PROJECT INFORMATION DOCUMENT (PID) CONCEPT STAGE Report No.: Project Name

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1 PROJECT INFORMATION DOCUMENT (PID) CONCEPT STAGE Report No.: Project Name Aligning Industrial Development with European Environmental Standards Region EUROPE AND CENTRAL ASIA Sector General public administration sector (100%) Project ID P Borrower(s) GOVERNMENT OF UKRAINE Implementing Agency Ministry of Environmental Protection Environment Category [ ] A [ ] B [ ] C [X] FI [ ] TBD (to be determined) Safeguard Classification [ ] S 1 [ ] S 2 [ ] S 3 [X] S F [ ] TBD (to be determined) Date PID Prepared January 13, 2006 Estimated Date of Appraisal Authorization August, 2006 Estimated Date of Board Approval December, Key development issues and rationale for Bank involvement Ukrainian industry is growing again. After a decade of economic stagnation, Ukrainian industry is investing and growing for a fifth year in a row creating a historical window of opportunity to restructure obsolete soviet plants and apply more energy efficient and environmentally friendly technologies and business practices. This would enhance the international competitiveness of the industrial sector and improve quality of life of citizens. The proposed operation will demonstrate how international emissions trading under the Kyoto Protocol can be used to encourage pollution control in the industrial sector. New incentives to improve environmental performance of industry are emerging. Recent industrial growth brings a threat of increased pollution but also an opportunity to improve environmental performance of industry. The threat arises from a combination of: (a) inappropriate environmental regulatory and policy framework, and (b) weak institutional capacity for enforcement needed to bring polluters in compliance with improved environmental standards. Industry still relies on post-soviet, energy intensive technologies. Pollution of the cities in the Eastern part of the country poses one of the largest environmental health hazards in Europe. High incidence of chronic bronchitis, bronchial asthma, higher cancer rates and lower life expectancy affects in particular the urban poor. The opportunity arises because richer firms and consumers are progressively more able to afford, and are willing to pay more for a cleaner environment. The recent change in gas price regime gives a strong impetus for industrial firms to improve their energy efficiency and associated environmental performance, and for the government to support it. Polluting enterprises are also under mounting pressure from European trade partners who are concerned about environmental dumping. Local citizen groups in pollution hot spots are campaigning against main polluters and President Yushchenko has urged in 2005 selected industrial Oblast Governors to reduce pollution. The Ukraine/EU Action Plan includes Government commitment to a number of policy actions to improve the environmental situation and Kyoto compliance. The Ministry of Environmental Protection (MoEP) has already launched aligning environmental permitting, enforcement and financing with European practices, and has received donor support, including an IDF grant, to support permitting reform. MoEP has

2 prepared an action plan to meet Kyoto Protocol commitments and to participate in flexible mechanisms, which was approved by the Cabinet of Ministers on August 18, Lack of access to adequate finance constrains efficient technology choices. Notwithstanding increasing liquidity of the banking sector, credit remains usually short term, expensive and trade related. Banks have limited experience in appraising risks of industrial development and pollution control projects. This distorts technology choices, as enterprises often have no choice but to invest in ad hoc and fragmentary fixes of existing energy intensive and polluting assets, instead of bringing best available technologies to improve their competitiveness. Flexible mechanisms under the Kyoto Protocol can leverage significant investments in needed clean technology transfer to industry. Selling the surplus Assigned Amount Units (AAUs) to OECD countries under international emissions trading system could generate a multi-billion US$ inflow of foreign currency revenues to Ukraine. Ukraine is the second largest potential seller of surplus Kyoto allowances after Russian Federation. Allowances are in surplus because industrial output has significantly decreased since The key OECD countries have announced that they would consider buying AAUs only if they are greened, i.e., if revenues are reinvested in projects and programs that further reduce emissions. The Green Investment Schemes (GIS) are being developed by some countries as a domestic mechanism to green AAUs in order to make them palatable to OECD buyers. In October 2005 the MoEP requested the World Bank to prepare an international emissions trading options study, which will identify options for a Green Investment Scheme. Japan has also approached president Yushchenko to express interest in promoting the Green Investment Schemes, and a Japanese (PHRD) grant is being made available via the Bank to assist MoEP to meet eligibility conditions to participate in the flexible mechanisms of the Kyoto Protocol. The Bank has unique ability to coordinate and scale up the currently fragmented donor assistance and to maximize benefits to Ukraine of participation in international emissions trading. Environmental Sustainability is among the CAS objectives and the IBRD lending program includes the proposed project, which would assist Ukraine to profit from the opportunities provided by the Kyoto Protocol, as highlighted in the CAS Progress Report The first PCN endorsed the rationale and general scope of the proposed project, while also recommending additional background analysis that has, subsequently been undertaken and has influenced the design of the current project concept. Stakeholders analysis demonstrated an increasing awareness of the value of clean environment, as well as a lack of confidence in the ability of environmental institutions to deliver. This led the task team to place emphasis on building incentives and capacity for pollution control. Some related actions are incorporated in the project, while others are financed through IDF and PHRD and by other donors cooperating with the Bank. A review of financial incentives in other countries informed development of the concept for disbursement instruments to enterprises from sub-loans to matching grants. Several donors have already expressed willingness to work collaboratively with the Bank in the framework of this operation. In June 2005, a Government Donors Task Force for coordination of Kyoto related activities was established, and the World Bank was requested to facilitate it. 2. Proposed objective(s) The primary objective of the project is to improve environmental performance and energy efficiency of heavy industry in Ukraine. Specifically, the project will establish the capacity of the 2

3 government to use efficient and market-friendly incentives to encourage early convergence of industrial enterprises with environmental performance and carbon intensity similar to European good practices. Should Ukraine and buyers agree on AAUs trade, the project will demonstrate the feasibility of establishing the industrial window of the Green Investment Scheme. The project will benefit global commons by mitigating climate change, and generate local public goods by improving the health of people living in industrial pollution hot spots. The country will attract additional foreign capital to help finance the modernization of industrial assets. The project will improve access of Ukrainian industry to Western markets, and will improve investment climate and governance. 3. Preliminary description Project objectives will be achieved by establishing within the Ministry of Environmental Protection the capacity to monitor and enforce air pollution emission reductions in industry, and by developing efficient financial incentives for enterprises to improve technologies and reduce emissions. Project design envisages two components: I. Monitoring and Enforcement of Air Pollution Emissions in the Industry. This component will build the physical and technical capacity of the State Environmental Inspectorate (SEI) to monitor, verify and enforce the emission reductions within the industry, which can be proposed as green investments to facilitate the sale of AAUs. The system will cover the GHGs which are used for hard greening, as well as the gasses used for soft greening such as dust, SO 2 and NO x. For GHGs this will also help meet one of the eligibility requirements for domestic verification of Joint Implementation projects under Track 1 procedure. The State Environmental Inspectorate has been appointed by the Minister of Environment to be the implementing agency for this component, and is being reorganized to strengthen its capacity to monitor and enforce pollution standards. SEI has prepared a draft investment program for the content of this component in September 2005, which includes investments in equipment (90% of costs) and capacity building (10% of costs). II. Industrial window of the Green Investment Scheme. This component will co-finance a pipeline of energy efficiency and environmentally friendly investments in the industrial sector. The design of the financial mechanism will be influenced by the findings of the WB sponsored International Emissions Trading Options Study, and will also draw from the previous analytical work and experience gained by the team during project identification. Assuming that this IET- GIS study leads to agreement on the establishment of a domestic financial intermediary, the project will be proposed as an industrial window of the future GIS Fund. In this scenario the World Bank would assist Ukraine in finding of a pool of buyers of greened AAUs and in generating stream of Government revenue over the period The proposed operation would help Ukraine negotiate the greening methodologies for industrial pollution reduction projects with the buyers. It would also identify and cofinance implementation of a pipeline of green investments in industrial enterprises so as to bring a package of AAU assets to the market in a relatively short time. Two financial mechanisms are considered for project support. First, the project would provide carbon finance advance payment or loan (depending on the results of the GIS work) to the Fund. This will be used as seed funding and converted for emission reduction grants and disbursed to enterprises before the carbon finance flows upon delivery of results. Secondly, the project could 3

4 provide a partial guarantee mechanism on payment risk by the Fund to enterprises and creditors either by establishing an escrow account or a partial risk guarantee facility. The selection of the appropriate option will be based on a detailed assessment carried out and agreed during project preparation. To encourage the financial sector to extend credit for underlying investment in clean technologies, the matching grant would be linked to credit provided by commercial banks. The proposed financial mechanism would facilitate enterprises access to credit from local commercial banks, thereby leveraging a significant volume of capital investments. The concept of the proposed financing scheme was discussed with, and generally endorsed by local banks, the Ministry of Finance, and the Carbon Finance Business team of the Bank. 4. Safeguard policies that might apply The primary safeguard policy that will apply to the Project is OP/BP 4.01 (Environmental Assessment) although given the diverse industrial sector and geographical locations, other safeguard policies may apply to individual investment sub-projects. The project is essentially an environmental initiative, the main objective of which is to reduce the emissions in the country's most polluting industries and therefore should have substantial positive environmental impacts. The overall Environmental Management Plan (EMP) developed for the project will provide for an estimation of these positive impacts and, where applicable, offsetting negative impacts that may be foreseen in the types of industrial sectors targeted and the generic kinds of investments envisioned. While it is premature to speculate on such impacts at this point, the enterprises selected for the project will in many cases be large industrial complexes such as iron and steel, chemicals and power generation, which will likely have historical environmental legacies and high ongoing pollution. These will be assessed on a subproject specific basis by the Environmental Authorities (Environmental Permitting Department and Environmental Inspection) and beneficiaries on the principal that every specific investment will incrementally contribute to significant reduction of local and global environmental impact. It is proposed that the overall project be designated as a Category FI under OP/BP 4.01 in recognition that it involves investment of Bank funds through a financial intermediary (FI), in subprojects that may result in adverse environmental impacts. As such, the provisions of OP/BP 4.01 will track through to the FI who will have responsibility for the screening sub-projects and ensuring consistent application of the requirements of OP 4.01 to each sub-project. The FI will be a public institution (GIS Fund) supervised by the Ministry of Environmental Protection and will ensure that beneficiary enterprises have or acquire the capacity to undertake EMPs and where applicable, Environmental Impact Assessment (EIA) for specific investments. They will also be bound by the Public Consultation and Disclosure requirements of OP/BP These arrangements will be further elaborated during preparation and assessed during Bank appraisal with the bank reserving the right on all subprojects to undertake prior review of the EMP and where, applicable EIA. With respect to the possibility that other safeguard policies may apply to individual sub-project's, the Bank will require that the GIS Fund has both the capability and practices in place to evaluate each subproject in terms of the policies and that these be strictly applied where they apply. The Bank will require compliance with these policies as a condition of the transfer of funds 4

5 agreement between the Government and the GIS Fund and grant agreements between the GIS Fund and beneficiary enterprises. Monitoring the application of the policies will be integrated into the Bank s oversight and supervision of the project. 5. Tentative financing Source: ($m.) BORROWER 4.00 INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT SWEDEN, GOV. OF 0.30 US, GOV. OF Contact point Contact: Grzegorz Peszko Title: Senior Environmental Economist Tel: (202) gpeszko@worldbank.org 5