Iceland - Sigalda Hydroelectric Project

FILE COPY DOCUMENT CF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION Not For Public Ux Report No. 2 39-IC APPRAISAL OF THE SIGALDA HYDROELECTRIC PROJECT OF LANDSVIRKJUN (NATIONAL POWER COMPANY) ICELAND November 26, 1973 Europe, Middle East and North Africa Region Public Utilities Projects Division This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  CURRENCY EQUIVALENTS Currency Unit = Icelandic krona (IKr) IKr 1 = 100 aurar (au) US$ 1 = IKr 87.50 1 US cent = IKr 0.875 1 US mil = US$0.001 = 8.75 aurar IKr 1 = US$0.01l14 IKr 1000,000 US$,11429 WEIGHTS AND MEASURES kW = kilowatt = 1,000 watts MW = Megawatt = 1,000 kW kWh = kilowatt hour - 1,000 watt hours GWh = Gigawatt hour = 1,000,000 kWh kV = kilovolt = 1,000 volts kVA = kilovolt-ampere = 1,000 volt-amperes MVA = Megavolt-ampere 1,000 kVA Hz = Hertz . cycles per second m = meter = 3.281 feet km = kilometer = 0.621 mile = cubic meter = 35.31 cubic fest km' = square kilometer = 0.386 square mile m3/s = cubic meter per second- 35,31 cubid feet per second rpm = revolutions per minute kg = kilogram = 2.205 lbs (pounds) ton = metric ton = 1,000 kg = 2,205 lbs ABBREVIATIONS AND ACRONYMS NPC - National Power Company (12ndsvirkjun) Nl.iA - National Snergr Authority RARIIh - State Electric Power Wdorks IShb L- Icleandic Alurini.um fompany Ltd. EW-11 - Electro-Watt Engineering Services Ltd (Swltzerland) Virkir H.F.- Associated Engineering Consultants TLtd. (Iceland) Harza - Harza Lngineering Company International NATO - North Atlantic Treaty Organization SDR - Special Drawing Right ESE - igectrictl and Mechanical O&M - Operation and Maintenance p.a. - per annum NPC's Financial Year Calendar Year  ICELAND APPRAISAL OF THE SIGALDA HYDROELECTRIC PROJECT OF LANDSVIRKJUN (NATIONAL POWER COMPANY) TABLE OF CONTENTS Page No. SUMMARY AND CONCLUSIONS ..................... i - ii 1. INTRODUCTION ....... .........................1 2. THE COUNTRY AND THE ECONOMY .... ............. 2 The Country ................................. 2 The Economy ........ ......................... 2 3. THE SECTOR 3.................................... 3 Energy Resources ...... .................... 3 Organization of the Power sector ......... ... 3 Existing Power Facilities ................ ... 4 Growth of the Power Sector ............... ... 4 Scope for North-South Interconnection ....... 4 Rural Electrification ..... .................. 5 Study of Power Sector Organization .......... 5 4. THE BORROWER ....... ......................... 5 Legislation ................................. 5 Organization and Management .............. ... 6 Existing Facilities ..... ................... 6 Operations ....... ...................... 7 Development Program ..... .................... 7 5. THE PROJECT ....... .......................... 8 Description ....... ...................... 8 Cost Estimate ...... ...................... 8 Amount of Loan ...... ..................... 9 Status of Engineering, Procurement and Disbursement ............... ............. 9 Construction Schedule .................... ... 10 Project Maintenance ..... .................... 10 Ecological Aspects ..... ..................... 11 This report has been prepared by Messrs. T.B. Russell, I. Mathai and H. Huang (consultant). It is based on information obtained by a mission to Iceland in January/February 1973 consisting of Messrs. Russell, D.C. Jones and Huang and on further information obtained by Mr. Jones on a visit to Iceland in April, 1973.  TABLE OF CONTENTS (Cont'd) Page No. 6. JUSTIFICATION OF THE PROJECT ................ 11 Market Growth ...................1.* ......... 11 Comparison of Alternatives ............... .. 12 Economic Rate of Return .............. .*...... 12 7. FINANCIAL ASPECTS . ................... . . . . . . . 13 Tariffs ..................... 13 Accounts and Audit . ..... ............... . ..*. 14 Past Operating Results ...................... 14 Performance under Loan 466-IC ............. .... 15 Present Financial Position .......... .......... 15 Financing Plan .............................. 16 Future Earnings . .. ....... .. 18 Proposed Rate of Return Covenant .. .......... 18 Future Financial Position *..... ................ 18 Debt Service Covenant ....................... 19 Guarantee Agreement .... . .............. . 19 8. AGREEMENTS REACHED AND RECOMMENDATIONS ...... 19 ANNEXES 1. Power Stations of Publ'c Utilities in Iceland 2. Extracts from NPC Act and Regulations 3. Power Stations of the Southwest Interconnected System 4. Description of Sigalda Development 5. Estimated Construction Costs 6. Estimated Schedule of Disbursements 7. Extracts from Environmental Impact Statement 8. NPC Actual Energy Sales and Generation 1963-1972 9. N?C Energy Sales, System Maximum Demand and Capability 10. NPC Forecast Energy Sales and Generation 1973-1985 11. Alternative Sales Forecasts 12. Comparison of Alternative Development Strategies 13. Economic Rate of Return 14. Assumptions Underlying Financial Forecasts 15. NPC T a-iffs 16. Long-Term Debt Outstanding at December 31, 1972 17. Actual and Estimated Income Statements 1972-1980 18. Actual and Estimated Balance Sheets 1972-1980 19. Estimated Sources and Applications of Funds 1973-1980 MAPS Iceland - Power Stations of Public Utilities (IBRD 10393) Iceland - Southwest Interconnected System (IBRD 10394)  ICELAND APPRAISAL OF ThE SIGALDA HYDROELECTRIC PROJECT OF LANDSVIRKJUN (THE NATIONAL POWER COMPANY) SUMMARY AND CONCLUSIONS i. This report appraises a Project for the construction of the Sigalda hydroelectric power station and associated transmission in southwest Iceland at an estimated cost of US$56.4 million (including contingencies), of which US$39.1 million is for civil works, US$14.3 million for electrical and mechan- ical equipment and US$2.9 million for transmission. A Bank loan of US$10 mil- lion is proposed towards the foreign exchange costs of the civil works and consultants' services totalling US$22.7 million out of the total foreign ex- change costs of US$35.5 million. ii. The power sector has a key role to play in the Icelandic economy, since Government efforts to diversify economic activity and exports depend mainly on the development of power-intensive industries utilizing the coun- try's abundant hydropower resources. In addition to meeting normal load growth in southwest Iceland, where over 70% of the national population re- side, the Project would make additional power available for existing and possible new power-intensive industries. iii. The Project would form part of the interconnected power system in southwest Iceland which accounts for nearly 90% of the electrical demand and which is operated by the National Power Company (NPC). Electricity consump- tion in the NPC service area has been growing at nearly 14% p.a. over the last ten years. This relatively high growth rate reflects the establishment of an aluminum smelter in 1969, which by 1972 accounted for over 50% of NPC sales. The growth rate is expected to be at least 10% p.a. over the next five years and additional generating capacity will be needed by the end of 1976 to meet this growth. The growth rate could be appreciably higher if new power-intensive industries are attracted as a result of the Project. The Project would provide two 50-MW units plus a 35-km double-circuit trans- mission link to the interconnected system. The first unit would be installed by October 1976 and the second by April 1977. This should meet the growth of demand to 1979 when a third 50-MW unit (not part of the Project) would be added at Sigalda. iv. Sigalda was selected as the next hydro development after detailed studies of alternative sites by NPC and its consultants over a period of years. Comparison with various alternative thermal developments indicates that it is the least-cost means of meeting the forecast requirements at discount rates up to 13.2%, which is above the estimated opportunity cost of capital in Iceland of about 8%. The estimated economic return on the Project is 10.7%. v. The civil works contract has been awarded in accordance with the Bank Guidelines for Procurement. The electrical and mechanical equipment contract has also been awarded following evaluation of international tenders with long-term financing.  vi. There have been two previous Bank power loans in Iceland, the first in 1951 (Loan No. 46-IC for US$2.45 million) for the construction of hydro- electric facilities and the second in 1966 (Loan No. 466-IC for US$18 mil- lion) for the Burfell hydroelectric project, which made possible the estab- lishment of the aluminum smelting industry in Iceland. Both projects were completed successfully and are operating satisfactorily. vii. The borrower would be NPC, a public utility established by law in 1965, which is owned 50:50 by the state and the city of Reykjavik. NPC is well managed but there is room for improvement in the organization of the sector as a whole, which is unduly fragmented at present. At the Bank's suggestion the Government has agreed to continue and expand, with the as- sistance of consultants, studies aimed at improving sector organization. viii. The Project comprises the bulk of NPC's 1973-77 construction pro- gram, of which the proposed Bank loan would finance 14%, suppliers' credits 13%, other borrowings 54%, equity contributions 6%, and self-financing 13%. The internal cash generation is rather low, despite a tariff increase of 20% effective December 1, 1973 and three further increases of 10% each assumed from June 1, 1974, May 1, 1975 and January 1, 1976, because 71% of NPC's sales at present go to two industries (aluminum smelter (ISAL) 63% and fertilizer plant 8%) on fixed tariffs operative till 1984, leaving only a comparatively small residual market to support expansion of facilities. However, the level of cash generation is acceptable considering NPC's high debt service obliga- tions and the fact that Sigalda represents a large addition to its system. The financing plan is dependent on NPC's ability to raise medium-term loans of at Least US$13 million in 1973-76 to be repaid from bond issues totalling US$25 million in the period through 1977. The arrangements for raising the medium- term loans are well under way. As regards the bond issues, NPC's investment bankers have expressed confidence in their ability to sell bonds for these amounts over the next three to four years in the prevailing market conditions. Throughout the construction period, NPC will be short of cash, the yearly internal cash generation being inadequate to meet the current debt service obligations including repayments of medium-term finance in 1973, 1976 and 1977 and barely adequate in '1974 and 1975. During negotiations, Government agreed to ensure that all necessary funds for the Project's timely completion would be made available in the event of NPC's inability to raise them. ix. Loan 466-IC recuires NPC to earn a return of 8% on realistically valued net fixed assets from 1973 onwards, a requirement which the company will fa'l short of by about 2% in 1973. During negotiations, NPC agreed to specific rates of return for the years 1974-77 ranging from 7% to 9.5% and 8% thereafter. Tariff increases of 10% are considered necessary in 1974, 1975 and 1976 to achieve these rates of return. Government has also confirmed its intention to continue and expand, with the assistance of consultants, its studies of the existing structure of power tariffs in Iceland. x. Tn view of the agreements reached with the Government and NPC as set forth in Section 8, the Project is suitable for a Bank loan to NPC of US$10 million for a term of 25 years including a 4-year grace period.  ICELAND APPRAISAL OF THE SIGALDA HYDROELECTRIC PROJECT OF LANDSVIRKJUN (NATIONAL POWER COMPANY) 1. INTRODUCTION 1.01 This report appraises a Project comprising the Sigalda hydroelec- tric development with two 50-MW units plus associated transmission to be con- structed between mid-1973 and 1977 by Landsvirkjun (the National Power Com- pany - NPC), a publicly owned utility set up in 1965. NPC operates the in- terconnected system supplying bulk power in southwest Iceland. The estimated cost of the Project is US$56.4 million equivalent. The proposed Bank loan of US$10 million would cover 44% of the foreign exchange cost of the civil works and consultants' services totalling US$22.7 million. NPC would be the borrower and the Government of Iceland the guarantor. 1.02 The Project is the next major stage in NPC's development program. In addition to meeting normal load growth in southwest Iceland, the Project would furnish additional power required for the expansion of an existing aluminum smelter and fertilizer plant. A third 50-MW unit would be added later. 1.03 Following the completion of the Burfell project in 1969, NPC en- gaged Electro-Watt Engineering Services Ltd. of Switzerland (EWI) as consul- tants to prepare a feasibility report on the Sigalda development; the report was submitted in February 1971. The same consultants were asked to prepare bidding documents. NPC has kept the Bank informed of the Project from an early stage and has asked the Bank to comment on technical matters. A Bank preappraisal mission in October 1972 led to the present appraisal. 1.04 The Bank has made two previous power loans in Iceland as follows: (a) Loan 46-IC of US$2.45 million to the Government in 1951, re- lent to two publicly owned utilities for construction of hydro- electric facilities; (b) Loan 466-IC of US$18 million in 1966 to NPC for construction of the Burfell hydroelectric project. Both these projects were completed successfully and are operating satisfac- torily. 1.05 This report has been prepared by Messrs. T.B. Russell, I. Mathai and H. Huang (consultant). It is based on information obtained by a Bank mission consisting of Messrs. Russell, D.C. Jones and Huang, who visited Iceland between January 16 and February 10, 1973, on further data obtained by Mr. Jones on a second visit in April, 1973 and on information provided by NPC and its consultants.  -2- 2 THE COUNTRY AND THE ECONOMY The Country 2.01 Iceland is an island of volcanic origin on the North Atlantic ridge close to the Arctic Circle. It has an area of about 103,000 km2, con- sisting of a coastal plain and a central plateau 640 to 760 m high, ringed by mountains rising to over 2,000 m, including active volcanoes. Although there are numerous rivers and lakes, the country is mostly barren, only about 20% of the land area being suitable for agriculture or grazing. The climate is milder than the northern location would suggest, owing to the influence of the Gulf Stream. The Economy 2.02 The structure and development of the economy have been conditioned by the relatively small population base and the limited natural resources. The present population is about 211,000, roughly two-thirds urban and one- third rural. The overall growth rate is about 1.2% p.a. but urban popula- tion has been growing at 1.7% p.a. Average population density is only 2 per km2, making Iceland the most sparsely populated country in Europe, with a correspondingly limited domestic market and difficult communications. Over 70% of the population inhabits the southwestern region of the country, the area served by NPC and the proposed Project. This region includes Reykjavik, the capital, with a population of over 80,000. The active labor force totals about 84,000 and is expected to reach nearly 100,000 by 1981. Unemployment, now 0.5%, has been virtually non-existent for the last 25 years except during 1967-69, when it rose to 2.5% (1969 average). 2.03 Apart from its rich coastal fishing grounds and the grasslands which support the livestock industry, Iceland's only significant natural resources are its hydropower potential and geothermal energy sources (paras. 3.01-3.02). It is the only country in Western Europe with untapped, relatively low-cost hydropower reserves. There are no known mineral deposits of commercial sig- nificance except for diatomite, used commercially as a filtration agent. 2.04 Fishing and agriculture (mainly sheep and dairy farming) have been the traditional mainstays of the economy. Fish products account for 80% of merchandise exports but this has made the economy vulnerable to the vagaries of the fishing industry. Thus, GNP, which has grown at an average rate of about 5% p.a. over the last 20 years (resulting in GNP per capita of US$2,652 1/ in 1972), actually declined in real terms in 1967 and 1968 largely because of falls in fish revenues, while recurrent fishing booms have been a major factor in continuous inflation, w'hich has averaged about 11% p.a. since 1950. In recent years, therefore, the Government has made increasing efforts to diversify the economy, particularly by encouraging the establishment of energy-intensive industries to utilize the country's low-cost hydropower and geothermal resources. 1/ World Bank Atlas method.  -3- As a result the share of agriculture and fishing (including fish processing) in GNP fell from 27% in 1966 to 20% in 1971, while that of manufacturing rose from 14% to 19%, reflecting largely the establishment of the aluminu- -e'_ ing industry in 1969. The Sigalda Project would provide power for a further extension of the aluminum smelter, for increased fertilizer production and also for possible new power-intensive industries, notably a ferro-silicon plant (para. 6.02). 3. THE SECTOR Energy Resources 3.01 Iceland has large unexploited resources of hydropower and geothermal energy. The technically exploitable hydropower reserves are estimated at 35,000 GWh under normal hydrological conditions, equivalent to 4,000 MW of continuous capacity. About 18,000 GWh could be harnessed economically with- out creating environmental problems. Only a fraction of this potential has been developed to date. Total installed hydropower capacity is 364 MW, over 90% of it (336 MW) in the southwest region served by NPC. Hydro plants ac- count for about 96% of total electricity supplies. 3.02 Estimated reserves of geothermal energy are roughly equal to the hydro reserves on a heat equivalent basis. Exploitation to date has been mainly for domestic heating and hot water, about 50% of the homes in Iceland being supplied, including 95% in Reykjavik. Geothermal heat is also used for small-scale commercial production of vegetables and fruit under glass. The only industrial processing application to date is for the diatomite plant at Lake Myvatn but research is being done on other possible industrial applica- tions. A 2.6 MW pilot power plant in northern Iceland uses geothermal steam but the feasibility of larger plants remains to be confirmed. 3.03 The only known fossil fuels are commercially unexploitable peat and lignite deposits. All oil requirements are imported as refined products, mostly from the USSR in barter exchange for fish products and textiles. Organization of the Power Sector 3.04 The power industry in Iceland is governed by the Energy Law of 1967 (Law No. 58). This created the National Energy Authority (NEA), whose func- tions include advising the Minister responsible for power (presently the Min- ister of Industry), basic investigations of energy resources, long term plan- ning and coordination of the energy sector, inspection of power plants and heating systems, and collection and publication of statistics. 3.05 The Law also reorganized the State Electric Power Works (RARIK), whose main function is to promote electrification in rural areas. Operating over the whole country, RARIK may generate power itself and purchase power in bulk from other utilities for sale to other undertakings or directly to individual consumers.  - 4- 3.06 The Law also established an Energy Fund, used mainly to finance rural electrification (para. 3.13). The Fund's main sources of income are state budget appropriations, including the proceeds of the price equaliza- tion tax (para. 7.06), and RARIK's profits. The Fund makes loans or grants to RARIK or other utilities for new power plants or systems and makes loans to individual farmers for hydro or diesel plants for domestic use. It fi- nances investigations of hydro resources by NEA and of geothermal resources by NEA and others. 3.07 There are 26 electric utilities. One (RARIK) is state-owned, two (NPC and Laxarvirkjun, which is owned by the state and the City of Akureyri) are under joint state-municipality ownership and 23 are owned by municipalities. 3.08 Most of the municipal utilities take bulk supply from NPC, Laxarvirkjun or RARIK. The two most important are the power undertaking of Reykjavik, which serves about 43,000 consumers with power purchased from NPC, and the power un- dertaking of Akureyri, which buys power from Laxarvirkjun. Existing Power Facilities 3.09 As of the end of 1972) there were 64 public utility power plants in Iceland with a total installed capacity of 454 MW. 1972 energy genera- tion was 1,768 GWh (96% hydro, 4% thermal). Details of capacity and genera- tion are shown at Annex 1 and power plant locations on the map (Power Sta- tions of Public Utilities). 3.10 Besides the public utility plants there are many small power in- stallations owned by farms, schools, commercial undertakings and industries with a total capacity of about 20 MW (hydro 16%, diesel 84%). Growth of the Power Sector 3.11 Electricity production by public utilities in Iceland rose from 641 GWh in 1963 to 1,768 GWh in 1972, equivalent to an average annual growth rate of 11.9%,, and installed capacity from 147 MW to 454 MW. Most of the growth occurred in the last three years of the period following the start- up in 1969 of the aluminum smelter operated by Icelandic Aluminium Company Ltd. (ISAL), a wholly-owned subsidiary of Swiss Aluminium Ltd. Excluding smelter demand (771 GWIh in 1972), the average annual growth rate was only 5%. Production per capita rose from 3,456 kWh to 8,405 kWh (4,740 kWh ex- cluding the smelter). Electricity generation in southwest Iceland rose from 76% of the national total in 1963 to 87% in 1972 as a result of the smelter demand. Investments in the power sector during 1968-72 totalled tKr 6,808 million, about 11% of the national total. Scope for North-South Interconnection 3.12 The load growth in the north, including tne country's second largest city of Akureyri, has been about 11.6% p.a. There are 19 power plants with a total capacity of 34 lw owned by Laxarvirkjun (65%), RARIK (19%) and munic- ipal utilities (16%). Most of them will be interconnected in 1973. Because  of strong opposition by local salmon interests to a proposed hydro development, load growth will probably have to be met by additional diesel installations or by interconnection with the NPC system. The NPC Act empowered Laxe':vii to merge with NPC (see Annex 2). The merger has not been carried out, apparently for political reasons. Extension of the NPC system to the north, with or with- out the merger, would be beneficial to the country since the north would bene- fit from the low cost hydroelectric generation in the southwest, and the addi- tional load would make Sigalda even more economical. Rural Electrification 3.13 All towns and villages have public electricity supply. Under a pro- gram launched in 1952 more than 4,000 farms (over 80% of the national total) were connected to public electricity supply by 1971. The present program is to connect nearly 800 more in the period 1972-74, including about 130 in the southwest region. When this program is complete only about 160 farms, repre- senting 0.3% of the population, will remain unconnected to the public supply. Study of Power Sector Organization 3.14 Although Iceland has made impressive progress in the electrification of the country, the power sector at present is unduly fragmented and there is scope for rationalization to improve its effectiveness. Closer integration of power generation, transmission and distribution under a single agency should be practical and economic. This would reduce overall utility operating costs, improve service to consumers (through more extensive interconnections) and facilitate development planning of the sector. During negotiations the Gov- ernment confirmed its intention to continue and expand, with the assistance of consultants, studies currently being undertaken on the organization of the power sector with a view to improvement. 4. THE BORROWER Legislation 4.01 In accordance with Act No. 59 of May 20, 1965, the Government of Iceland and the city of Reykjavik concluded an equal partnership agreement on July 1, 1965 establishing NPC, which began operations on January 1, 1966. Its main objects (see Annex 2) are to construct and operate generation and transmission facilities and to sell power wholesale to municipal distribu- tion systems and RARIK. With the permission of the responsible Minister it may also sell power directly to industrial enterprises utilizing more than 100 GWh annually. 4.02 NPC acquired the assets and liabilities of the former Sogsvirkjunin, a company jointly owned by the state and the city of Reykjavik, including three hydro stations and a thermal station.  -6- 4.03 Subsequent legislation empowered NPC to develop the Tungnaa River, a tributary of the Thjorsa, at Sigalda and Hrauneyjafoss and increased the Government's capital contributions to NPC and the amount of the Government guarantee for the Burfell and Tungnaa River projects. 4.04 NPC is exempt from paying import duties and sales taxes on materials, equipment and machinery for authorized projects, and also from state income tax, stamp tax, municipal tax and other charges. Organization and Management 4.05 I'PC is an autonomous Government agency, governed by a Board of six Directors and a Chairman, appointed for six-year terms (renewable). The Althing (the Icelandic Parliament) and the City Council of Reykjavik each elect three Directors. The Chairman is jointly appointed by the Government and the City Council or, in the event of disagreement, by the Supreme Court. 1/ The pres- ent Board is representative of the political and business community. The present Chairman is concurrently Governor of the Central Bank of Iceland. 4.06 The Board has supreme authority for the operations of NPC, but must obtain the approval of the Minister for constructing new power plants and main transmission facilities and for concluding long-term contracts with large in- dustrial enterprises. The Board is empowered to set wholesale tariffs, after consultation with the Economic Institute, so as to obtain a reasonable return on investment and earn an adequate surplus for supporting expansion. However, under the present system of price controls introduced to restrain inflation, Government approval is required for tariff revisions. 4.07 The Board appoints the General Manager of NPC and, on his recommenda- tion, a Deputy General Manager and three heads of departments (Administration, Engineering and Operations). 4.08 NNC is well managed and has an efficient staff consisting of about 70 permaaent employees. The present General Manager is an electrical engineer with extensive administzative and engineering experience. To assist the con- sultants in the design and construction of the Project, NPC proposes to recruit additional staff, as part of its training program. Existing Facilities 4.09 The NPBC facilities consist of six power stations with a total capac- ity of 383 MW, including the 240-MW Burfell station, which began operation in 1969. Power is transmitted to the main Geithals substation in the Reykjavik area through two single-circuit 220-kV lines completed respectively in 1969 and early 1973. 11 These arrangements would be changed in the event of a merger between Laxarvirk.jun and NPC (see para. 3.12 and Annex 2).  - 7 - 4.10 NPC completed a storage project at Lake Thorisvatn in 1972. The water flow of the Kaldakvisl River is diverted by two dams and a canal into the lake, as shown on the map (Southwest Interconnected System). A str-s- capacity of 1,000 million m3 in the lake is available to regulate thL naLa,ra. flow for the benefit of Burfell and later of Sigalda and other downstream plants. 4.11 In addition to the above, there are five small power stations owned by other organizations, totalling about 18 MW, connected to the southwest power system. 4.12 Details of the power facilities are given in Annex 3 and their location is shown on the map (Southwest Interconnected System). Operations 4.13 NPC sells bulk power to the municipal undertakings of Reykjavik and Hafnarfjordur. NPC also supplies power wholesale to RARIK, which in turn sells in bulk to 12 municipal utilities in the southwest region and directly to the NATO base at Keflavik. These three customers of NPC constitute the so-called "iordinary market" for power. The Icelandic Aluminium Company Ltd. (ISAL) and the state-owned fertilizer factory are the only two industrial enterprises to which NPC supplies power directly. 4.14 In 1972 NPC generated 1,495 GWh (99.7% hydro) and sold 1,408 GWh.. In 1973 sales are expected to increase to 1,870 GWh, of which 29% would be to the ordinary market (Reykjavik 16%, Hafnarflordur 2%, RARIK 11%) and 71% direct to industry (ISAL 63%, fertilizer plant 8%). Development Program 4.15 NPC's present development program calls for installation of two 50-MW units at Sigalda in 1976-77 and a third in 1979 (para. 5.10). NPC tentatively plans to develop another downstream hydro site on the Tungnaa River at Hrauneyjafoss with an ultimate installation of three 54-MW units. Given the energy capability of Sigalda in relation to forecast load growth, construction of the Hrauneyjafoss plant should be deferred until after the installation of a fourth unit at Sigalda (which could be in 1982 -- see Annex 12), unless the load should grow faster than expected - with the materializa- tion, for example, of the proposed ferro-silicon project (para. 6.02) or with the addition of the northern market (para. 3.12). 4.16 The Thjorsa River system possesses half of the country's hydro po- tential. According to preliminary studies ten major sites in addition to Burfell and Sigalda, as shown on the map (Southwest Interconnected System), could be developed to a total capacity of over 800 MW. Because of their favorable location NPC plans to concentrate its further development efforts on these sites for meeting its longer-term needs.  -8- 5. THE PROJECT Deseription 5.01 The Project would comprise: (a) the construction of the Sigalda hydroelectric scheme with two 50-MW generating units; (b) the construction of a 35-km long double-circuit 220-kV transmission line from Sigalda to Burfell with associated tie-in equipment; and (c) the provision of consulting services for the above. The Sigalda development is described in detail in Annex 4. It is located on the Tungnaa River, a tributary of the Thjorsa River in southwest Iceland, and is about 40 km upstream of Burfell. At the site the Tungnaa loops around a rocky ridge in rapids and waterfalls with a drop of about 55 m which would be harnessed by the development. The main features would consist of: (a) a rackfill dam with a maximum height of 44 m and crest length of 1,050 m with upstream asphalt facing; (b) a 1,020 m headrace canal; (c) a surface powerhouse controlled from Burfell with two 50-MW units operating under about 70 m head, with provision for a third; and (d) a 550 m tailrace canal. The dam and other structures have been designed with due consideration for seismicity. With three units installed the Sigalda development will increase the firm energy of the existing system by 750 GWh p.a. Power will be trans- mitted to Burfell by the 35-km 220-kV line and thence fed into the existing system. Cost Estimate 5.02 A detailed cost estimate, with explanatory notes, for the Sigalda development (three 50-MW units) is shown in Annex 5. The total construction cost, covering the period to 1980, is estimated at US$68.5 million including expenditures incurred up to the end of 1972 but excluding interest during construction. 5.03 The bulk of the total construction cost would be incurred during the period 1973-77 for the installation of the two units plus transmission comprising the Project. The estitaated cost of the Project, also shown in Annex 5, is US$56.4 million, as summarized below:  -9- IKr (millions) US$ Equivalent (thousands) Local Foreign Total Local Foreign Total (a) Civil Works 1,040 1,654 2,694 11,886 18,903 30,789 (b) E & M Equipment 159 967 1,126 1,817 11,051 12,868 (c) Transmission System 62 156 218 708 1,78 24 Sub-total 1,261 2,777 4,038 14,411 31,737 46,148 (d) Contingencies Physical 116 221 337 1,326 2,526 3,852 Price 449 108 557 _ 1,234 6,365 Total Cost of Project 1 3_106 4 932 20 868 35 497 56 365 z~ .a' ' .' - L_ Engineering costs of US$4,525,000, including US$2,960,000 foreign costs, are included in items (a), (b) and (c) above. 5.04 The costs of the civil works and the E & M equipment are based on actual bid prices. Physical contingencies are 10% for civil and 5% for equip- ment and transmission. Price contingencies on local costs are 16% p.a. for civil and 11% p.a. for equipment and transmission. Price contingencies on foreign costs are 4% for all items. High price contingency percentages on local costs are adopted to cover possible inflation in Iceland during the construction period. Amount of Loan 5.05 The proposed Bank loan of US$10 million would cover about 47% of the foreign exchange cost of the civil works excluding engineering (US$19.7 million 1/) and 25% of the foreign exchange cost of the consultants' services (US$3 million), or 44% of the total (US$22.7 million). Suppliers' credits of about US$8.8 million would finance 80% of the foreign exchange cost of the E & M equipment excluding engineering (US$11 million). Other financing requirements would be met as shown in paragraph 7.21. Status of Engineering, Procurement and Disbursement 5.06 In 1970 and 1971, NPC engaged Electro-Watt Engineering Services Ltd. of Switzerland (EWI) in association with Virkir H.F., an Icelandic consulting firm, to submit a feasibility report on the Sigalda development and to prepare 1/ US$18,903,000 less US$1,874,000 for engineering plus $2,674,000 for physical and price contingencies (see Annex 5).  - 10 - the related bidding documents. With the Bank's agreement NPC has appointed the same consultants to make detailed designs and assist in the supervision of construction work. 5.07 Bidding on the civil works followed the Bank Guidelines for Pro- curement. International competitive tenders with long-term financing were invited for the E & M equipment. NPC will engage local consultants for the transmission system, for which selected international bids will be invited. 5.08 The civil works' bidding documents were issued in September 1972 and tenders were received in April 1973. NPC awarded the contract to Energoprojekt of Yugoslavia in July 1973 after review by the Bank. The equipment contract was awarded to a consortium of Brown Boveri of Germany and Energomachexport (USSR). 5.09 it is recommended that the proceeds of the proposed loan be dis- bursed against 50% of the foreign exchange cost of the civil works contract and 25% of the foreign exchange cost of consultants' services. Disbursements are expected to be completed by December 1977 as shown in the Estimated Schedule of Disbursements (Annex 6). There will be no retroactive financing nor unallocated category. The above percentages will be adjusted in the final disbursements so that the full amount of the loan is utilized. No savings are therefore anticipated. Construction Schedule 5.10 Civil construction work has begun in the fall of 1973. No major difficulties are foreseen and completion is expected in about three years. The first unit would begin commercial operation by October 1976, ready to meet the winter peak (November-December), and the second by April 1977. According to the present loed projection the third unit would not be required until 1979 and NPC has agreed during negotiations to exercise its option to uefer del ivery c.f this unit to not earlier than October 1, 1979 unless the Bank agrees otherwise. Work on the transmission system would be phased to fit in ;K'ith che above schedule. Project Maintenance 5.11 NPC has agreed during negotiations to engage experienced consultants to assist its staff in preparing maintenance programs for the dam, reservoir and '.aterways of the Project and of the Burfell project respectively. 1/ These programs should specify the detailed items to be checked on periodic inspections. NPC will prepare the programs not later than one year prior to the expected completion of the Project and will submit them to the Bank for review and approval.. NPC proposes to engage EWI and Harza Engineering Company International for these tasks. 1/ The small cost involved has been included in the cost estimates for the Project.  - 11 - Ecological Aspects 5.12 As required by Icelandic law the Iceland Conservation Council has reviewed the environmental impact of the Project and has confirmed that there are no objections on ecological grounds (see Annex 7). The site is in a re- mote, uninhabited part of the country, where the land to be flooded is un- suitable for farming, and does not include any sites or areas of conservation interest. There are no traditional fishing rights in the area with which the proposed dam and reservoir might interfere. Conservation interests and natural resources downstream of the Project would not be adversely affected. The short transmission line to link Sigalda and Burfell passes through un- inhabited country where amenity considerations are minimal. 6. JUSTIFICATION OF THE PROJECT Market Growth 6.01 The Project would form part of NPC's interconnected system serving southwest Iceland. This area contains about 70% of the total population and accounts for nearly 90% of total electricity production. It includes the capital, Reykjavik, where most of the commercial and industrial development of the country is concentrated. Two major power-intensive industries, alumi- num smelting and fertilizer production, are located in this area. The aver- age annual growth rate of electricity sales in the system since 1963 has been about 13.7%. Excluding sales to the two power-intensive industries the growth rate has been 5.4%. The detailed figures by consumer category are shown in Annex 8, together with the corresponding trend in generation. The trend of maximum demand is shown in Annex 9. 6.02 For forecasting purposes NPC analyzed the power market into (a) the ordinary market, comprising bulk sales to the two distribution undertakings (Reykjavik and Hafnarfjordur) and to RARIK; (b) the power-intensive indus- tries; and (c) the new domestic space heating market which it is intended to promote. The NPC forecast implied an average growth rate for the ordi- nary market of 6.5% p.a. and additional requirements, commencing in 1977, of 160 Xl (half firm, half interruptible) for the aluminum smelter and 40 GWh for the fertilizer plant. A market survey indicated an additional space heating market of 35 GWh in 1976 rising to 280 GWh in 1983. After reviewing this NPC projection the mission made its own forecast, as shown in Annex 10. This resulted in a slightly slower growth rate than in the NPC forecast but confirmed the need for additional capacity in 1976. To allow for uncertainty a "high" and a "low" forecast were also made. The main feature of the "high" forecast was the inclusion of a large additional power-intensive load for a proposed ferro-silicon plant (see Annex 11), the prospects for which look promising.  - 12 - Comparison of Alternatives 6.03 Studies of alternative hydro sites by NPC and its consultants led to the conclusion that Sigalda would be the best hydro development, partly because it would reduce icing problems at Burfell, thus improving the relia- bility of that station under severe weather conditions. 6.04 The adopted unit size of 50 MW for the Project represents about 10% of the total system capacity after Project completion and fits in well with the demand growth. 6.05 To confirm that Sigalda was the least-cost solution, four alterna- tive programs based on the installation of different types of thermal genera- tion units were compared with the proposed program. On the main demand fore- cast, the equalizing discount rates were found to range from 13.2% to 17.1%, indicating that the proposed program with the Sigalda development would be more economic than any of the four thermal alternatives for discount rates up to at least 13.2% (see Annex 12 for details). 6.06 The sensitivity of the equalizing discount rate of 13.2% between Sigalda and the best thermal alternative (4 x 25-MW gas-turbines and 2 x 50-MW steam-turbines) was tested for variations in the assumptions regarding market growth, capital costs and fuel costs. As shown in Annex 12, this resulted in an upper limit of 23.7% and a lower limit (if all the less favorable assump- tions are combined) of 9.4%, which is still above the estimated opportunity cost of capital in Iceland of about 8%. Economic Rate of Return 6.07 The economic rate of return on the Project is estimated to be at least 10.7% (see Annex 13). The quantified benefits consist of attributable NPC revenues (including sales tax) from incremental sales to the ordinary market and power-intensive industries; net benefits from additional sales of electricity for domestic space heating, compared with the alternative of oil- fired heating; extra taxes payable by ISAL; extra revenue from the shipment by Icelandic vessels of raw materials and finished aluminum on behalf of ISAL; extra wages earned by the additional workers employed by ISAL compared with what they could earn in alternative employment; and the savings in power sys- tem operating costs through reduced icing at Burfell station when Sigaida is in operation. The estimated rate of return of 10.7% understates the true re- turn to the economy since it takes no account of unquantifiable benefits, such as the reduction of air pollution resulting from the substitution of hydro- electric space heating for oil-fired heating. 6.08 Sensitivity tests (see Annex 13) indicated that the rate of return is relatively insensitive to individual changes in the values assumed for the main variables (load growth, capital costs, tariffs and oil price). Even if all the less favorable variations are combined, an unlikely contingency, the rate remains above 8%, and it is nearly 14% if the more favorable assumptions are taken together.  13 - 7. FINANCIAL ASPECTS Tariffs 7,01 Under the existing law and regulations, NPC fixes its tariffs to cover amortization in excess of depreciation and interest on its own funds, secure a reasonable return on capital and provide runds for expansion. NPC's autonomous power to set tariffs is currently inoperative because of general price controls requiring government approval for all price increases. Under Loan 466-IC, NPC is required to fix tariffs at a level which will provide a return of 3% from 1973 on realistically valued fixed assets in operation at the beginning of each year. Details of existing tariffs are given in Annex 15. 7.02 Under a tripartite agreement between ISAL, NPC and Government, made in 1966 when the Burfell project w'as under consideration, ISAL pays for supplies to the aluminum smelter at 3.0 US mils per kWh until September 30, 1975 and at 2.5 US mils per kWh thereafter. These charges fully cover present annual costs of Burfell but are fixed for a 25-year period with provision for revision only after 15 years to cover increases in operating expenses. The cost of new de- velopment will therefore fall almost entirely upon consumers in the ordinary market. 7.03 Simultaneously with the radouction of *zhe ISAL tariff from 3 US mils per kWh to 2.5 US mils on October 1. 1975, the Government will, under the agreement, increase its tax on ISAL's production by the equivalent of 0.5 US mils/kWh i.e. the Government takes vwhat NPC loses. NPC hopes to reach revised agreement with ISAL and Government unider whichithe present price will continue. During negotiations, Government and NPC agreed to seek revision, in collabora- tion with Alusuisse, of the present agreement with ISAL. 7.04 Extension of ISAL's second potline by 40 pots, planned for 1977, will require an additional 20 MW of power (part firm and part interruptible). NPC has still to negotiate the price of this power but an average of 4 US mils has been used in the financial forecasts and economic return calculations. During negotiations, NPC confirmed its intention to negotiate a price from ISAL which would give an adequate return and also to provide for future adjustments in the light of increases in production costs or significant variations in currency values. NPC also confirmed its intention to provide for such price adjustments in any similar contracts in future. 7.05 The fertilizer plant has a contract with NTPC to take up to 185 GWI p.a. at the same tariffs as apply to ISAL under the latter's existing contract. 7.06 NPC pays into the Energy Fund (para. 3.06) a price equalization tax of IKr 383 per kW of power and IKr 0.01 per kWh of energy for financing rural electrification. Efforts to have the tax removed have so far been unavailing. During negotiations, NPC confirmed its intention to seek the repeal of, or exemption from, the tax from January 1, 1974.  - 14 - 7.07 NPC raised its tariffs 20% on March 1, 1973, but Government ordered a 2% reduction effective May 7, 1973 as part of an overall anti-inflation plan. The forecasts assume four tariff increases, 20% from December 1, 1973 and 10% each from June 1974, May 1975 and January 1976, which would enable NPC to earn the rates of return agreed during negotiations for the Project period (8% in 1974, 9.5% in 1975, 8.5% in 1976 and 7% in 1977). Government has already approved the 20% increase effective December 1, 1973. During negotiations NPC confirmed its intention to revise tariffs periodically to take account of the rising costs of supply and Government confirmed its recognition that measures of this kind would be necessary for NPC to meet its obligations under the proposed loan. 7.08 To make full use of the power which would be available from Sigalda, NPC hopes to extend the market for electric space heating (para. 6.02) by offering a promotional price of IKr 0.80/kWh, i.e. about 52% cheaper than ordinary market tariffs. 7.09 The above highlights the need to extend the studies currently under way of all existing power tariffs in Iceland (including retail tariffs). The main objective of these studies is to devise tariffs which take into account the costs of supply to the various categories of consumers and the financial needs of the power utilities. During negotiations, Government confirmed its intention to continue and expand its studies in this direction with the as- sistance of consultants. Accounts and Audit 7.10 NPC's accounting arrangements are adequate. With only five con- sumers, there are no billing or collection problems. The small finance de- partment is efficiently run, and the annual financial statements are well presented. The accounts are audited by an independent Icelandic firm of accountants, which is satisfactory. Past Operating Results 7.11 Since starting operations in January 1966, NPC's main activity has been the construction of Burfell concurrently with the establishment, by ISAL, of aluminum smelting facilities. During the latter part of 1972, both the power and the smelter facilities came fully into operation. 7.12 During 1969-1972 the company managed to break even and added only IKr 12.9 million to retained earnings. The return on fixed assets fell from 9.3% in 1969 to 4.2% in 1970 but rose to 6.3% in 1971 and 6.9% in 1972. 7.13 NPC began operations with very little cash working capital and has been beset by cash shortages ever since, necessitating considerable resort to bank overdrafts and short-term loans, e.g. IKr 24.7 million overdraft and IKr 117.5 million short-term loan at the end of 1972. The cash position has been aggravated by several factors. Firstly, costs have increased as a re- sult of inflation of over 10% per annum, not matched by tariff increases. Secondly, repeated devaluation of the Icelandic krona at about 7% annually  - 15 - on average from January 1969 has resulted in higher debt service require- ments, an acute problem when over 90% of the debt is in foreign currency. Thirdly, with an average life of fixed assets of about 35 years and an average term of loans of about 14 years, amortization of debt significantly outstrips depreciation accruals. 7.14 NPC's income statement for 1972 is given in Annex 17 and its bal- ance sheet as of December 31, 1972 in Annex 18. Performance under Loan 466-IC 7.15 NPC is required to set tariffs so as to earn, from January 1, 1973, an 8% minimum rate of return on fixed assets in operation at the beginning of each year. With a view to achieving this, NPC raised its tariffs 20% on March 1, 1973 (since reduced by 2%) and has agreed to raise them another 20% from December 1, 1973 (para. 7.07). 7.16 The fixed assets are required to be revalued from time to time to take account of any changes in currency valuations or significant changes in prices. Since January 1969, no such revaluations have taken place. External debts have been periodically revalued to take account of currency devaluations and the resulting loss included in the rate base, but this does not fully re- flect a realistic revaluation of assets based on general price level changes in the country. Based on a more realistic valuation of assets (paras. 7.19 and 7.20) and the proposed tariff increase, NPC is estimated to earn a return of only 5.8% in 1973, below the required 8%. During negotiations NPC agreed to specific rates of return for the years 1974-77 ranging from 7% to 9.5%, which would make up the 1973 shortfall (para. 7.27). Present Financial Position 7.17 Debts have been NPC's principal source of financing, as indicated by the debt/equity ratio of 86/14 at the end of 1972. Its loans bear interest rates varying from 2.5% to 9.5%. 7.18 NPC's fixed assets are substantially undervalued because of sig- nificant increases in Icelandic prices in the past as reflected, among other things, in several devaluations of the krona from IKr 43.00 to the US$ in 1966 to IKr 98.56 at the end of 1972. In 1967 and 1968, when the krona was devalued, NPC adjusted its fixed assets in the same proportion as the deval- uation, treating the excess of asset revaluation increase over the increase in foreign debts (IKr 109 million) as revaluation surplus. Plant values were increased by subsequent exchange losses; at the end of 1972 the total of such increases amounted to IKr 984 million. 7.19 A tentative revaluation of assets as of January 1, 1973 has been made during appraisal by revaluing local expenditure using annual coeffi- cients based on the housebuilding index, while increasing foreign expendi- ture, as already done by NPC, by the gross amount of devaluation loss at the end of 1972.  - 16 7.20 This results in an increase in net asset values of IKr 1,312 mil- lion 06%) over and above the adjustment made as at the end of 1972 (12%), raising total net asset values at the end of 1972 to IKr 7,966 million. '