/d) in 1977, but due to depletion of reserves and OrEC quota restrictions, production has since declined to 1.2 million bbl/d in 1987 and is expected to continue at about 1.1 to 1.3 million bbl/d in the coming years. In a bid to spur more exploration and production of oil, GOI recently announced easier terms for oil contractors especially in the more remote areas of eastern Indonesia. In July 1989, GOI signed nine new production-sharing contracts with international oil firms with fourteen more scheduled to be concluded by the end of the year. 1.4 Natural Gas. Indonesia's natural gas resources are estimated at about 106 trillion cubic feet (TCF), of which a total of 84 TCF is proven. The proven reserves are in Sumatra (22 TCF), Java (5.5 TCF), Kalimantan (20 TCF), Natuna in South China Sea (36 TCF), Sulavesi (0.4 TCF) and Irian Jaya (0.2 TCF). About 90 4 of these reserves is non-associated and can be developed independently of oil. In 1987, gross ratural gas production was about 1.7 TCF (300 million boe).1/ Since 1980, natural gas output has increased at an annual average rate of 7.5 Z. Indonesia's large gas reserves suggest a continued growth in natural gas production which is projected to outpace production of crude oil in the coming decade. GOI estimates gas production to increase to 2.8 TCF (490 million boe) by 1993/ Coal. Total coal resources are estimated to exceed 25 billion tons located primarily in Sumatra and Kalimantan, proven reserves of which a,e estimated at 1280 million tons. The current production level is 2.7 million tons per year with plans to boost production to over 10 million tons annually in the early nineties. GOI envisions coal as a major fuel for power generation as well as a growing export commodity. Work on a three million ton-per-year mine at Bukit Asam in South Sumatra and on a 0.6 million ton-per-year mine at the nearby Muara Tiga coal field is nearing completion. TLe Bukit Asam mine is estimated to have 2 billion tons of coal reserves. Its output is now usei mainly as fuel for power generation, specifically for the thermal station in Suralaya, West Java. In Ombi'Lin, West Sumatra, which is estimated to have 150 million tons of reseives, GOI is implementing a rehabilitation and development program to raise the production rate from the current 0.75 mil'lion tons per year to 1.3 million tons per year, mostly for export. In Kalimantan, exploration activities undertaken by contractors under production-sharing arrangements with the GOI have defined 700 million tons of recoverable coal in the region. 1.6 Hydropower. Hydroelectric potential has been estimated to total 75,000 MW consisting of 22,370 MW in Irian Jaya, 21,600 MW in Kalimantan, 15,000 MW in Sumatra, 10,200 MW in Sulawesi, 4,200 MW in Java, 620 MW in Bali and Nusa Tenggara, and 430 MW in Maluku. It is estimated that some 34,000 MW of the total potential can be developed for power generation. But while Indonesia's hydroelectric resources are large, their development is limited by their geographic distribution relative to demand. The greatest potential (over 307) lies in Irian Jaya where the demand is less 1/ 1 TCF of Gas = 176 million barrels of oil equivalent

10 -3- than 12 of total domestic demand, while Java wqhich accounts for 80% of electricity consumption has less than 6% of the total potential. Existing hydroelectric installations total about 2800 MW and are mostly situated in Java (1,840 MW). Sumatra *(736 MW), and Sulawesi (203 MW). Schemes with an aggregate capacity of about 300 MW are currently under construction and based on a systematic countrywide resource survey conducted by the State Electricity Corporation (PLN), various prefeasibility and feasibility studies of identified hydroelectric sites are being pursued. 1.7 Geothermal Energy. The Indonesian archipelago lies in a volcanic belt and has large geothermal energy potential estimated at 10,000 MW of which 5,500 MW is in Java and Bali, 1,100 MW in Sumatra, 1,400 MW in Sulawesi and 2,000 MW in other islands. Several sites have been investigated of which the first to be developed was the Kamojang field in West Java. In 1976, GOI, in collaboration with the Government of New Zealand, initiated development of the field and the first 30 MW generation set was commissioned in Additional power plant installation, of 110 MW was commissioned in In 1982, PERTAMINA (The National Oil and Gas Company) entered into a joint operation contract with Union Geothermal, a subsidiary of Union Oil of California, for development of the Salak field in West Java. A. potential of over 200 MW has been proven by exploration. Pertamina has also explored geothermal fields in the Dieng and Drajat areas in Java, which appear promising for further development. During the next five years, exploration drilling in 14 areas in Java has been programmed as well as the development of the Salak and Drajat fields to the extent of 110 MW each. Power 1.8 Electricity demand has grown rapidly in Indonesia with per capita consumption expanding from 59 kwh in 1977 to about 200 kwh in Despite the rapid growth, only 24Z (542 urban and 13% rural) of all households in Indonesia have been electrified as of The principal sources of electricity supply have been PLN (State Electricity Corporation) and self-generation by industries. PLN's total installed capacity in 1988/89 was 8100 MW. PLN's sales grew by about 14Z per year since 1982 due to increased consumption by existing customers, opening up of new service areas and the gradual take-over of supply to industries with captive generation. At the same time, captive capacity continued to increase, reaching 7000 MW in / meeting the growth in industrial demand that could not as yet be serviced by PLN. GOI's development program for the electricity sector is aimed at raising the electrification ratio to 35% by 1993/94 and to 54% by 2000/01. It also calls for tv- substitution by PLN grid supply of 80X of captive generation in Java by.993/94. To achieve these targets, PLN's proposed expansion program will.aise PLN's installed rapacity to MW by the end of 1993/94 and to MW by 2000/01. By giving priority to the development of coal, natural gas and geothermalbased power plants, PLN's least cost program will result in a reduction in the share of oil anc diesel-based capacity from nearly 60Z in 1987/88 to less than 32Z by 1993/94. 2/ Including 1900 MW capacity in five major enclave projects.

11 -4- Organization of the Energy Sector 1.9 The Ministry of Mines and Energy (MME) is the principal agency responsible for the development and implementation of Government policies in the energy sector. The MME was established in 1978 to coordinate and supervise the activities of public and quasi-public enterprises operating in the sector, namely: PERTAMINA, responsible for the development of Al, gas and geothermal resources; P.T. Aatubara and P.T. Bukit Asam for coal mining and developm,;nt; PLN for electriclty supply; and PGN for gas distribution. Othe miristries and agencies at, also involved in the sector. These include the Ministry of Public Works, which deals with hydropower resource surveys; the Ministry of Forestry, which oversees forestry products; and the National Atomic Energy Commission. which is responsible for nuclear development. To ensure proper coordination of energy policy, the GOI has established a cabinet-level interministerial National Energy Coordinating Board (BAKOREN) to oversee sectoral development. Reporting to BAKOREN is the Energy Resources Technical Committee currently chaired by the Director-General for Electricity and New Energy; the committee is tasked with the formulation of the energy development plan and providing policy advice and assessment to BAKOREN. The Natural Gas Subsector 1.10 The gas subsector is regulated and monitored by the MME through the Directorate General of Oil and Natural Gas (MIGAS). The entities supervised by MIGAS are ka) PERTAMINA which is responsible for exploration and development of gas fields (including supervision of production-sharing contracts), as well as transmission and distribution of gas to bulk users; and (b) PGN (State Gas Corporation), which is responsible for the supply and distribution of manufactured and natural gas to medium-sized and small industries, commercial establishments and domestic consumers. In addition, MIGAS issues licenses to service companies that conduct business in the petroleum and gas sector, enforces safety and environmental regulations and supervises training for local workers. MIGAS also includes LEMIG'AS (Research and Development Center for Oil and Gas Technology) and PPTMGB (Oil and Gas Manpower Development Center). Gas Utilization 1.11 Natural gas production has steadily increased from 0.5 TCF in 1981 to 1.5 TCF in 1984 and reached 1.7 TCF in Of the 1987 production, (4600 MMCFD), 232 was used for field operation, 8.5Z was flared, 53Z was used in liquid natural gas (LNG) production, 9Z in fertilizer production, and the balance of 6.52 (300 MMCFD) was utilized as commercial fuel and process gas. Domestic consumption of natural gas has largely been restricted to use as feedstock, process gas and fuel in fertilizer production, the steel industrv, refinery and LPG operations, and cement plants located near gas supplies. Small city and town systems operated by PGN and power generating units run by PLN have also used small amounts of gas. In 1987, the cement sector accounted for 0.7X of total commercial fuel and process gas consumption; the steel industry for 2.4?; LPG production, 1.42; refinery operation, 1.22; the power sector, 0.32; and other industries, 0.5Z.

12 1.12 Developrn,ent of natural gas for domestic use as fuel has been limited because large gag fiejds are generally located far from the major centers of population and industry and infrastructure for bringing these gas supplies to the end-consumers at reasonable costs have yet to be sufficiently developed. Consequently, most gas production has been directed towards LNG operations situated on-site or adjacent to the fields. But with slowdown in the growth of the Far Eastern LNG export markets, use of Indonesia's large surplus reserves for domestic energy consumption is becoming more economically attractive. In particular, the large offshore and onshore reserves in Java and Sumatra readily lend themselves for development as fuel sources in view of their accessibility to the major economic and industry centers at Surabaya and Medan. Natural gas is now considered as the most economical fuel (except for coal in certain cases) fo: power generation and manufacturing industries in these regions. Accordingly, GOI is promoting the use of gas as a substitute for higher value oil, thus releasing petroleum products for exports. Potential demand for gas in FY91, on a fuel substitution basis, is estimated by GOI to reach 480 MMCFD (31 million boe/year) in West Java, 300 MMCFD (19 million boe/year) in East Java (19 million boe/year), and 337 MMCFD (22 million boe/year) in Sumatra. Key Sectoral Issues and Strategy 1.13 Dominant issues in the gas sub-sector relate to (a) development of a regulatory framework to promote safe and efficient utilization of natural gas; (b) establishment of least cost long-term gas development program; (c) creation of modern and efficient institutions to manage natural gas transportation and utilization; and (d) formulation of an appropriate gas pricing policy GOI's strategy to facilitate economic substitution for petroleum products in domestic energy consumption, by non-tradeable, indigehlous natural gas involves coordinated pursuit of four courses of actions: (a) expansion of gas supply in Java and Sumatra through efficiently phased and designed infrastructure projects; (b) building of institutions and upgrading the Indonesian expertise in gas technology; (c) studies to help define long-term plans; and (d) review and formulation of a gas pricing policy that would attract investors further to explore and develop gas resources, as well as to encourage energy consumers to substitute gas for liquid petroleum products wherever economical. Natural Gas Sub-sector Planning 1.15 Due to the availability of ample gas reserves in Java and Sumatra, where the demand for energy is immediate, and to forestall environmental pollution, GOI has given priority to the expansion of gas supply and distribution systems in these islands. As a first stage of planning, GOI, through PGN, has formulated a medium-term program consisting of discrete expansion projects for existing service areas of PGN in Java and Sumatra. The on-going Gas Distributien Project (Loan 2690-IND) for expanding PGN's facilities in Jakarta and Bogor in Java, and for Medan in North Sumatra is part of this strategy. It involves laying of supply and feeder mains to nine industrial and commercial areas and setting up local distribution

13 -6- networks to serve an initial core group of 350 new industrial consumers and 800 large commercial consumers. As part of the same program. GOI plans next to expand the use of gas for power generation and manufacturing industries in and around Surabaya (East Java) and Medan (North Sumatra) through the rehabilitation and expansion of gas transmission and distribution systems in these cities. This will be the core of the proposed Gas Utilization Project Parallel to the implementation of the medium-term program, GOI is defining a long-term plan for Java and a strategy for expanded gas utilization for which it has commissioned the Java Gas Grid Study under a bilateral assistance from the Dutch Government. This study commenced in September 1988 and is expected to be completed by June A similar study for Sumatra is under consideration. Insitutional Development 1.17 Apart from the expansion of infrastructure, the building of institutions to sustain the growth and to ensure efficient utilization of gas has been a key component GOI's planning from the outset. Under the current Gas Distribution Project (LN IND), PGN is being transformed into a modern gas utility through a Bank-designed long-term technical collaboration (twinning) with British Gas; and an Energy Pricing Policy Study is being conducted to provide a basic framework to promote the efficient use of fuels. Under the proposed project, GOI plans to develop and institutionalize Indonesian expertise in (a) promoting safe and efficient gas usage, through the establishment of a Gas Technology Development Unit, (b) long-term planning and growth management of gas utility business by enhancing PGN's capabilities, and (c) coordination of development planning in the gas sector and improvement of gas safety regulation by upgrading the capabilities of MIGAS The Gas Technology Development Unit will be established within LEMIGAS, which is a department of MIGAS entrusted with research and development of oil and gas technology under a statute that permits it to undertake such activities. Its scope is outlined in the terms of reference (Annex 4.02) for its on-going planning study. This study is being conducted by the Institute of Gas Technology (IGT) of Illinois, USA and is expected to be completed by June Through high quality research and reliable dissemination of knowledge, this Unit is expected to establish itself as a primary source of technical information on natural gas. Its principal interactions will be with: - the government, for legislation and human resource development; - the gas producing and marketing companies, for research on standards, materials and equipment; - the universities, for development of curriculae for gas engineering and technology courses;

14 -7- manufacturing industry, for the manufacture of efficient materials, equipment and appliances; and - the consumers of gas and other fuels, for interfuel substitution and energy conservation PGN is steadily developing its expertise in all areas of the gas utility business and has increased its credibility with its customers and the Government. It has demonstrated its medium-term planning skills in the preparation of the proposed project and now intends to develop its skills in longer-term planning, growth management and system optimization, under the proposed project Development planning for the gas sector requires active coordination by the Ministry of Energy through MIGAS. It involves assessing exploration and production schedules at the supply end, and matching these with the build-up of suitable markets and the phasing in of investments in transmission and distribution systems. To pursue this role effectively, MIGAS will need to strengthen its technical expertise in detailed evaluation of natural gas expansion plans. MIGAS also intends to enhar.ne its capability for developing a legislative, regulatory and technical program (with technical support from the proposed Gas Technology Development Unit) to ensure that natural gas delivery and utilization systems in Indonesia will continue to be installed and operated safely. Gas Pricing 1.21 The gas tariff in Indonesia is characterized by differential pricing, largely reflecting GOI's development priorities among users. Producer prices paid by PERTAMINA are determined within the context of production sharing agreements. PERTAMINA, in turn, sells gas to consumers at prices fixed by the GoveLnment which may be higher or lower than the producer prices, thus implying cross-subsidies among users. The current categories of users and the applicable gas charges are as follows: Table 1 Category US$/MMBTU a/ Krakatau Steel 0.65 for use as feedstock in production process 2.00 for use as fuel for power Fertilizer 1.00 Other Industries 3.00 PLN (Electricity) 2.53 in East Java; 3.00 in North Sumatra PGN purchase price 2.00 PGN city gas selling price 2.86 a/ At the exchange rate of Rp l,750/us$.

15 Since the present structure of gas and other fuels pricing is not consistently based on the economic costs of supply and the economic value to Indonesia of alternative energy resources that gas replaces, the signals received by the gas producers and users make it difficult to ascertair :he appropriate balance between supply and demand for gas. Accordingly, through the on-going Energy Pricing Policy Study funded by the Bank under the Gas Distribution Project (Ln IND), GOI is reviewing gas tariffs in the context of an overall energy pricing review, with the objective of developing a comprehensive energy pricing strategy that will encourage increased gas production, especially of non-associated gas, as well as promoting increased gas utilization by the power and industrial sectors The general objective of the energy pricing review is to minimize distortions in domestic prices by using economic costs of supply and netback value as benchmarks. Specifically, the price for nontradeable surplus energy resources such as natural gas, coal and geothermal steam would be established with the costs of competing fuels as ceilings and the economic cost (LRMC) of supply as the floors. The domestic prices of petroleum products, particularly kerosene and diesel, will also need to be re-aligned to correct distortions between domestic and international prices. To illustrate, preliminary findings of the Energy Pricing Policy Study indicate that the marginal cost of most gas supply in Indonesia is estimated to be less than US$0.50 per MCF at field gate, and depending on the transport route, gas costs wo;l d range from US$1.00 and US$1.50 per MCF at city-gate. The latter cost is.ess than half the international price of substitutable petroleum products (equivalent to US$2.9 per MCF in the case of fuel oil and to over US$4.0 per MCF for other products). These suggest that gas tariffs to the final consumer could be set between US$1.50 and US$2.9 per MCF if fuel oil is to be replaced, with the actual level to be determined by the equipment conversion cost of customers, and by financial and fiscal considerations In addition, under the Power Sector Efficiency Project, the GOI has agreed to specific proposals for institutionalizing the process of review of the energy prices, including the prices of petroleum fuels (LPG, kerosene, gasoline, diesel, fuel oil), gas, geothermal steam, coal and electricity. The proposals consist of the following: (a) establishment of an Interdepartmental Energy Pricing Task Force to review and to advise Government on energy prices -- the Steering Committee for the "Energy Pricing Policy Study' would be the core group for this; and (b) establishment of an Energy Pricing Unit in MME to provide analytical support and technical data to the Task Force -- the counterpart team for the Energy Pricing Policy Study could be the core group for this.

16 -9- Bank Role and Strategy 1.25 The Bank's involvement in Indonesia's natural gas subsector began with the Fnergy Assessment Report of 1981, which concluded that alternative energy sources could be developed economically and expeditiously to replace oil consumed domestically in order to conserve the limited oil reserves for exports. This was followed by studies (in 1984 and 1985) for Natural Gas Utilization and City Gas Distribution financed under Fifth Technical Assistance Project (Cr. 898-IND). The Natural Gas Utilization Study supported the policy of developing large-scale domestic markets for natural gas as a substitute for oil. The City Gas Distribution Study confirmed the potential for economical distribution of natural gas to medium and small industries, commercial entities and households in urban areas. It resulted in a decision to rehabilitate and extend the use of gas distribution systems in Jakarta, Bogor and Medan, with the prospect for further implementaticn in other cities. Assistance for this project was provided by the Bank through LN 2690-IND. This was the first Bank-financed project in the natural gas sub-sector in the country. Since then, the Energy Options Review report of August 1987 prepared by the Bank has confirmed the important role of natural gas as a substitute for petroleum products to meet the growing fuel requirements of the power, industrial and commercial sectors, especially in Java Currently, the Bank's involvement in gas is through three activities: (a) the gas distribution project (Ln 2690-IND) which, inter alia, aims to strengthen the institutional capability of PGN to play a more effective role in gas distribution, (b) the Energy Pricing Policy Study financed from the same loan, which is designed to help GOI to rationalize fuel prices and thereby promote efficient utilization, and (c) monitoring the Java Gas Grid Study, funded by a Dutch grant, which should help define long-term gas development strategies. Also, through close involvement in the power sub-sector, the Bank has been promoting gas utilization for power generation which, in certain cases, can be managed to exploit economies of scale in gas transportation, and allow the gas to be supplied to industrial and other pitential consumers at the lowest possible cost The expansion of natural gas utilization in Java and Sumatra would evolve through a number of discrete but interlinked projects. Formulation of adequate policies is necessary at this stage to ensure efficient sector development. Through project financing and ensuing policy dialogue, the Bank can assist GOI irn (a) developing a natural gas pricing policy framework for optimizing its development and utilization, (b) determining the appropriate scale and phasing of investments, (c) formulating policies conducive to private sector participation in natural gas utilization, including spawning of an efficient natural gas appliance manufacturing industry, and (d) creating modern, efficient institutions to regulate and manage natural gas transmission, distribution and utilization, as well as to develop technology and standards suitable to local conditions Mo,reover, the Bank will continue to assist GOI to coordinate the developmer.t of gas and power strategies and to devise suitable institutional and financing arrangements which would attract private sector participation in gas-fired power plants.

17 -10- II. THE BENEFICIARIES 2.1 The promotion of natural gas utilization in domestic energy consumption would involve three organizations namely: PGN (State Gas Corporation), for building and operating of gas supply facilities and consumer conversion; MIGAS (Directorate General of Oil and Gas), for safety regulation and coordination of development plans; and LEMIGAS (Research and Development Center for Oil and Gas Technology), for research and development of standards to facilitate safe and efficient usage. Since PGN would be the core organization for project implementation, receiving about 9oz of the proceeds of the loan, this chapter mainly refers to PGN and the other beneficiaries are briefly discussed at the end. Background PGN (STATE GAS CORPORATION) 2.2 PGN (Perum Gas Negara) was.reated in 1958 as a Government agency to take ovpr the foreign interests in the manufacture and distribution of town gas in the cities of Jakarta, Bogor, Bandung, Cirebon, Semarang and Surabaya in Java; Medan in North Sumatra and Ujung Pandang in Sulawesi. With the availability of natural gas in west Java, several local distribution systems in Jakarta, Bogor and Cirebon were wholly or partially converted to natural gas during Under a Government regulation of 1984, PGN was turned into a Public Corporation, which gave it some operating autonomy within the Government regulations but restricted the capital ownership to the Government. By 1985, PGN's total gas sales amounted to 95 million cubic meters (MMCM) per year, equivalent to an average sale of 7.4 million cubic feet per day (MMCFD), with a sales mix of 702 natural gas and 30X manufactured gas, which was about 20X of the then estimated potential demand from private industries and commercial entities. It had failed to expand the use of natural gas in the growing fuel market primarily due to lack of technical expertise. As a remedial measure, in 1986 GOI negotiated and signed a Bank loan (No IND) for PGN's first major expansion project (the Gas Distribution Project) providing a ten-fold increase in natural gas distribution (from about 5 MMCFD to 50 MMCFD) by 1992 to about 350 medium size industries and 800 commercial entities in Jakarta, Bogor and Medan. 2.3 The implementation of the Gas Distribution Project began in December 1986; its progress has been satisfactory and it is expected to be completed by July The institution building of PGN is a key component, for which the Bank designed a long-term collaboration (twinning) of PGN with a prominent and experienced gas utility (British Gas). This relationshi provided the means to integrate the know-how transfer and staff training on site in the course of project implementation and exposed PGN to an experienced operating organization acting as a role model. It has been very successful, and has enabled PGN to upgrade its management and technical skills. PGN's on-going skills development program covers 130 professionals (engineer, accountants and sales executives) and 250

18 -11- technicians of PGN, 200 technicians of gas pipeline construction contractors and internal gas n 4 Ding installers, and 800 technicians of industrial consumers. 2.4 Since 1986, PGN's sales have increased at an average rate of 362 per year and its gas losses have been reduced from 302 to 6Z. Prior to 1986, PGN operated at a loss, in FY88 it achieved breakeven and, in FY90 it made a 2.6Z return on net fixed assets in operation, which was short of the target of 10X but still reflects a turnaround in its operations. (The reasons for the shortfall are discussed in para 4.3). It is to PGN's credit thet, despite the adverse domestic price movements in gas and liquid fuels, it was able to expand its gas sales in a competitive market through skillful marketing. Statutory Functions 2.5 The main functions of PGN under its charter are as follows: (a) production, supply and distribution of manufactured gas; (b) supply and distribution of natural gas to customers with a contracted demand not exceeding 5 MMCFD (except in specific cases with the prior permission of GOI); (c) planning and construction of natural gas distribution systems; and (d) provision of services associated with the supply of gas and gas by-products. Current Organization 2.6 PGN, being a state-owned utility, is held responsible to the Government through the Minister of Mines and Energy. It is managed by a Board of Directors, which comprises a President Director and a maximum of four Directors appointed by the President of the Republic on the recommendations of the Minister of Mines and Energy. The Board of Directors is entrusted, under the statutes of the Government and within the guidelines set by the Minister of Mines and Energy, to draw up the annual work plan and budget, appoint and discharge employees, establish pay scales and determine the numbers and categories of staff required. The performance of PGN is periodically reviewed by a Board of Supervisors. This Board, also appointed by the President of the Republic, comprises senior staff of the Ministrv of Mines and Energy and the Ministry of Finance. 2.7 The President Director is the Chief Executive Officer of the corporation. He is assisted by a Director Operations, a Director Development, a Director Finance and General Affairs and an Internal Auditor. The Director Operations is responsible for gas marketing and distribution systems operations. The Director Development is responsible for planning and design of new transmission and distribution systems, their

19 -12- construction management and procurement of materials. The Director Finance and General Affairs is responsible for finance, personnel management, general administration and stores management. 2.8 PGN's field activities are geographically organized through eight regional branches, located at Jakarta, Bogor, Bandung, Cirebon, Semarang and Surabaya in Java, Medan in North Sumatra and Ujung Pandang in Sulawesi The gas marketing and distribution system operations in the regions are managed by Branch Managers who report to the Director Operations and maintain functional links to other Directors. The construction activity is managed by Project Managers who are responsible to thz Director Development and maintain functional links to Branch Managers and the other directors. 2.9 Each Director is supported by Sub-Directors with responsibility for a major function or a group of smaller functions. Additionally some key functions i.e. research, train.ing and information service, are headed by Senior Managers reporting directly to the Board of Directors. This structure (Annex 3.01) was agreed with PGN and implemented as a condition of loan effectiveness under the on-going Gas Distribution Project (Ln IND). Proposed Reorganization 2.10 To facilitate the management of increased corporate and development activities under the proposed project, PGN will enlarge its existing management structure and regroup some of the functions. In the proposed reorganization (Annex 3.01) the President Director will be assisted by four Directors and an Internal Auditor. The titles of the four Directors and their responsibilities will be: Director Operations - gas marketing, operation and maintenance of gas transmission and distribution systems; Director Development Director Finance Director Administration - and Logistics - planning and design of gas transmission and distribution systems, materials control and construction management; - corporate budget, finance, accounting and cost control; and personnel management, procurement and stores management, general administration and legdl services The significant changes involved in the organization are: (i) consolidation of personnel management, logistics and administration under the fourth Director to provide the necessary focus on performance and skills development; (ii) appointment of a sub-director with the sole responsibility for each of the functions of material control, maintenance,

20 -13- cost control and logistics to enhance operational efficiency and cost effectiveness; and (iii) the addition of regional planning in the responsibilities of the Branch Manager to coordinate the project preparation and design with local authorities. Technical Assistance Requirements 2.12 PGN has matured considerably during the execution of the on-going Bank financed Gas Distribution Project (Ln 2690-IND) with substantial increase in skills in all areas of its operation, and has developed credibility with its customers and the Government institutions with which it interfaces. This rapid maturation has given PGN an adequate base from which to undertake another expansion project. However, there is still a large experience gap within the company as a result of earlier years of stagnation and lack of recruitment. Therefore, PGN will require further technical assistance, along the same lines as that in the current project This technical assistance is in the form of a long-term technical collaboration (twinning) with an experienced operat..g entity to provide a broad based package of technical assistance in key operating areas, integrate know-how transfer and staff training on site in the,urse of project implementation and expose the client to mature operations of the collaborating entity. In such an arrangement the seconded staff of the experienced operating entity work in parallel with the client's nominated staff to build-up the client's skills and to upgrade its operations rather than the consultants being made responsible for discreet tasks. It ensures a higher level of on-the-job training and a higher level of understanding and commitment by the clients' staff who remain responsible for all aspects of project execution. It also permits the work program to remain flexible overtime, permitting some variation in the input of technical assistance to suit the project needs and staff capabilities Apart from strengthening its skills in the areas addressed in the current project, PGN needs to develop skills for a larger role in the gas utility business, notably in long-term planning, growth management and system optimization. As PGN's current technical collaboration (twinning) relationship with British Gas is working well, it Lntends to extend this arrangement (Annex 4.01) for the duration of the proposed project which will provide both continuity and consistency of approach. This has been acceptable to the Bank PGN will finance this arrangement through bilateral aid and has sought assistance from the Overseas Development Administration (ODA) of the UK Government which in principle has agreed to continue funding it. Since the twinning arrangement is considered critical to the successful implementation of the project, its finalization would be a condition for loan effectiveness. Human Resource Requirements and Training 2.16 The proposed project will involve about a two-fold increase in PGN's operation and a three-fold increase in its gas sales. Since under

21 -14- the current project (Ln 2690-IND) PGN is developing a sizeable base of highly skilled manpower (130 professionals i.e., engineers, accountants and sales executives and 250 technicians) it will require proportionately less additional manpower to manage the proposed project and follow-on operations. The additional staff it would need to employ would comprise about 80 professionals in the fields of engineering, marketing, human resource development and finance and approximately 100 technicians. As PGN's pay scales are comparable with other public sector corporations, the recruitment of additional staff is not expected to po e any problems. During negotiations, it was agreed that GOI would allow PGN to maintain its pay scale at a level as remunerative as that offered by similar public sector corporations In the proposed project, PGN's skills development program will cover, (a) the training of its newly recruited staff under a program similar to that being followed in the on-going project but expanded to recognize the new areas of PGN's operations (e.g. gas transmission and compression); (b) advanced training to its existing professional staff in long-term planning, growth management and system optimization; and (c) the training of an aaditional 200 technicians of pipeline construction contractors and internal gas piping installers and 700 technicians of the industrial consumers in basic skills and safe operations. During negotiations assurances were obtained that PGN, with the help of the consultant to be appointed after the proposed loan is made, will prepare a detailed training program and discuss it with the Bank for implementation under a timetable acceptable to the Bank. Accounts 2.18 PGN's accounts are maintained in accordance with the "Indonesian Accounting Principles' issued in 1983, the relevant parts of the Government's 1984 regulations on public corporations, the 1984 Government decree converting PGN into a public corporation, and the instructions from PGN's management on specific accounting procedures. Each branch office is expected to send a monthly financial report (mainly income statement) to the head office within 5 days of the close of the month for consolidation, as well as an annual report within two months of the close of PGN's fiscal year. PGN's annual consolidated statements are generally completed within three months of the close of its fiscal year as required for tax purposes. PGN's Board of Directors is required to submit the annual financial statements to concerned Government agencies (including the State Audit Board) within six months of the close of its fiscal year. Furthermore, PGN's Board of Supervisors submits quarterly and annual reports to the Ministries of Mines and Energy and Finance The accounts of each branch office are supervised by a certified bookkeeper and the timeliness and accuracy of reporting is generally satisfactory. On the whole, PG1's accounting system follows generally accepted principles and utility practices. Under the ongoing project, a team was formed within PGN for the implementation of an integrated accounting system, including cost accounting and budgeting and for computerization of accounting routines (e.g. billing/collection, wages,

22 -15- stores, budgets and project accounts) to permit PGN to expand its operations in an efficient way. With the assistance of the twinning agency and consultants, PGN has made substantial progress in the simplification and computerization of its accounting routines and PGN staff have well absorbed the necessary computer skills. The new integrated accounting is expected to be operational in FY In recent years, PGN may have charged excessive amounts of interest to capital investment and transferred work in progress (WIP) to assets in operation before the work was actually commissioned and started to produce revenues. The computerization of VIP and stores will be completed in FY91, and this will provide PGN with the tools to improve its project accounting procedures. This may have an impact on PGN's income taxes as well as the rate of return. During project implementation, this matter will be reviewed to ensure a sound and consistent basis for rate of return calculations. Audit 2.21 According to its 1984 charter, PGN's accounts are audited by Government auditors: the Finance and Development Supervisory Board (BPKP), and if serious reasons so indicate, the State Board of Auditors (BPK). For projects financed by the Government, the Tschnical Department of the Ministry of Mines and Energy also carries out project audits. PGN's internal audit unit reports directly to its Board of Directors and consists of five officers. External audits are carried out following generally accepted audit practices and PGN's audit arrangements on the whole are satisfactory. PGN's financial statements are generally submitted for audit within 4 months of the end of PGN's fiscal year. The number of observations in the audit reports has been substantially reduced in recent years and PGN expects a FY89 report without qualifications. Audit reports are often finalized late, however, about a year after the closing of PGN's fiscal year. During negotiations, agreement was obtained that PGN will provide the Bank with its unaudited annual financial statements within six months of the end of its fiscal year, and the corresponding audited report within nine months after the end of its fiscal year. Budgeting 2.22 Under its charter, PGN is required to submit its project and operating budgets to it,; Supervisory Board for review and to the Ministries of Mines and Energy and of Finance for approval. Budgets have to be submitted at least three months before the start of the budget year. If the Government does not object to PGN's budget before the budget year begins, the budget is implemented as submitted. Supplementary or amended budgets may be submitted during a budget year following the same procedures as for the annual budgets. As a public corporation, PGN can redistribute amounts between different headings in its operating budget on directive from its Board of Directors. The budget procedures prescribed for PGN are reasonably flexible and should be adequate for carrying out the proposed project. PGN's internal procedures for preparing its budget and monitoring actual expenditures have been improved with the assistance of the twinning agency; as from FY90, expenditures are compared with budget estimates monthly within five days of the close of the month.

23 -16- Billing and Collection 2.23 PGN bills its customers monthly and gas bills generally reach the customers within a month after the close of the billing period. In 1986, bills were prepared with the help of obsolete office machines and monthly summaries for accounting purposes were prepared manually. Under the ongoing project, PGN was provided with adequate equipment and is now implementing the computerization of its billing and collection procedures. Customers generally pay their gas bills ;ithin one month after receipt, as required by PGN, and the value of outstanding bills currently equals less than two months of billing, which i3 satisfactory. The number of unpaid bills is insignificant and PGN's current provisions for bad debts appear adequate. Insurance 2.24 PGN's assets are spread over eight different cities and any single loss would be relatively small in comparison with PGN's total assets and operations; PGN, therefore, did not carry any comprehensive insurance coverage, except for vehicles and material in transit. Under the ongoing project, PGN agreed to review the adequacy of its insurance coverage and discuss the findings of the review with the Bank. This resulted in a strengthened insurance coverage for PGN, including a blanket cover of capital works in progress combined with fire insurance for assets in operation and third party injuries and/or damages. Assets underground are not insured. This insurance coverage is acceptable and in line with gas industry practices. However, during the implementicion of the proposed project, PGN's insurance coverage will be monitored to avoid double coverage, e.g. by PGN and turnkey contractors for major nipe works. MIGAS AND LEMIGAS 2.25 MIGAS (MINYAK DAN GAS BUMI) is the Directorate General of Oil & Gas in the Ministry of Mines & Energy. lt is responsible for planning, regulating and monitoring the development and utilization of hydrocarbon and aeothermal resources in the country. It is headed by a Director General who reports to the Minister of Mines & Energy. The Director General is assisted by six Directors, responsible for: exploration and production of oil and natural gas; exploration and production of geothermal resources; technical services; business development; research in hydrocarbon development and utilization; and human resource development LEMIGAS (PUSAT PENELITIAN DAN PENGEMBANGAN TEKNOLOGI MINYAK DAN GAS BUMI) is the organization for research and development of oil and gas technology. It was established in MIGAS in 1984 with the following statutory functions: - research to acilitate the development and utilization of oil and natural gas resources in Indonesia; - collection and dissemination of technical information; and - technical consultancy service to the oil and natural gas industry in the country.

24 LEMIGAS currently employs about 900 professional and support staff of whom more than 200 hold university degrees and a further 37 hold postgraduate qualifications. Its current duties include survey and evaluation of oil and gas deposits and research in oil production, processing and utilization. MIGAS now wants it to acqui-e expertise and facilities for research to promote safe and efficient natural gas utilization through the establishment of a Gas Technology Development Unit. Organograms of MIGAS and LEMIGAS are given in Annex The organization of the Gas Technology Devrelopment Unit will be determined after the completion of its planning study (para 1.18) and its implementation will be a condition for the disbursement of funds allocated under the project. Background III. THE PROJECT 3.1 The Bank's Energy Assessment Report of 1981 and the studies of 1984 and 1985 for Natural Gas Utilization and City Gas Distribution financed under Cr. 898-IND, established a basis for expanding the use of natural gas in domestic consumption, and identified the need for institutional and policy reforms in the sector to facilitate the penetration of natural gas in the domestic economy. Accordingly, the ongoing Gas Distribution Project (Ln 2690-IND) was formulated and launched in 1986 for: (a) the expansion of gas supply to medium-size industries and commercial entities in Jakarta, Bogor and Medan; (b) the institutional strengthening of PGN to enable it to function as the core organization for the development of gas utilization; and (c) the Energy Pricing Policy Study to provide a framework for developing a comprehensive energy pricing strategy. Subsequiently, the Bank's Energy Options Report of 1987 reconfirmed the importance of natural gas as an economic substitute for petroleum products to meet the growing fuel requirements of power generation, and the industrial and commercial sectors, especially in Java. The proposed projel.t is a follow-up to consolidate the gains being made in the on-gcing project and to sustain and accelerate the economic expansion of natural gas utilization. Market 3.2 The market to be served by the project comprises medium-sized industries and large commercial firms and three large customers i.e., PLN's two power stations in the Medan area dnd a paper mill at Leces, about 80 Km southeast of Surabaya. Residential and small industrial/commercial demands have not been considered in view of the relatively higher cost involved in supplying low volume consumers. Focusing on large-volume consumers would render PGN's operations more cost-effective permitting strong product competitiveness and enabling PGN to establish its market base faster. Based on market surveys conducted by PGN, the current and potential average and peak sales of gas in the project areas of Surabaya and Medan are estimated to be as follows:

25 Table 2 FY ending Ove. max. ave. Max. ave.max. ve.max. ave.max.ave.max. ave.max UMCFD Surabaya Indus./Commercial Paper Lecos O Total Medan Industries PLN ao Total TS E i i g i 3.3 In the Surabaya area, PGN's market presence is currently restrictc_ Lo the distribution of manufactured gas and LPG supply to 38 small industrial and commercial users and 3,572 domestic consumers situated in downtown Surabaya. Gas sales in FY89 consisted of 0.20 MMCFD of manufactured gas to industrial and commercial consumers, and 1,290 tons of LPG to domestic consumers. There are about 3,000 industrial and commbrcial enterprises using petroleum products as fuel in Surabaya and 12 small towns in the vicinity, of which 340 medium-s.ze industries and 150 commercial entitites, accounting for about 702 of the total demand, have been targettel for natural gas supply under the project. There is also a major industry, the paper mill at Leces, that would like to substitute petroleum product fuels (fuel oil and diesel) with natural gas. According to the current rules, major consumers (contracting for more than 5 MMCFD gas supply) should be PERTAMINA's customers, which in this case would entail duplication of investments in supply facilities. To avoid this, PERTAMINA and PGN have agreed that the Leces paper mill will be PGN's customer. The average-day sale of natural gas is projected to grow from 10 MMCFD in FY94 to about 80 MMCFD by FY2000 and to about 90 MMCFD by '-Y In Medan, PGN currently supplies natural gas to about 100 mediumsized industrial and commercial consumers, 2000 households and a PLN's power station at Paya Pasir near Belawan. The industrial, commercial and household consumers are PGN's customers, while the PLN power station is PERTAMINiA's customer. PGN is paid a carrying charge by PERTAMINA for transporting gas to the power station. In FY90, PGN's average day supply to its customers and to PLN's power station reached 5 MMCF and 30 MMCF respectively. Urnder the proposed project, it is expected to increase to 60 MMCF (including 48 MMCF for PLN9s stations) by FY93. Further growth will depend on the availability of gas supply from the fields being appraised and developed in the vicinity. The PLN stations will remain PERTAMINA's customers and PGN will be paid an adequate charge (being negotiated) for transporting gas to these stations. 3.5 The sale forecasts are considered reasonable given the stable base of industrial activity in and around the cities of Medan and

26 -19- Surabaya, and the target levels of gas connections under the project are deemed achieveable particularly in the light of recent PGN experience in penetrating the liquid fuels market. Gas Supply 3.6 PGN's Surabaya gas transmission and distribution system can be provided up to 90 MMCFD natural gas from ARCO's Kangean offshore field (located about 250 miles east of Surabaya) througn an offshore pipeline to be laid by ARCO from Kangean to a landing point at Porong. This pipeline is being planned to provide 220 MMCFD gas supply for PLN's power station at Gresik and 60 MMCFD gas supply for Petrokimia, also at Gresik, in addition to the aforementioned quantity for PGN. The supply for PGN will be at a pressure of 17 to 20 bars. The pipeline is required to be built and commissioned within thirty months of the signing of the gas supply contract between PLN and PERTAMINA. (The gas supply agreement between PLN and PERTAMINA was signed in March 1990.) This gas supply would meet the level of consumer demand (para 3.2) that is expected to be attained by Increments in demand above that level can be met from the development of other offshore fields, particularly Mobil's recent discovery of non-associated gas about 80 Km offshure Leces. 3.7 The gas delivery from PERTAMINA's onshore fields to PGN's existing supply system for Medan is being raised from 30 MMCFD to 40 MMCFD at Pangkalan Brandan to provide additional gas to PLN's power station at Paya Pasir near Belawan. An additional 20 MMCFD gas from PERTAMINA'S onshore fie'.a, near Wampu, is now planned to be delivered at Payapasir through a 24 Km long transmission pipeline to be built under this project. As this supply would only partially meet PLN's demand of 270 MMCFD, further development of fields in the vicinity is being undertaken by PERTAMINA to enhance the supply. 3.8 The conditions of gas supply for the Surabaya and Medan areas involving quantity, price, and the carrying charge for PGN's transportation of the desired quantities to PLN's power stations at Medan are being negotiated. The execution of supply contracts, satisfactory to the Bank, bett.fen PGN and PERTAMINA for gas supplies to the Surabaya and Medan systems covering the project requirements, will be a condition of loan effectiveness. Additionally, PGN will have to continue to prepare (as under the ongoing project agreement) a rolling five-year plan covering its future gas requirements to be updated each year and discussed with GOI and PERTAMINA to form the basis for further network expansion. Project Objectives and Rationale 3.9 The primary objective of the project is to support GOI's program of diversifying domestic energy consumption away from heavy reliance on petroleum products by substituting petroleum product fuels in power generation, industrial and commercial sectors with natural gas. This objective will be pursued through: (a) the provision of an assured supply of natural gas, at competitive prices, to power plants, manufacturing

27 -20- industries, and commercial entities in Surabaya and twelve other towns in its vicinity in East Java and in Medan in North Sumatra; (b) the integration of gas utilization plans and operations to achieve economies of scale in the development and operation of gas supply infrastructure; (c) istitution building, technology transfer and, marketing studies to accelerate safe and efficient utilization of natural gas and to help define its long-term development plans The use of natural gas by small and medium-sized industries in Surabaya and Miedan is expected to yield an average economic netback value to Indonesia of US$4.1 per MMBTU and US$4.3 per MMBTU, respectively, compared to an estimated cost of gas supply of UJS$1.50 per MMBTU. For power generation, the netback value for gas is estimated to exceed US$3 per MMBTU relative to a plant using industrial diesel oil (IDO). Gas sales to industries will be largely market-driven as gas prices will have to compete with the domestic price of liquid fuels creating a strong incentive for the gas sector constantly to strive for efficiency in its plans and operations Identificatior and selection of Surabaya and Medan as project service areas is based on the availability and accessibility of abundant proven gas reserves and the existence of a market ready to shift from use of liquid fuels to natural gas. By integrating the gas utilization plans of the power sector with that of industrial and commercial users in the design of common delivery systems, the project would be able to achieve economies of scale in the establishment of the gas transmission and distributio networks. Moreover, the economic base in the these cities is deemed adequate to sustain a growing demand for energy creating favorable long-term prospects for a stable and expanding market for gas. Accordingly, by focussing on these service areas, it is anticipated that faster gains in GOI's program for increasing the share of natural gas in domestic energy consumption will be achieved The expansion of natural gas utilization, being linked with the demand and resource development, would involve lumpy infrastructure investments in the form of discret; but interlinked projects spread over several years. Efficient planning and phasing of these investments, implementation of projects and the management of follow-up operations would therefore require building of Indonesian institutions for long-term planning, growth management and safe utilization. The proposed project aims to bring about the development of these capabilities through the institution building and interaction of PGN, LEMIGAS and MIGAS Specifically the project aims to: (a) promote the use of natural gas as fuel for power generation, manufacturing industries and commercial entities by

28 -21- constructing new gas transmission and distribution facilitiesfor Medan and Surabaya; (b) develop Indonesian expertise in long-term planning of gas utilization, including the planning of integrated supply systems common to all categories of consumn :s, through the skills upgrading of MIGAS and PGN and through the establishment of a Gas Technology Development Unit in LEMIGAS; (cj build PGN's expertise in the optimization of expanding gas supply systems and the management of expanding gas utility operations; (d) develop cost effective standards and codes of practices appropriate to the Indonesian environment for safe, - efficient transportation and utilization of natural gas through research at the proposed Gas Technology Development Unit; and (e) promote the establishment of a regulatory system for safe utilization of natural gas under the control of MIGAS with the technical support of the Gas Technology Development Unit and active participation of PERTAMINA, PGN and the manufacturers of transportation and end-use equipment Other objectives of the project are to: (a) enhance the safety and efficiency of PGN's operations in Surabaya through the rehabilita&ion and replacement of its out-dated pipeline networks; and (b) reduce environmental pollution by using gas which is a cleaner fuel than the other fossil fuels it would replace. Project Description 3.15 The project consists of four main components: A. Provision of Natural Gas Supply System in Surabaya and its surrounding areas, involving: (i) the laying of about 80 km of high pressure transmission pipelines, 190 km of medium pressure steel pipelines and 165 km of medium pressure polyethylene pipelines; (ii) the construction of 5 gas metering, pressure regulating and odorization stations with associated instrumentation and 4 pressure reducing stations on the pipeline networks; and (iii) the construction of service lines, pressure regulation and flow metering stations for 375 medium size industries and 150 commercial enterprises and the paper mill in Leces.

29 -22- B. Expansion of Natural Gas Supply System for Medan involving: (i) the construction of about 24 km of high pressure transmission pipeline with associated cathodic protection, pressure/flow monitoring facilities and three pressure reducing stations; and (ii) construction of service lines and pressure regulating and flow metering stations for two PLN power stations at Belawan. FT C. Technical Assistance involving: (i) enhancement of PGN's skills and efficient implementation of its expansion project; (ii) establishment of a Gas Technology Development Unit in LEI4IGAS; and (iii) upgrading of skills in MIGAS to facilitate the coordination of development plans in gas sector and to institute a regulatory system for safe utilization of natural gas. D. Studies: Feasibility studies for natural gas marketing in Palembang (South Sumatra), Jambi (Central Sumatra), Batam Island (Riau), and Balikpapan (Kalimantan). Gas Supply Systems 3.16 The project provides for the detailed design, construction, testing and commissioning of gas supply systems involving high pressure and medium pressure natural gas transmission and distribution networks, pressure regulating stations, service lines and customer meter stations for the supply of natural gas for power generation, manufacturing industries and commercial entities in Surabaya and its environs and additional supply for similar consumers in Medan on the basis of the conceptual design prepared by PGN with the assistance of its consultants (British Gas) The Surabaya supply system, comprising the gas transmission as well as the distribution networks, will cover Surabaya city and twelve other towns in East Java within a 100 Km distance from Surabaya. It will supply natural gas to about 375 medium-size industries, 150 large commercial enterprises and the paper mill at Leces. The existing low pressure manufactured gas distribution system supplying 3600 households in a limited area in downtown Surabaya will be rehabilitated and integrated with the planned system after conversion to natural gas PERTAMINA has indicated an input pressure of 17 to 20 bars for the Surabaya system at the receiving stations. The max-day demands of the consumers in the medium and long term (i.e. by FY99 and FY2006) are estimated at about 90 MMCF and 120 MMCF respectively. Since Mobil

30 -23- recently discovered non-associated natural gas 80 Km offshore Probolinggo (near Leces), which is being evaluated, there is a possibility of additional gas supply at an input precsure of 40 bars. The additional cost of increasing the system capacity by about 30Z (from 110 MMCFD to 140 MMCFD) and the operating pressure capability by 130Z (from 17 bars to 40 bars) is approximately US$5 million i.e., 1OZ of the basic cost. The transmission pipelines of this system have therefore been designed to deliver 140 MMCFD with an input pressure of 17 bars along with provicion for raising the operating pressure to 40 bars. The design of distribution pipelines is based on the supply mains operating at 10 bars (the maximum safe pressure under the prevailing procedures) and the reticulation networks at a uniform pressure of 4 bars, resulting in a simpler design, reduction in pipe size and substantial (about 20Z) reduction in cost as compared with the alternative multi-stage pressure system. This approach has alreadv been tried with good results in the distribution system designs under the on-going Gas Distribution Project (Ln 2690-IND) The expansion of the Medan supply system involving a high pressure transmission pipeline from Wampu to Payapasir will enable supply of additional quantities of natural gas to the two PLN power stations at Paya Pasir and Belawan. The existing gas supply system for Medan comprises a transmission pipeline from Pangkalan Brandan to Medan via Wampu and a compressor station at Pangkalan Brandan for boosting the pipeline input pressure from 17 bars to 40 bars. The total max-day demand of the consumers in Medan is estimated at 150 MMCF in FY93, growing to about 300 MMCF by FY2000. About 60 MMCF of this demand will be met after the proposed expansion of existing supply systerm and the balance of 240 MMCF through further expansion of this system as additional gas becomes available upon development of other fields in the area. Technical Assistance 3.20 To fulfill the institution 1 -uilding aims as discussed in para 3.12, the project will provide multi-disciplinary technical assistance involving three organizations, namely PGN, LEMIGAS and MIGAS PGN will execute an agreement for its twinning arrangement (TOR in Annex 4.01) for the duration of the project, with British Gas or with another gas utilicy acceptable to the Bank to ensure successful implementation of this project concurrently with the on-going project. This arrangen&qnt will provide assistance in: - detailed design and cost estimates, preparation of tender documents and evaluation of bids for goods and services, preparation and monitoring of the project implementation schedule, construction management, market development, and customer conversion; - planning and operation of integrated gas supply systems with automated supervisory control and data acquisition; - corporate planning and management of an expanding gas utility business;

31 long-term development planning, involving demand forecasting, gas supply systems optimization, investment appraisal and risk analysis; and - preparation of a training program as discussed in para Bilateral financing for this purpose is being discussed between GOI and the Government of the United Kingdom. The extension of PGN's twinning arrangement with British Gas (or execution of a similar agreement with another established gas utility), on terms of reference satisfactory to the Bank, will be a condition for loan effectiveness A Gas Technology Development Unit will be established in LEMIGAS for the development of in-house expertise in (a) research on ar.d development of efficient and safe standards and codes of practices, appropriate to Indonesia, for all the activities in the transportation of natural gas and its usage; (b) studies and research in gas utilization, interfuel substitution and energy conservation; (c) human resource development; and (d) dissemination of reliable technical information to promote safe and efficient use of gas and to encourage private sector industry to support it. The technical assistance for its establishment and initial operation will be obtained through a long-term (3 to 4 years) collaboration with a prominent gas technology institute in inorth America, Western Europe or Japan. The execution of an agreement, satisfactory to the Bank, for such a collaboration, will be a condition for the disbursemf!nt of the funds allocated under the Bank loan MIGAS will strengthen its expertise in (i) the coordination and evaluation of development plans in the sector; and (ii) the institution of a regulatory system (outlined in Annex 4.03) to ensure continued safe utilization of natural gas. For this purpose, four engineers and two financial analysts from MIGAS will be provided broad-based training at overseas institutes in gas production, transportation and utilization; and three staff members will be sent to North America and Western Europe for six to eight weeks to study the regulatory procedures of prominent gas consuming countries. The training program will be prepared by MIGAS with the assistance of the consultants to be engaged for setting-up the Gas Technology Development Unit. Studies 3.25 Under the project, MIGAS, with the assistance of PGN and its twinning partner, will conduct studies into the feasibility of distributing and marketing natural gas in Palembang (South Sumatra), Jambi (Central Sumatra), Batam island (Riau) and Balikpapan (East Kalimantan). These areas are developing commercially and are located close to known reserves of natural gas, with the exception of Batam island which lies on the route of the pipeline proposed for the transportation of Natuna gas to Singapore. Project Costs 3.26 The total project cost, based on the scope and design in paras 3.15 through 3.25, is estimated at US$108.3 million, of which US$91.1 million is expected to be in foreign exchange as shown below (details of project costs estimates are given in Annex 5.02).

32 -25- Table 3 Local FE Total Local FE Total A. Expansion of Natural Gas ---US$ million Rps billion--- Transmission & Distribution Systems for Surabaya & its environs Pipelines Regulator Stations Meter Stations & Service Lines Total Medan Pipelines Meter Stations & Service Lines Total Base Cost (A) B. Technical Assistance PGN Twinning Arrangement Staff Training Equip. (computers & software) Total LEMIGAS (Gas Tech. Devl. Unit) Consulcancies Staff Training Equipment Total MIGAS Staff Training Base Cost (B) C. Studies Marketing Feasibility Studies for Palembang Jambi, Base Cost (C) Total Base Cost (A+B+C) Physical Contingencies Price Contingencies Total Project Cost 17.2a/ a/ Capitalized interest During during Construction Total Funding Required a/ Includes US$11.0 million equivalent as duties anfd taxes.

33 The cost estimates are based on September 89 price levels. As the project has been designed in sufficient detail, the physical contingencies for FE cost have been estimated at 5Z of the base cost, however to provide for any unforeseen problems in civil works, the physical contingencies for local cost have been estimated at 10% of the base cost. Price contingencies for foreign costs have been estimated at 5.4% per annum for 1990 and 4.3% for 1991 and thereafter and for local costs at 72 for 1990 and 6% for 1991 and thereafter. Financing Plan The project funds required, totalling $118.8 million equivalent, are expected to be financed as follows: Table 4 Source Local Foreign Total US$ million Proposed Bank Loan Bilateral Funds PGN Internal Cash GOI Total The Bank loan will cover all foreign exchange costs of the project, ixcept for interest during construction (IDC) and the cost of PGN's twinning with an experienced gas utility. The Bank loan represents 87% of the foreign exchange cost, 73X of total project funding required or 80% of the total project funding, exclusive of duties and taxes. Remaining project expenditures will be funded by bilateral assistance (4%), PGN's internal cash generation (8Z), and GOI (15Z). During negotiations, agreement was obtained from GOI that it will ensure that MIGAS/LEMIGAS and PGN are provided with the necessary funds to carry out the project Of the proposed Bank loan $10.0 million will be made available by GOI to MIGAS/LEMIGAS for the Gas Technology Development Unit, training and marketing studies; the remaining $76.0 million will be onlent by GOI to PGN under a Subsidiary Loan Agreement satisfactory to the Bank. The on-lending rate will be 13% p.a., with GOI carrying the foreign exchange risk in line with GOI policies towards public corporations, and PGN will repay the loan to GOI over fifteen years including five years of grace. GOI is also expected to fund capitalized interest during the grace period, as it has done under the ongoing gas project. During negotiations, assurances were obtained from GOI that $10.0 million of the proposed Bank loan will be made available to MIGAS/LEMIGAS and that the Bank would be furnished with the audited project accounts for the Gas Technology Development Unit and the marketing studies within nine months of the end of each fiscal year. The signing of a Subsidiary Loan Agreement between GOI and PGN, satisfactory to the Bank, will be a condition of Loan effectiveness.

34 -27- Implementation 3.30 PGN will have the overall responsibility for the implementation of the Surabaya and Medan components of the project. It will be assisted by the consultants (under the twinning arrangement) in the detailed engineering, procurement, and construction management of the supply systems as well as in the marketing of gas, customer connect'on and follow on operations along the same lines as for the on-going project. The project planning is already in progress, market and route surveys and basic designs have been completed. GOI will enable PGN to secure the necessary rights of way/way leave for the pipelines to be built under the project, in a timely fashion, at least six months prior to the estimated start of the related construction All construction works will be carried out by contractors. As the construction of transmission pipelines for Surabaya and Medan is on the critical path in the implementation schedule, these works will be contracted on a turn-key basis, through internationsl competitive bidding (ICB), following the Bank guidelines, to facilitate early completion. The construction of distribution pipelin' s, sc4ttered geographically and spread over tinie, will be carried out by local contractors (as in the on-going Gas Distribution Project) who possess the necessary skill, equipment and resources to undertake the expanded workload under the project. To provide an independent check, an outside agency will be engaged for inspection of quality and tests The transmission pipelines to Medan and Surabaya areas are scheduled to be commissioned by July 1992 and February 1993 respectively. The gas supplies to major consumers, the PLN stations near Medan and the paper mill at Leces are expected to commence soon thereafter. The construction of distribution pipeline networks in Surabaya and its environs will continue till March The implementation schedule is given in Annex The pipeline construction and customer connection is expected to proceed as follows: Table 5 Customers to be Connected in Pipelines for Surabaya Medan Fiscal Year Surabaya Medan Industrial Commercial Industrial Commercial - (Km) No _ 3.33 LEMIGAS will be responsible for the establishment of the Gas Technology Development Unit with the technical assistance as discussed in para Its implementation schedule will be determined by the on-going planning study (para 1.18). The preparation of its implementation schedule, satisfactory to the Bank, will be a condition for the disbursement of funds allocated under the project.

35 -28- Procurement 3.34 All major items of material, equipment and related services and construction contracts financed from the proceeds of the loan would be procured through international competitive bidding (ICB) in accordance with the Bank guidelines except for items of small value to be used for the distribution component (not exceeding US$50,000 each and US$3 million in total for PGN and US$500,000 in total for LEMIGAS) which are available off-the-shelf, such as electrical switch-gear, flex, low pressure pipes and valves, etc. Such small value items will be procured through prudent shopping after receiving price quotations from at least three eligible suppliers in accordance with procedures acceptable to the Bank. For the purposes of evaluation and comparison of bids for the supply of goods under ICB, qualified domestic suppliers will be allowed a preference of 15% of the CIF price or the applicable import duty, whichever is lower. In the evaluation of bids for construction contracts, local eligible contractors will be given a preference of 7.5Z. Bidding packages over US$300,000 will be subject to the Bank's prior review of procurement documentatior. Thus the documents for the procurement covering over 952 of the lan amount will be subject to the Bank's prior review. This is not expected to pose any major problems as the procurement documents have already been standardized under the current Gas Distribution Project and will be reviewed again a- the outset of the proposed project to ensure efficient processing The procurement arrangements are summarized in the following table. The figures in the parentheses are the respective amounts to be financed from the proceeds of the Bank loan. Table 6 Project Component ICB LCB Others N.A. a/ Total US$ million Gas Supply System Line Pipes b/ (Steel pipe,pe Pipe,valves & fittings) (41.5) (0.5) (-) (42.0) Other Materials b/ (Compressors, regulators, (6.8) (1.8) (-) (8.6) meters, SCADA, etc) Construction (22.9) (-) (22.9) 2. Technical Assistance Equipment for: PGN (computer software) (0.6) (-) (0.6) LEMIGAS (Gas Technology Develop. Unit) (5.0) (-) (5.0) Consulting Services for: PGN 5.0 c/ 5.0 (-) LEMIGAS 2.0 d/ 2.0 (2.0) (2.0)

36 -29- Staff Training for: PGN (2.5) (2.5) LEMIGAS (1.5) (1.5) MIGAS (0.5) (0.5) 3. Studies 0.4 dl 0.4 (0.4) (0.4) Total ) () (9.2) (-) (86.0) a/ Customs duties and taxes. b/ Prudent shopping. cl Financed by bilateral aid funds (para 3.22). d/ Following Bank guidelines for the use of consultants. Disbursement 3.36 The Bank loan will be disbursed against: (a) 100% of the foreign exchange cost of imported equipment, materials and related services; (b) 100X of the cost of local equipment and materials (ex-factory); (c) 65% of the cost of other items procured locally (off-the shelf); (d) 1002 of foreign expenditures for training; and (e) 1002 of expenditures for consultants services The implementation period for the project is estimated at six years and the disbursement schedule (Annex 5.03) is largely in line with the Bank's standard disbursement profile. Projected disbursements are based on loan effectiveness and the signing of major pipeline contracts in FYs92 and 93. Therefore, substantial disbursements are expected for the early years of the project To facilitate disbursement, a Special Account will be opened with an authorized allocation of US$5.0 million equivalent, the estimated average loan disbursement for a four-month period. The account will be opened in US dollars in a bank acceptable to the Bank and will have subaccounts for PGN, MIGAS and LEMIGAS respectively. Applications for replenishment of the Special account will be submitted quarterly or whenever the Special Account is drawn down to 502 of its initial deposit, whichever comes first. Disbursements will be made against priced corntracts for the goods, services and works procured under the Bank loan, and SOEs --if any. Interim certification of works completed and costed at unit rates in the contracts will be done by PGN/MIGAS/LEMIGAS. DisburseLuents for training overseas will be made against the actual costs of travel, subsistence and tuition or training fees. Disbursements against statements of expenditure will be made for the training component and for goods or services costing less than US$300,000. Documents supporting the expenditure statements will be retained by PGN/MIGAS/LEMIGAS and the DG budget office, as appropriate, and made available for review by Bank supervision missions. During negotiations, instructions for the operations of the Special Account were provided to PGNIMIGAS/LEMIGAS.

37 -30- Environment 3.39 As the project was appraised (in May 1989) before the environmental evaluation directive (No A) was issued, it was not subjective to environmental analysis. Its implementation will however not pose any significant hazard to the environment. Design configuration and pipeline system layout has been established taking into account safety norms and standard design codes. Substantial segments of the pipeline network will be buried using existing easement strips where there are minimum obstacles to the laying of pipes. In heavily congested areas, pipeline routing has been carefully planned to ensure that service lines will be situated at safe distances from human traffic. For waterlogged areas or where soil conditions are heavily corrosive, upgraded materials and construction design have been provided and are reflected in the higher cost of pipelines for these segments. Aside from the limits posed by operating pressure and mechanical loads on the pipes, selection of pipelines materials are also based on proximity of property and risk of interference damage. U 3.40 The project will also alleviate urban pollution particularly within the industrial zones with the replacement of liquid hydrocarbon fuels by natural gas. The combustion products of gas are less polluting than those for petroleum products. M-reover, replacement of old and inefficient gas pipelines would reduce the hazards earlier posed by gas leakage in the old system. Reporting Requirements 3.41 During negotiations, assurances were obtained that PGN will collect relevant data through the monthly operating reports, combine it with project data and use it for compiling quarterly progress reports on the project. The progress reports should be made available to the Bank within 45 days of the end of the reporting period. An outline of the quarterly progress report is given in Annex The progress reporting requirement for the Gas Technology Development Unit will be prepared by LFMIGAS after the completion of the planning study and will require the Bank's approval prior to the commencement of disbursement of funds allocated under the Bank loan for the Gas Technology Development Unit. PGN's Margin on Gas Sales IV. FINANCIAL ASPECTS 4.1 In recent years, PGN gas sales price varied from about Rp 4,900 to Rp 5,300/MMBTU depending on the volume the consumer contracts for. A comparison between this gas price and the current domestic prices of liquid fuels competing with gas is given below: ; r

38 -31- Table 7 Current Domestic Price (Rp/liter) Rp/MMBTU Fuel Oil 200 5,200 Diesel (ADO) 200 5,600 Kerosene 165 4,700 LPG (per Kg) ,300 Natural gab - 4,900-5, The average natural gas price of about Rp 5,000 thus represented a discount of 4% to 11 from fuel oil and diesel, the principal fuels competing with it. According to PGN's experience under the ongoing gas distribution project, this discount was needed to provide a sufficient financial incentive for potential customers to convert from liquid fuels to natural gas. Once the customers have made the necessary investment in conversion equipment, installed gas burning boilers etc., they experience firsthand the advantages of natural gas over liquid fuels: lower transportation and storage cost, improved security of supply, improved combustion efficiency, lower maintenance costs and increased cleanliness. In the long run, this permits PGN slowly to increase its gas prices for already connected users up to, or even slightly exceeding, the prices of fuel oil and diesel without losing customers. 4.3 Before FY87, when the Rupiah (Rp) was devalued by 452 against slhe US dollar, the gas price in PGN's supply contract with PERTAMINA was US$2.70JMMBTU (Rp 3,000/MMBTU). A new price of Rp 3,500 was subsequently agreed between PERTAMINA and PGN. At the same time, due to weakening wo-ld market prices, the domestic prices for industrial diesel and fuel oil were reduced by 9% compared with FY86 ievels, 3 / thus reducing the price PGN could charge potential industrial and commercial customers and still induce them to shift from competing fuels to gas. These price movements effectively reduced PGN's margins on gas sales by about 252, and in FY89 PGN operations therefore yielded only a 1.42 return on revalued net fixed assets in operation against the 10% return covenanted under the ongoing Gas Distribution Project (which improved to 2.6% in FY90). Without this unexpected reduction in PGN's gas sales margin, the rate of return covenant would have been met. The economic argument for increased domestic use of gas is unassailable and the support for expanded PGN gas distribution is in line with the Bank's sector strategy. T'o provide PGN with the necessary flexibility to expand gas sales rapidly in a competitive market, the Bank therefore agreed to PGN's request to postpone until FY95 the application of the 102 rate of return covenant under the ongoing project (Ln IND). A monitorable program to ensure continued improvement of PGN's efficiency (e.g., closure of obsolete gas manufacturing plants, reduction of gas losses and higher increases in sales than in operating costs) and financial performance (e.g. interim rate of return targets) was reviewed and agreed during the negotiations (para 4.18 and Annex 6.05). 3/ With oil at about US$18/bbl the domestic price of fuel oil is now about 1OZ, above its international parity price and the domestic price of industrial diesel about 30% below.

39 -32- PGN's Past Financial Performance 4.4 At appraisal of the ongoing Gas Distribution Project in FY86, PGN was an inefficient, small scale distributor of natural and manufactured gas; its iivestments were financed by Government and it operated at a loss. Under the Gas Distribution project, PGN's rate of return on revalued net fixed assets increased from a negative 3.72 in FY86 to a positive 2.62 in FY90. PGN was able to achieve this result mainly by improving its efficiency: the volume of gas sold increased by over 200Z between FY86 and FY90 and gas losses were reduced from 30Z to 6Z dur:.ng the same period. With the assistance of the twinning agency (British Gas) provided under the ongoing project, PGN successfully implemented a flexible gas marketing strategy that pernitted PGN to expand sales quickly at competitive prices, and procedures for maintenance and planning were improved. These efficiency improvements were necessary to protect PGN's financial viability after the FY87 reduction in PGN's margin on gas sales. 4.5 PGN's income statements for FYs86-89 (Annex 6.02) are summarized below: Table 8 FY ending March 31: / a/ 1990 b/ Rp billion Gas Sales Cost of Gas Sold Other Expenses (net) Operating Income Non-operating Tilcome 7.9 (0.7) Profit after Tax 5.6 (0.1) Ratios (Z): Operating Income/Sales ROR on Net Fixed Assets in Operation: Valued at Cost (8.6) On Revalued Basis (3.7) a/ Unaudited b/ Provisional 4.6 Over the last five years, PGN's gas sales have increased by over 302 p.a. while the percentage of gas lost has been reduced from dbout 30? to about 6Z. However, higher cost of gas and operating expenses, especially wages, consumed PGN's revenue increases causing operations barely to break even up to FY88. The impact of efficiency improving measures, initiated under the ongoing project (pars 4.4), was reflected only in FY89 and FY90, when PGN's operating income increased from zero to Rp 3.4 billion ($1.9 million) and PGN's rate of return on revalued net fixed assets in operation from zero to about 2.6? despite unusually large salary increases in FY90.

40 In the past, PGN's investments were funded by th: Government Development Fund (DIP) and PGN was able to accumulate some surplus funds from its own cash generation; those funds were i 4 ivested in time deposits providing a substantial non-operating income that was not taxed. As from FY92, GOI will not provide PGN with new DIP funds and PCN will therefore have to rely on its own cash generation and other external sources. 4.8 As from FY86, PGN pays 35Z in tax on its net income (excluding interest on time deposits) and, as from FY87, PGN is not allowed to carry forward any tax losses to subsequent years. PGN also pays 55Z of after tax income to GOI as a contributioni (DPS) instead of dividends. This leaves PGN with less than 301 of income before tax to be retained within the company. Present Financial Position 4.9 PGN's unaudited balance sheet as of March 31, 1990 (Annex 6.03) is summarized as follows: Table 9 Rp. Billion z Net Fixed Assets in Operation Work in Progress Total Net Fixed Assets Current Assets Less: Current Liab. (11.3) (9) Other Assets, net a/ Total Assets Financed by: Equity Social Fund Long-term Debt Total Liabilities Current Ratio (times) 1.8 Debt/Equity Ratio 33/67 a/ including time deposits 4.10 PGN's past investments have been financed largely by Government equity contributions from DIP funds and PGN has therefore, despite poor financial results from its operations, a strong financial position with a current ratio of 1.8, a debt equity ratio of 33/67 and over Rp 10.0 billion in time deposits. Nearly all long-term debt is to the Bank for the ongoing project.

41 PGN's plant and equipment were revalued in FY80 as required of all public corporations by the Ministry of Finance. The revaluation was recorded in PGN's books and the method was accepted by the Bank. In FY86, a revaluation of land owned by PGN as of FY85 was also recorded in PGN's books, resulting in a Rp 18.3 billion increase, or about a doubling of the value of PGN's net fixed assets. PGN's old gas distributio networks, which are obsolete and nearly fully depreciated, are being replaced under the ongoing and proposed projects. The average age of PGN1's fixed assets is therefore re'latively low; in FY89 about 50X had been in operation for less than five years and in FY97 this percentage will be about 75Z. In FY89, the currency fluctuations and price increases since the FY80 and FY86 revaluations were estimated to have increased the replacement cost of PGN4's assets by 55Z and this percentage was used to revalue PGN's FY89 fixed assets for ROR calculations as agreed under the ongoing project. The Indonesian accounting practices do not provide for regular revaluation of fixed assets and the revaluation exercise was therefore done on a memorandum basis outside PGN's books; these arrangements are satisfactory PGN's FY90 fixed assets in operation may be overstated due to transfer of capital works to assets in operation before they were actually put into operation and capitalization of interest that should have been charged against income. The distortion of PGN's asset values is not material, steps are however being taken for future correction (para 2.2) Under the ongoing project, it was agreed that the value of land (for gas manufacturing properties that will not be needed for PGN's gas operations when manufactured gas has been replaced by natural gas or LPG) would not be included in the rate base for ROR calculations. This agreement will continue under the proposed project. For fixed assets other than such land, assurances were obtained from PGN during loan negotiations that PGN will revalue its fixed asse.s in operations annually according to methods acceptable to the Bank and that this revaluation will be submitted to the Bank, together with PGN's unaudited financial statements (para 2.20), within six months of the end of each financial year. Financial Projections for PGN 4.14 PGN's budget for FY91 is based on a margin on gas sales of about Rp 2,000/MMBTU between PGN's gas cost of Rp 3,500/MMBTU and an average sales price of Rp 5,500/MMBTU would be sufficierlto produce adequate returns for an efficiently operated gas company of reasonable size. Under the proposed Gas Utilization Project, PGN would achieve both the necessary economies of scale and efficiency: the volume of gas sold would increase three times from FY91 to FY96. Gas losses would be reduced from 6Z to 2X; and obsolete gas manufacturing plants closed and replaced by either natural gas or LPG distribution. A program to achieve these objectives was agreed during negotiations and will be closely monitored under the proposed project (Annex 6.05). The income projections for PGN (Annex 6.02) indicate that a 1O return will be achieved in FY95, reaching 17? in FY97, when all facilities under the proposed project would be fully utilized. PGN would provide all local project costs (except for GOI funded capitalized interest) out of its internally generated funds, after payment of all operating costs, debt service, income tax, DPS contributions to Government

42 -35- and pensions; this would be satisfactory considering the rrpid pace of expansion PGN's projected financial statements for FYs9l-97 with notes and assumptions are given in Annexes 6.01 through Some highlights are presented below: Table 10 FY ending March 31: Gas Sales: (Million M3) (Rp Billion) Operating Income/Sales (%) Net Profit/Sales (X) Rate of Return a/ on: Book Value Bisis (%) Revalued Basis (%) Current Ratio (times) Debt/Equity Ratio 42/68 68/42 66/35 86/36 65/35 64/36 59/41 Debt/Service Ratio(times)b/ n.a / After income tax (35%) but before interest and DPS contributions, which have been treated as appropriation of after tax profits as indicated by the Ministry of Finance. b/ Defined as: internal cash generation divided by debt service (including Interest charged to income). FY91 ratio is abnormally high as most interest will be capitalized and amortization of Ln 2690-IND and an EXIM Bank (Japan) loan start only in FY These projections are based on a gas margin of about Rp 2,000 and gas sales projections according to PGN's plans, which have been worked out with the assistance of the twinning agency (British Gas). As under the ongoing project, PGN is expected to manage a quadrupling of its gas sales with an increase of only about 20% in its staff; the new transportation and distributio network will require less maintenance than the old ones, gas manufacturing plants will be closed, gas losses reduced from the current 62 to 22, staff will be trained, and offices will be equipped with modern technology, all to further improve PGN's efficiency. This efficiency improvement program is ambitious, but should be ach.evable judging from PGN's performance since FY86 under the ongoing project. During negotiations, the implementation of an efficiency improvement program for PGN (Annex 6.05) was discussed and agreed, including monitorable targets for: closure of gas manufacturing plants; natural gas sales; gas losses; number of staff; and, training PGN's debt/equity ratio will increase during the project period to a maximum of 65/35 in FYs93 to 95 due to the new loans required to implement the proposed project; as from FY97, this ratio will decline rapidly. A 65/35 debt/equity ratio is acceptable, as gas distribution is a relatively stable and predictable business. In FYs9O and 91, PGN will receive part of an EXIM

43 -36- Bank (Japan) loan as government equity. However, GOI will not provide PGN with new DIP funds for the project; and therefore PGN will have to fund local project costs from internal cash generation as from FY Under the ongoing project, a lox ROR on net fixed assets in operation was agreed for PGN as from FY89. Due to the FY87 squeeze on its gas sales margins (para 4.3), PGN was unable to achieve this rate of return despite a satisfactory performance in gas sales and efficiency improvements. PGN would first have to implement the efficiency improvement program (para 4.16) before a ROR of 1OZ can be achieved. In FY95, at the end of the proposed project when most new gas users have been connected and produce revenues, financial projections indicate that PGN will produce a ROR over 102, reaching 17Z in FY97. During negotiations, interim ROR targets were agreed and assurances were obtained that PGN will take all necessary measures, including the implementation of an efficiency improvement program, to produce a rate of return on revalued net fixed assets in operation of not less than 42 in FY91, 52 in FYs92-93, 8Z in FY94 and 10Z thereafter. If GOI increases the retail prices of fuels competing with gas, thus permitting PGN to increase its margins on gas sales, the date for application of the 1O0 rate of return covenant will be advanced PGN's funds flow statements for FYs86-97 are given in Annex The cumulative funds flows for the FYs92-96 project period are summarized below: Table 11 FY ending March 31: (Rp billion) (US$ million) (2) Internal Cash Generation Less: Debt Service Tax & DPS Payments Increased Working Cap. a/ Change in Other Assets, Net Funds Used for Capital Works Proposed Bank Loan b/ IBRD Loan 2690-IND Other Loans c/ Total sources Proposed Project d/ Other Capital Works Total Requirements Debt Service Ratio (Times) a/ Mainly accounts receivable and inventories; excludes current maturities, which are included under long-term debt. b/ Excluding $10.0 million in FE for the gas technology center and studies for LEMIGAS/MIGAS. c/ Includes capitalized interest during construction, which will be financed by GOI under the GOI/PGN on-lending agreements, $5.0 million for continued twinning to be financed by bilateral assistance, and GOI funding of ongoing works. d/ Project cost includes capitalized interest during construction, but excludes the LEMIGAS/MIGAS component ($10.5 million), expenditures incurred before FY92 and twinning ($5.0 million) and training ($1.5 million), which are expected to be charged against current income.

44 In the past, GOI has provided PGN with equity contributions of DIP funds for its investment program. As from FY92, however, GOI will not provide new DIP funds to PGN and the financing plan for the proposed project has been made on this basis. Out of total capital investments, including capitalized interest during construction during FYs92-96, PGN is expected to contribute US$11.1 million (or 92) from internally generated funds (this would cover all local project costs except for GOI funded capitalized interest), the proposed Bank loan US$76.0 million (or 592), Loan 2690-IND US$5.0 million (or 42), bilateral assistance US$5.0 million (or 42), and GOI the remainder (242, mainly for capitalized interest and ongoing works). During negotiations, assurances were obtained from PGN that by January 1 of each calendar year, it will prepare an annual investment program and submit it to the Bank for comment In addition to the capital expenditures for the proposed and ongoing projects, PGN will in FYs91-96 repay an EXIM Bank loan of about US$13.5 million equivalent, amortize the Bank Loan 2690-IND with about US$4.5 million p.a. as from FY92 and pay taxes and DPS dividends to GOI totalling about US$54.7 million equivalent. Even so, PGN is expected to generate $22.5 million equivalent in excess of project needs; those funds will be invested to cover eventual social fund obligations. Now that PGN's operations are financially viable and earlier qualifications have been removed from its audit reports and its FY89 report is expected to be without qualifications, PGN has the option to issue obligations in its own name or make other commercial funding arrangements. As from FY96, when the project will be completed, PGN's financial performance and cash generation will improve substantially and PGN would be able to repay project financing at an accelerated rate. During negotiations, assurances were obtained from GOI that it will ensure that PGN will be provided with sufficient funds to carry out the project. Risks in Financial Proiections 4.22 As in 1986, there is a possibility that PGN's margin on gas sales could be squeezed again by adverse movements in the cost of gas and the domestic prices of competing liquid fuels. However, this risk is considered minor, as GOI is considering an increase in domestic liquid fuel prices and the conservative assumption (based on the Bank's commodity forecast for crude oil) that prices of petroleum products will largely remain at today's levels in real terms until the end of the century has been used for projection purposes. Project implementation may be delayed, which would lead to slower than projected growth of PGN's gas sales. This risk will be minimized by extensive use of turn-key contracting. The risk of delayed gas supplies will be minimized by requiring the signing of supply contracts as a condition for loan effectiveness. Finally, efficiency improvements, e.g., further reduction of gas losses and closure of old gas manufacturing plants, may take longer than planned. However, projections are based on what PGN has been able to achieve under the ongoing project and the twinning agency (British Gas or another experienced gas utility) will remain with PGN under the proposed project to assist as necessary. If, for unforeseen reasons, PGN's sales margins were further reduced by about 20Z and project implementation were delayed up to two years, PGN would still be able to raise its rate of return to 102 by FY97.

45 -38- Project's Financial Rate of Return 4.23 The calculations of incremental financial rate of return (IRR) and projected income statements for the main project areas (Surabaya and Medan) are given in Annex Assuming a carrying charge of $0.23/MCF in Medan for gas transported by PGN to PERTAMINA customers, a constant margin on PGN gas sales at current $1.14!MCF and including all taxes and duties in the project capital and operating cost, the IRR for Surabaya would be 162 and for Medan 142. These IRRs are satisfactory and above PGN's cost of capital A sensitivity analysis of the IRRs was carried out with the following results: Table 12 IRR Z Surabaya Medan (a) Capital Expenditures (b) Operating Cost + 10X (c) Revenues ;0 (d) Combination of (a), (b), (c) 13 8 This analysis indicates that the IRR is sensitive mostly to changes in project cost and revenues, but even in the case of combined adverse events, the IRR would be acceptable. A delay in project execution is likely to delay costs and benefits at roughly the same rate, so the impact on the IRR would not be substantial, even if the present value of the project would decline; the extensive use of turnkey contracts for the project should reduce the risk of delayed project implementation. The risks for lower IRRs due to insufficient or late gas supplies and inadequate carrying charges and/or gas margins will be minimized by requiring PGN and PERTAMINA to agree on these vital project parameters before loan effectiveness (para 3.8). V. PROJECT JUSTIFICATION AND RISKS 5.1 The primary justification for the proposed project are the fuel cost savings and potential foreign exchange earnings to be generated by substituting non-tradeable surplus gas for exportable petroleum fuels. The abundance of gas reserves in East Java and North Sumatra which are accessible to the major industrial centers at Surabaya and Medan has set a stage conducive to expanding the domestic energy market for natural gas. With the incremental cost of gas supply estimated to be lower than alternative energy sources, the promotion of gas use in the power and manufacturing sectors has become a cornerstone of GOI's energy diversification program. It is thus opportune that the gas sector in East Java and North Sumatra offers extremely favorable prospects for accelerating the diversification program and this has prompted the GOI to accord high priority to the development of the proposed project. 5.2 The project will serve medium-sized industries engaged in various manufacturing activities with significant demand expected from the steel and fabricated metals sector, glass and ceramic manufacturing, paper production and chemical industries (Annex 2.01). The bulk of fuels to be replaced by gas among these industries consist of high value middle distillates. At the

46 -39- same time, the project will make gas available to PLN's power stations at Medan, and thus ensure stable and more economical fuel supply to meet the region's growing electricity requirements. 5.3 By integrating the gas utilization programs of the industrial and power sectors, and through the upgrading of the managerial and technical knowhow in the gas industry, the project will promote optimization of investments and greater efficiency in operation of the gas subsector. In addition, the project will lead to a reduction of environmental pollution arising from the use of gas which is a cleaner fuel than the fossil and wood fuels it would supplant. Economic Evaluation of the Project 5.4 In assessing the economic viability of the proposed Project, an evaluation of the costs and benefits to the country with and without the Project was undertaken and the associated economic internal rate of return estimated. Essentially, this involved quantifying the value of liquid fuels to be replaced by natural gas among potential users in the Surabaya and Medan service areas. The net savings to the country resulting principally from this shift to gas use by r-gn's potential customers is estimated to reach US$97 million annually, of which US$9 million is due to PGN's operations in Medan and US$88 million in Surabaya. 5.5 Project Economic Benefits. Benefits consist of the gas sales to PGN's industrial and commercial customers and supply deliveries to PLN thermal power stations. The projected gas sales attributable to the project are as follows: Table 13 Ey ending: MCFD Surabaya Ind./commercial Paper (;eces) Sub-total Hedan Industries PLN Sub-total Grand Total The benefits due to PGN's gas sales are valued in terms of the international market value of the tradeable petroleum fuels to be replaced. A survey of potential PGN customers in Surabaya indicates that the structure of industrial fuel demand is such that approximately 43Z of gas deliveries will substitute for industrial diesel oil (IDO), 202 for high speed diesel (HSD), 182 for fuel oil and residual, 10X for kerosene and the balance will replace LPG and wood fuel. A similar survey conducted among industries in Medan yielded an energy demand profile replaceable by natural

47 -40- gas consisting of 582 IDO, 20X HSD, 122 kerosene, 92 LPG and 1% fuel oil. In the case of the paper mill at Leces in Surabaya, 602 of gas use will substitute for HSD and 402 for fuel oil. But while the gas supply to PLN's power plants will displace fuel oil, benefits attributable to the project were assessed only in terms of pipeline carrying charges to PERTAMINA assumed at US$0.23 per MCF in Medan. (For purposes of this analysis, PLN's investments and operating cost savings associated with the power plant conversion and construction were excluded.) 5.7 The value of petroleum products to be replaced by gas was arrived at assuming an average price of US$18 per barrel of Indonesian crude and applying average price of petroleum products on the Singapore spot market during the last three years (Annex 7.03). Their equivalent gas values are as follows: Table 14 International Price (US $/Kl) Equivalent Value of Gas (US $/MCF) Kerosene Automotive Diesel Industrial Diesel Fuel Oil LPG ($Iton) Applying the above values to the structure of liquid fuel demand to be displaced by gas, the estimated equivalent economic value of gas sales to PGN's industrial customers is US$4.1 per MCF in Surabaya and US$4.3 per MCF in Medan. The value of gas supply to the paper factory at Leces is equivalent to US$4.0 per MCF. 5.8 Since natural gas lends itself more readily to combustion than de liquid fuels, the resulting increased thermal efficiency is estimated to yield 52 to 10% more savings to industrial users in terms of fuel value, depending on the industry and type of burner used. For purposes of the analysis, a 5% increase in benefits to medium-sized industries is imputed. Moreover, gas utilization affords lower operating costs to industries due to reduced fuel handling and storage expense, as well as reduced risk of pollution compared to the use of fuel oil and diesel. These added benefits were not, however, quantified. 5.9 The present heavy reliance of industries on diesel compared to fuel oil is partly attributable to the absence of any domestic price differential between the two products. The current price of Rp 200 per liter approximates the international price of fuel oil but is 25% to 33% below that for diesel products. If domestic diesel prices were realigred with international prices, it is likely that many of the industries would opt to use cheaper fuel oil without having to disrupt their production process. Still, a limited number may elect to continue using diesel and pass on the added costs to the consumers, depending on their nature of

48 -41- operations and produce mix. In any case, it is technically possible for all the industries concarned to shift to fuel oil. Accordingly, in the absence of the natural gas option, the least cost scenario would be one in which fuel oil use would predominate among the industries in Surabaya and Medan. Against this scenario, the incremental benefits derived from the proposed project are reduced by 40?. To the extent that it may take some time for GOI to correct existing domestic price distortions among petroleum products, the proposed project will mitigate the effects of these distortions by encouraging industries to accelerate their shift to a more cost effective energy source, in this case, natural gas Project Cost. The major cost components considered were: (a) the capital cost of the Project excluding taxes and duties, with the cost of local materials subjected to a standard conversion factor (SCF) of 0.8; (b) investments to be made by the new industrial and commercial customers for conversion of their equipment, assumed at US$10 million for Surabaya; and (c) operating expenses associated with gas distribution estimated to be equivalent to 2.52 of the purchase cost of gas supply Natural gas supplies in East Java and North Sumatra which will feed into PGN's d...tribution systems in Surabaya and Medan are considered to be surplus to Indonesia's LNG export requirements and are thus nontradeable. Accordingly, the cost of gas supply to the project is taken at its long run marginal cost plus depletion charge estimated on the high side at US$1.5L per MCF. At this level, ample provision for depletion premium has been made not having accounted for the very recent large gas discoveries in Maduras Strait offshore East Surabaya which may result in negligible depletion charges Economic Rate of Return. Based on the aforementioned costs and benefits, the Project is expected to yield an overall economic internal rate of return of 592. The project component in Medan is estimated to result in a return of 154Z, while that in Surabaya is expected to yield a return of 51Z. The high rates of return derived reflect the high value of petroleum products to be displaced as well as the relatively low investments required for the transmission and distribution of gas to the established industrial centers at Medan ed Surabaya, further complemented by the low marginal cost of gas production in the region. To the extent that the calculations exclude the net benefits attributable to PLN's conversion of its power stations into gas-fed units, the rates of return are underestimated. Even if PLN stations were not supplied through PGN's proposed distribution system, the project's rate of return would still exceed 50Z Relative to the least cost alternative scenario of correcting domestic price signals for diesel such that the fuel structure to be replaced by natural gas would be predominantly fuel oil, the derived economic rate of return for the over-all project is 381. The rate derived

49 -42- for the Medan component is 882 and that for Surabya, 33Z. (Results of these ca.culations are given in Annex 7.04.) 5.14 Sensitivity analyses indicate that the project remains viable even under adverse variations in market demand, relative value of substitute fuels, project costs and carrying charges. The results of the sensitivity tests are as follow:., Thble 15: Economic Rate of Return (Z) Medan Surabay Total Project Base Case Market Demand Down Down 25 Z Value of,ompeting Fuels Down 10 Z Down Project Costs Up l Up 25 Z Carrying charge Down Down 25 Z Project Risks 5.15 Among the major determinants of the project'b viability are a) the timely availability of gas; b) build-up in gas sales; c) stable values of petroleum fuel to be replaced; and d) shortfalls in institutional capabilities to implement the project The supply of gas to Surabaya is expected to commence by June 1992 at the latest based on the expectation that ARCO's proposed Kangean-Gresik pipeline would be completed within thirty months from the signing of the gas supply agreement between PERTAMINA and PLN. The latter is scheduled by end of On the other hand, gas supply in Medan from the JAPEX fields offshore Brandan is expected to be provided by December A delay in the aforementioned arrangements will affect the project's operational schedule and reduce the Project's EIRR and present value of benefits; e.g., a one-year delay in operation will result in the following: Medan Surabaya Total Project Economic IRR: Base Case 154Z 51% 59% One-year delay % 452 Net Present Value at: 10% 12% 10 12% 10o 121 (in million US $) Base Case One-year delay To minimize the risk of delays in gas supply arrangements on PGN's project, close coordination with PERTAMINA and the gas producers is being undertaken by PGN. Moreover, the high priority given by GOI on the early

50 -43- commissioning of PLN's gas-fired power stations at Gresik and Medan is expected to result in the timely conclusion of the gas supply contracts A second determinant of the project's success is the build-up of demand among the target industries. There is no foreseeable risk of a slowdown in this demand since based on the survey of existing industries, the demand to be met by the project is considerably lower than the potential loads in the business districts of Surabaya and Medan. Further, based on PGN's successful track record in expanding gas sales under the Bank-financed Gas Distribution Project, its marketing, pricing and technical service programs are deem3d responsive to customer requirements provided the competitive price of gas is sustained. In this connection, any reduction in PGN's sales margins would affect the financial performance of PGN (para 4.22) but not the project's economic viability. Prospects for greater gas demand become even more favorable should GOI, in the context of the on-going energy price review, decide to realign domestic prices of diesel (which account for the bulk of petroleum fuel to be replaced by gas) with the price it could fetch in the international market. The resulting greater flexibility in gas pricing could significantly accelerate market demand for gas. Nevertheless, assuming actual sales were to fluctuate below the projected levels, the project can withstand a 502 reduction in demand and still be able to generate an acceptable return of 35? due to the high value of fuels being replaced by gas The risk of a decline in the international prices of petroleum products is considered minor in view of current Bank forecas's suggesting gradual increases of 22 per annum in international prices (in real terms' for crude oil between now and year Nevertheless, sensitivity tests indicate that, should there be downward movements in the international prices of petroleum products, say to US$11/barrel of crude, the prdject would still yield an acceptable rate of return of 28Z. Theoreticall7 such a decline in the value of oil would correspondingly be reflected in a decrease in the depletion value of natural gas leading to a reduction in the cost of gas supply to the project. Adverse impact on the project's economic viability would thus be minimized The risk of shortfalls in the institutional capability of PGN to implement the Surabaya and Medan components of the project is minimized through the proposed technical assistance (twinning) arrangement, which will be a condition of loan effectiveness. Similar risk in the establishment of a Gas Technology Development Unit will be covered by the technical collaboration of LEMIGAS with a prominent gas technology institute in Western Europe or North America, on terms satisfactory to the Bank, and which will be a condition of disbursement of funds allocated for the Gas Technology Development Unit under the Bank loan. Fiscal Impact of PGN's Operations 5.20 Under the on-going and proposed Bank-financed projects, PGN's operations will expind to a level which will allow the company to begin reaping the benefits of efficiencies and economies of scale. A manifestation 3f these gains would be the reduced reliance of PGN on GOI budgetary support and an increasing capability on PGN's part to contribute to the national treasury and thus support other development priorities of GOI outside of the gas utility sector (Annex 7.05).

51 During the period 1990 to 1997, PGN's operations are expected to result in a total fund transfer to GOI of about Rp 305 billion consisting of debt service remittances (42Z), contributions to the DPS fund (25%), income tax payments (24Z) and customs duties and taxes associated with construction work under both the on-going and proposed Bank-financed projects (9Z). On the other hand, GOI fund releases for PGN will total nearly Rp 119 billion during the same period, assuming the foreign exchange rate remains stable at Rp 1,750 to US$l. The bulk (76Z) of these GOI outlays constitutes debt service payments by the GOI as borrower of foreign loans relent to PGN. The balance represents GOI's final DIP equity contribution of Rp 28 billion programmed for fiscal years 1990 and Thereafter. GOI outlays for PGN would be restricted to debt service payments. The resulting net fund transfer between PGN and GOI amounts to Rp 185 billion in favor of the national treasury. However, should there be a devaluation of the Rupiah such that there is effectively no differential between debt service levels of PGN and GOI, the net funds flow from PGN to GOI would be around Rp 147 billion. Benefits from Institution Building 5.22 A salient aspect of the proposed project concerns the strengthening of expertise within the gas subsector in the areas of longterm planning, growth management, formulation of cost effective standards and appropriate codes of practices, and establishment of regulatory framework for the safe utilization of gas. Although not directly quantifiable, the benefits due to these institution building efforts are significant and far-reaching. Enhancement of planning capabilities will help ensure that the sector's long-term expansion will be based on a least cost program. Accordingly, investments by various entities in the sector can be optimized thus avoiding duplication of facilities and resulting in better synchronization of their respective development activities. The establishment of standards for engineering design, equipment and consumer appliances which are tailored in the context of local requirements, will enable the gas sector to avail of greater economies in the domestic production of these goods and services. Development of zafety regulations will protect the population and environment from potential hazards of gas operations and will help sustain industry's credibility as a safe and stable source of domestic energy. The proposed marketing surveys and research on consumer preferences and behavior with respect to gas use, as well as on inter-fuel demand, would go a long way in ensuring that the gas industry is responsive to consumer needs. Consistency in customer satisfaction is a key gauge to m&rket growth and stability. Finally, the technology transfer and enhancement of managerial skills associated with the project will develop the sector's human resources and add to the pool of experts needed to manage the growth of the gas industry. The expected over-all impact of these institutional upgrading is the accelerated development of the gas sector on an economically rational basis thus expediting the country's diversification from oil-based domestic consumption and increasing its foreign exchange earning potential.

52 -45- VI. AGREEMENTS REACHED 6.1 Prior to negotiations, assurances were received from GOI that the quantities of gas required for Surabaya and Medan components of the project shall be made available to PGN. 6.2 During the negotiations, agreements have been reached with GOI that, (i) it will provide PGN and LEMIGAS with necessary funds to carry out the project (para 3.29 and 4.21); (ii) it will prepare and furnish to the Bank, for its review and comments, a proposal for the establishment of a Gas Technology Development Unit in LEMIGAS, taking into Account the recommendations of its ongoing planning study and the Bank's comments, in accordance with a timetable acceptable to the Bank (paras 2.27, 3.22 and 3.33); (iii) it will furnish the Bank with audited project accounts for the Gas Technology Development Unit and the marketing studies within nine months of the end of its each fiscal year (para 3.29); (iv) it will ensure that PGN obtains, in a timely fashion, the necessary rights of way/way leave for the pipelines to be built under the project (para 3.30); (v) it will allow PGN to mainti.in its pay scale at a level as remunerative as that offered by similar public corporations (para 2.16); and with PGN that it will, (i) furnish the Bank with a detailed training program (including the component for efficiency improvement) according to a timetable acceptable to the Bank (para 2.17); (ii) provide the Bank with its unaudited financial statements within six months and the corresponding audited report within nine months of the end of its fiscal year (para 2.21); (iii) prepare a rolling five-year plan covering its future gas requirements, which will be updated each year and discussed with GOI and PERTAMINA to form the basis for further network expansion (para 3.8); (iv) submit to the Bank quarterly progress reports according to a format acceptable to the Bank (para 3.41);

53 -46- (v) revalue its fixed assets in operation annually according to the method acceptable to the Bank and submit it to the Bank, together with unaudited financial statements within six months of the end of each fiscal year (para 4.13); (vi) implement the efficiency improvement program (para 4.16); (vii) take all necessary measures to produce a rate of return on revalued net fixed assets in operation of not less than 4Zin FYs9l-93, 82 in FY94 and loz thereafter (para 4.18); (viii) by January 1 of each calendar year prepare an annual investment program and submit it to the Bank for comment (para 4.20); and 6.3 Conditions of the effectiveness of the proposed Loan would be: (i) the execution of gas supply contract, acceptable to the Bank, for the supply of natural gas to PGN'9 Surabaya and Medan transmission and distribution systems covering the project requirements (para 3.8); (ii) the execution of a technical assistance agreement, acceptable to the Bank with an established gas utility in order to assist PGN in the implementation of the project kparas 2.15 & 3.21); and (iii) the execution of a Subsidiary Loan Agreement, satisfactory to the Bank, between the Borrower and PGN (para 3.29). 6.4 Condition(s) of disbursement of funds allocated for the Gas Technology Development Unit would be, (i) the Borrower's approval of its organization as determined by its planning study, including ar. implementation schedule and reporting requirements satisfactory to the Bank (para 3.22); and (ii) signing of a technical assistance agreement satisfactory to the Bank, with an established gas technology instituate (paras 3.22, 3.33 & 3.42); and for the marketing feasibility studies, it would be the Bank's approval of the terms of reference and expertise required for their conduct (para 3.24). Recommendation 6.5 With the above agreements, the proposed project would be suitable for a Bank loan of US$86 million, repayable over 20 years, including 5 years of grace, at the standard variable interest rate, with the Government bearing the foreign exchange risk.

54 -47- Annex 1.01 INDONESIA GAS UTILIZATION PROJECT GAS SECTOR DATA - ESTIMATED GAS RESERVES As of January (In Billion SCF). REGION PROVEN POTENTIAL TOTAL ACEH NORTH SUMATRA CENTRAL SUMATRA SOUTH SUMATRA WEST JAVA EAST JAVA a/ EAST KALIMANTAN CENTRAL KALIMANTAN NATUNA SOUTH SULAWESI CENTRAL. SULAWESI IRIAN JAYA TOTAL a/ Excluding potential reserves of about 2.5 TCF based on recent discovery. Source: MIGAS

55 INDONESIA GAS UTILIZATION PROJECT HISTORICAL GAS PRODUCTION (in Billion SCF) PRODUCER Pertamina MIGAS-CEPU Contract of Work Contractors Production Sharing Contractors ,286 1,342 1,378 1,471 Total 542 1,112 1,186 1,521 1,580 1,629 1,732 Source: MIGAS

56 -49- Annex 1.03 INDONESIA GAS UTILIZATION PROJECT GAS PRODUCTION/UTILIZATION BALANCE (in Billion SCF) A. Gross Production B. Own Use 1. Gas Injection Gas Lift Fuel Gas Subtotal C. Net Production D. Sales 1. Electricity (PLN) City Gas Fertilizer Plants Cement Cilamaya 1/ Refinery LPG Plants LNG Plants Gas Industries/Others Subtotal E. Flared / Delivered to Kujang fertilizer plant, Krakatua Steel, Cibinong Cement and City Gas for Jakarta and Bogor.

57 -50- Annex 1.04 INDONESIA GAS UTILIZATION PROJECT HISTORICAL GAS PRODUCTION BY REGION (in Million SCF/Day) REGION 1984/ / / / /89 Aceh 1,821 1,866 2,001 2,220 2,424 North Sumatra Central Sumatra South Sumatra West Java East Java East Kalimantan 1,450 1,484 1,497 1,550 1,687 Total 4,189 4,299 4,487 4,746 5,118 HISTORICAL GAS CONSUMPTION BY REGION (in Million SCF/Day) REGION 1984/ / / / /89 Aceh 1,190 1,200 1,332 1,542 1,702 North Sumatra South Sumatra West Java East Kalimantan 1,289 1,277 1,272 1,312 1,479 r Total 2,831 2,875 3,036 3,264 3,613 Source: == == IG AS= ======= Source: MIGAS, July 1989

58 INDONESIA GAS UIILIZATION PROJECT COMPOSITION OF CURRENT* 1NDUSIRID.L DEUAND IN SURABAY AND MEDAN (in Thousand Cubic Motor) A. SURABAYA Texti le Area 8aMetal Chem Food Class Others Pherm. Palo Oil Print. Rubber Wood Ceramic Pzpar Elect. Total Kot Dupak Tend.s Si;o e K. Pi;ang Runokut S.goroeadu R-are Driyorejo Waru Aloha Tuaa Total As 3 of Total 261 8a 4X 23% 31 0% 4X 0 1% 0% % 1001 S. MEDAN Area B.Mtal Chem Food Wood Text. Print. Phare. Class Elect. Others Total Bolawan sinjoi Tg. Morgue Total As a 1 of Total 14% 37% % 1i is 13% 01 4% 3001 _ _ -_ - - -_ _ -_ -_ -_ _ _ -_ -_ - -_ -_ -_ -_ -_ -_ -_ - - -_ - -_ _ - -_ -_ -_ - -_ - -_ _ -

59 GAS DEMAND AND SUPPLY PROJECTIONS FOR S')RA8AYA AND MEDAN (All Figures in MMCFD) A. MELAN DEMAND SUPPLY P1) PLN PW N PGN Total Demand PlA PLN PGN PGN Total Supply Year AV. MAX. AV. MAX. Total Demand MAX. AV. MAX. AV. MAX. Tota! Supply MAX. Ending DAY DAY DAY DAY AV. DAY DAY DAY DAY DAY DAY AV. DAY DAY a S so S s o so o s so o 88 DEMAND 8. SURABAYA Total Total MED. Size MED. Size Paper Paper MED. Size MED. Size Paper Paper Demand Demand Year Industrial Industrial Loces Lecos Total Demand Total Demand Industrial Industrial Leces Loces AV. iax. Ending AV. DAY MAX. DAY AV. DAY MAX. DAY AV. DAY MAX. DAY AV. DAY MAX. DAY AV. DAY MAX.DAY DAY DAY i S l s s8 60 S S a l SO so SO se ? a e 103 l X SUPPLY Note: AV. DAY = average day; MAX. DAY = maximum day. C

60 INDONESIA GAS UTILIZATION PROJECT PGN Existing Organogram r I~~ l ~~~~~~~~~~~PRE8BNT DIMCTtlUl l _ Dlf ebr A<sbutbn~~~~~&ona VW Interna Sub- Sub- ~~~~- Sub - ~ -W - ~ -ab -~ Sb -eob- -~ ctr Bachs*Sb --- Okractnw Okectof Operaflon Boranch O~ct Oletr Oirctot Stores and Conditruc- MWOIS Mi Mdi QVb,ace cowut Pereonnd AdVndioon ~ ~ ~ ~~~eneostretlon~ C"drd -CorAratrl CSw4Iop- - Set". - Coroon Coentol -J - sow -Standards OaeUp Motwung d- Can"rl -Mtra - Cuawu012~teru Cm,nS ncowraonmet Clir b- - QadIy ->*e CSItO - S f_tn Cottl Srica op. mu - BU - corue- - SW.be - Fcooem am ~ ~ ~ ~ ~~~a~ -W - AStrdb I Sale Operaionm Accowies Aeulstl@fl 16-a,cb E catim Cet er Cenz1 _ter 2l Sl ersicn ak/w45 166a 0 c con2of serwees " 0~~~~~

61 INDONESIA GAS UTILIZATION PROJECT PGN Proposed Organogram l ~~~~~~~~~~~~~~PR SOENT DIRECTORI [~ Xprun ~ ~~~~~ I~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ t Fwaeo Xcea a hueo -~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Caeerim L4oin - -a sb Operations M.aing- ModanAlak -ped- - FS - OltS - 80U1. - Ogbt,lI- - Coa0*Sb - JbkO,tO S Sull - ODirt CSlAl butl@n Contrel rmccu _I - Sogo -~~~~~~~~Le -,b - -waw rklwd qm041er WO te PCnnr- C Cuon _. htrmn - Cot_ro - vmst)' - c..*- t Coitbg -Jakm 4au - Camba-e Cattiot SuCdc. 9ewrC o - Boom =.d - COna~ wcw. W - Msxedban - Accao.Wa Op a o a - A6t.batloa and Cam I I I L I I sa,. PiaFS_ opwatlon Accounts Atsnftlo lb D I I fd ID l &.w.b Edac&bUM CentaX a" a" tw CeDoge 1ra*f bdomauo. C_de Caetb Stci e Tral"Ifte bw4wwamm~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~3~0- O

62 INDONESIA GAS DISTRIBUTION PROJECT ORGANIZATION OF MIGAS DIRECTOR GENERAL Dietr,)rctr Director, Director, Director, Director, Director, Director, Director, Exploration Exploration Technical Business Research and Human Resource & Production & Production Services Development Development Development I of Oil & Gas Geothermal Centre for Resources Oil & Gas Technology (LEMIGAS) : 1 o. IA N*

63 INDONESIA GAS DISTRIBUTION PROJECT ORGANIZATION OF LEMIGAS DIRECTOR Divisional Head, Divisional Head, DivislInal Head, Divisional Head, Divisional Head, Divisional Head, Research and Technical Ser- Research and Technical Ser- Data Collection General Affairs Development in vices for Development in vices for and Analysis (Finance,Personnel I Petroleum Petroleum Petrochemical Petrochemical and General Services Exploration Exploration and Process and Process and Administration) and Exploitation Exploitation Application Application OFa mo w o0. FN N

64 57 Annex 4.01 Page 1 of 9 INDONESIA GAS JTILIZATION PROJECT Implementation and Technical Management Assistance Terms of Reference I. Introduction 1.1 The Government of Indonesia (GOI) proposes to develop and expand natural gas utilization in and around Surabaya and Medan. Perusahaan Gas Negara (PGN), henceforth called the "Client", will be responsible for implementing the project and operating the facilities. PGN is a public corporation placed under the supervision of the Ministry of Mines and Energy. It is already engaged in the transportation and distribution of natural gas and manufactured gas for power generation, industrial, commercial and domestic use in these areas. Since the project would entail a manyfold expansion in PGN's operations, it requires institutional strengthening to enable it to discharge its expanded responsibilities efficiently. For this purpose PGN intends to enter into a long term technical collaboration (twinning) arrangement with a prominent gas utility, hereinafter called the "Consultant". 1.2 The proposed twinning arrangement will be characterized by a closer involvement between the two parties than is generally obtained in a standard client-consultant relationship. It is intended that the twinning utility should identify itself fully with the needs and objectives of PGN, and would provide PGN with continuing back-up services, advice, and experienced personnel over a number of years. The objectives of such twinning would be: (a) to provide sustained technical and managerial support aimed at strengthening PGN to the point where it can independently operate all asnects of a complex gas distribution system; (b) to assist in the development and implementation of the systems required by a commercial gas utility, including: (i) design of market development strategies and systems, including market surveys, pricing, and contractual arrangements; (ii) planning and design of gas compression, transmission and distribution systems; (iii) material control and procurement; (iv) construction of pipelines compression, pressure regulation, flow measurement, telecam/scada, and odorization facilities;

65 -58- Annex 4.01 Page 2 of 9 (v) gas compression, transmission and distribution operations and maintenance; (vi) accounting, billing and collection; (vii) management information and cost control; (viii) long-term planning, investment appraisal and risk analysis; (ix) financial management and control; (x) human resource development. (xi) advisory service to customers on efficient and safe utilization of natural gas; involving design of houselines, selection of suitable gas firing equipment and safety procedures; (xii) preparation of all necessary standards and manuals for construction and maintenance of the gas systems; and (xiii) to the extent requested by the Client, advice on institutional structure and personnel arrangements. (c) to provide back-up support in day-to-day technical and financial operations; and (d) to provide conventional technical assistance services in support of the design and execution of the proposed expansion project (the Project) as described in Section II. 1.3 The mechanisms for achieving these objectives would include: - secondment of experienced professional personnel from the Consultant's own organization into parallel positions in the Client's organization. - provision of back-up services from the headquarters organization of the Consultant. - design and implementation of a comprehensive training program, including training courses, on-the-job training, and the selective assignment of the Client's personnel to the Consultant's organization for the first-hand exposure to operations. - provision of specialist technical personnel and services to undertake discrete tasks as required. II. The Project 2.1 Most of the activities of the Client over the next six years will comprise of the expansionlrehabilitation of its gas supply systems for

66 -59- Annex 4.01 Page 3 of 9 Surabaya and Medan. This project will be undertaken concurrently with the on-going Gas Distribution Project, which is due to be completed by July The main components of the Project are: (a) Provision of Natural Gas Supply System in Surabaya and its surrounding areas, involving: (i) the laying of about 80 km of high pressure transmission pipelines, 190 km of medium pressure steel pipelines and 165 km of medium pressure polyethylene pipelines; (ii) the construction of about five gas metering, pressure regulating and odorization stations with associated instrumentation and about four pressure reducing stations on the pipeline networks; and (iii) the construction of service lines, pressure regulation and flow aetering stations for 375 medium size industries and 150 commercial enterprises and the paper mill in Leces and conversion of consumer's equipment (excluding PLN's) involved in gas usage. (b) Expansion of Natural Gas Supply System for Medan involving: (i) the construction of about 24 km of high pressure transmission pipeline with associated cathodic protection, pressure/flow monitoring facilities and three pressure reducing stations; and (ii) construction of service lines and pressure regulating and flow metering stations for PLN power station at Belawan and conversion of consumer's equipment (excluding PLN's) involved in gas usage. (c) Technical Assistance involving long-term consultancy for the enhancement of PGN's skills and efficient implementation of its expansion project; (d) Studies: Feasibility studies for natural marketing in Palembang (South Sumatra), Jambi (Central Sumatra), Batam Island (Riau), and Balikpapan. III. Scope of Consultancy Services 3.1 General. On assignment the Consultant will promptly plan and render all necessary advice/assistance to the Client to achieve the objectives set forth in para 1 and 2 above within the time frame to be specified in the contract. Such assistance will include but will not be limited to the following:

67 -60- Annex 4.01 Page 4 of 9 (a) back-up services from headquarters organization of the Consultant for systems development referred in para 1.2 (b); (b) review of clients existing organization and submission of recommendations for changes as considered necessary for strengthening the organization in the functions of (i) marketing/conversion/consumers service; (ii) systems operations/maintenance; (iii) systems planning/design; and (iv) project implementation/procurement of materials. (c) assistance in the implementation of the systems referred to in Section I above, by providing the services of well-qualified and experienced personnel from the Consultant's own organization. While the exact number of such personnel will be determined in consultation with the Client, it is imperative that at least five such personnel be posted at the Client's head office to assist/advise the Client's management and ensure achievement of the objectives set forth above. These five personnel will cover (i) marketing/conversion/consumers services; (ii) cransmission and compression systems design, operation/maintenance; (ii4) distribution system operation/maintenance; (iv) distribution system planning/design; and (v) project implementation/ procurement of material; and (d) providing, to fullest extent possible, on-the-job training to the Client's staff at all levels, starting from the level of sub-directors downwards. The four personnel referred to in (c) above will have as counterpart the respective sub-director of the Client's organization responsible for his particular discipline. The advisors will be responsible both for (i) the successful implementation of the Project, and (ii) through the full involvement of the Client's staff at all levels in the execution of the Project, for building up the capability of the Client to discharge efficiently the functions of a modern gas utility upon completion of the Consultant's assignment. 3.2 The Consultant will carry out the assignment using modern up-to-date techniques of gas industry. He will work in close cooperation with the Client's representative, henceforth called the "Manager', who will render all assistance to the Consultant in carrying out the assignment. The Consultant will render to the Manager all necessary advice, including but not necessarily confined to, the items listed in this section, to ensure the successful implementation of the ;roject. It is understood that the Manager will seek/receive and the Consultant will promptly render/initiate all such advice in time; and also that in order to enable the Consultant to be held responsible for the assignment, the Manager will normally act upon the advice in time or keep the Consultant advised of the reasons to the contrary. In general, the Consultant will keep the Manager continuously informed on progress of the project, particularly with reference to problems that could cause delays. Detailed Assignments 3.3 The detailed assignments of the Consultant have been specified in relation to the Project to be implemented by the Client. However, in all