China - Global Environment Facility (GEF) Trust Fund : Thermal Power Efficiency Project

Document of The World Bank FOROFFICIAL, USEONLY ReportNo: 47907-CN PROJECT APPRAISAL DOCUMENT ON A PROPOSED GRANT FROMTHE GLOBAL ENVIRONMENT FACILITY (GEF) TRUST FUND INTHEAMOUNT OF US$19.7 MILLION TO THE PEOPLE'S REPUBLIC OF CHINA FOR A THERMAL POWEREFFICIENCY PROJECT April 1,2009 Transport, Energy and Mining Sector Unit SustainableDevelopment Department East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective December 3 1,2008) CurrencyUnit = US$ RMB7.0 = US$l.O US$ = SDR1.O FISCAL YEAR January 1 - December31 ABBREVIATIONSAND ACRONYMS CHP CombinedHeadandPower IFC International FinanceCorporation CO2 CarbonDioxide IGCC IntegratedGasification CombinedCycle CPS Country PartnershipStrategy kWh Kilowatt-hour CRESP China Renewable Energy Scale-up MCSU Mechanismfor the Closure of Small Units Project M&E Monitoring andEvaluation DA DesignatedAccount MOF Ministry ofFinance EA Environmental Assessment MWh Megawatt-hour ECD Economic Construction Department NCB National Competitive Bidding EIA Environmental Impact Assessment NDRC National Development andReform EIRR Economic Internal Rate of Return Commission EMF Environmental ManagementFramework NOX NitrogenOxide EMP Environmental ManagementPlan O&M OperationalandMaintenance ESD EfficientFuelSavingDispatch PCO Project Coordination Office ESMAP Energy Sector Management PEO Project Executive Office Assistance Programme PMlO ParticulateMatter (particles of 10 FIRR Financial InternalRate of Return micrometersor less) F M Financial Management PMO Project Management Office FMM Financial ManagementManual PPG Project PreparationGrant FMR Financial ManagementReport RPF ResettlementPolicy Framework GDGP GuangdongPower GridCorporation SDFB Shandong Provincial FinanceBureau GDP Gross Domestic Product SERC State ElectricityRegulatory Commission GEF Global Environmental Facility SFCCD Strategic Framework on Climate Change and GOC Governmentof China Developmentfor the World Bank Group GHG Greenhouse Gas SXFB ShanxiProvincialFinanceBureau GJ Gigajoule SO2 Sulfir Dioxide GNP Gross National Product SOE Statement of Expenditure GW Gigawatt Tce Tons of Coal Equivalent GWh Gigawatt-hour TWh Terawatt-hour I A Implementing Agencies TSP Total SuspendedParticulate IBRD International Bank for Reconstructionand UNDP UnitedNations Development Programme Development USAID United States Agency for International ICB International Competitive Bidding Development IEA International EnergyAgency UNFCCC UnitedNations Framework Conventionon Climate Change VSD Variable SpeedDrive Vice President: James W. Adams Country Director: David R. Dollar Sector Director: John Roome Sector Managers: JunhuiWu, Ede Jorge Ijjasz-Vasquez Task Team Leader: Jie Tang  FOROFFICIAL USEONLY CHINA ThermalPowerEfficiencyProject CONTENTS Page I. STRATEGIC CONTEXT AND RATIONALE..................................................................... 1 A. Country and sector issues.................................................................................................... 1 B. Rationale for Bank involvement ......................................................................................... 4 C. Higher level objectives to whichthe project contributes .................................................... 4 I1. PROJECT DESCRIPTION..................................................................................................... 5 A. Lending Instrument.FinancingArrangements and Other Approaches .............................. 5 B. Project development objective and key indicators.............................................................. 6 C. Project components ............................................................................................................. 6 D. Lessons learned reflected inthe project design .................................................................. 7 E . Alternatives considered and reasons for rejection.............................................................. 8 I11. IMPLEMENTATION......................................................................................................... 9 A. Partnership arrangements (ifapplicable) ............................................................................ 9 B. Institutional and implementation arrangements .................................................................. 9 C. Monitoring and evaluation o f outcomes/results................................................................ 10 D. Sustainability and replicability ......................................................................................... 10 E. Critical risks and possible controversial aspects............................................................... 12 F. Loadcredit conditions and covenants............................................................................... 13 IV. APPRAISAL SUMMARY ............................................................................................... 13 A. Economic andfinancial analyses...................................................................................... 13 B. Technical........................................................................................................................... 14 C. Fiduciary ........................................................................................................................... 15 D. Social................................................................................................................................. 17 E. Environment...................................................................................................................... 19 F. SafeguardPolicies............................................................................................................. 20 G. Policy Exceptions and Readiness...................................................................................... 20 I I This document has a restricted distribution and may be used by recipients only in the performance o f their official duties.Its contents may not be otherwise disclosed without World Bank authorization.  Annex 1: Country and Sector or Program Background................................................................ 22 Annex 2: Major RelatedProjectsFinancedby the Bank and/or other Agencies ......................... 32 Annex 3: Results Framework and Monitoring ............................................................................. 33 Annex 4: DetailedProject Description ......................................................................................... 36 Annex 5:Project Costs ................................................................................................................. 54 Annex 6: Implementation Arrangements...................................................................................... 60 Annex 7: Financial Managementand DisbursementArrangements............................................ 67 Annex 8: ProcurementArrangements........................................................................................... 74 Annex 9: Economic and Financial Analysis................................................................................. 85 Annex 10: SafeguardPolicy Issues .............................................................................................. 97 Annex 11: Project Preparationand Supervision......................................................................... 112 Annex 12: Documentsinthe Project File................................................................................... 114 Annex 13: Statementof Loans and Credits ................................................................................ 115 Annex 14: Country at a Glance................................................................................................... 119 Annex 15: Incremental Cost Analysis ........................................................................................ 121 Annex 16: STAP Scientific and Technical Screening................................................................ 136 Annex 17: Map ........................................................................................................................... 138  CHINA THERMAL POWER EFFICIENCY PROJECT PROJECT APPRAISAL DOCUMENT EAST ASIA AND PACIFIC EASCS Date: April 1, 2009 Team Leader: Jie Tang Country Director: David R. Dollar Sectors: Districtheating and energy efficiency Sector ManagerIDirector: Junhui Wu, Ede services (80%); Power (1O%);Central Jorge Ijjasz-VasquedJohnRoome government administration (10%) Project ID: PO98654 Themes: Climate change (P);Pollution Focal Area: Climate change management and environmental health Environmental Assessment: Partial (P);Regulation and competition policy (P) Assessment Lending Instrument: Specific Investment Loan [ ] Loan [ ] Credit [XIGrant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Total Bank financing (US$m.): 0.00 Proposedterms: Sub-borrower(s) 63.76 10.00 73.76 Total: 86.46 22.50 108.96 Borrower: Government of China Ministry of Finance Sanlihe, Beijing 100820 China Tel: 86-10-68551123 Fax: 86-10-68551125 Email: xz.guan@mof.gov.cn ResponsibleAgency: MinistryofFinance Room2518 Economic Construction Dept. Sanlihe, Beijing 100820 China Tel: (86-10) 6855-2879 Fax: NA Email: ccid ljg@sina.com  ICumulativeI 0.20 I 4.40 I 12.40 I 16.70 I 19.70 I Project implementation period: Start June 5,2009 End: December 31,2012 Expected effectiveness date: July 30,2009 Expected closing date: June 30,20 13 Doesthe project depart from the CAS incontent or other significant`respects? Ref:PAD I.C. [ No .I Does the project require any exceptions from Bank policies? Ref. PAD IKG. [ ]Yes [XINO Have these beenapproved by Bankmanagement? [ ]Yes [XINO I s approval for any policy exception sought from the Board? [ ]Yes [XINO Does the project include any critical risks rated "substantial" or "high"? Ref:PAD III.E. [ ]Yes [XINO .I Does the project meet the Regional criteria for readiness for implementation? Ref:PAD IKG. [XIYes [ ] N o .I Project development objective Ref. PAD II.C., TechnicalAnnex 3 The project development objective is to reduce coal consumption andGHGemissionper unit o f electricity production in ShanxiProvince, Shandong Province and Guangdong Province in China, through (i) mitigating the financial barriers o f closing inefficient small-sized coal-fired units; (ii) demonstrating the viability o f investmentsinefficiency improvements inexisting mid- sized thermal units; and (iii)developing effective regulations to implement the pilot ESD programs and conducting studies to supportthe transition to efficient generation dispatch. Global Environment objective Re$ PAD II.C., TechnicalAnnex 3 Same as above. Project description[one-sentence summary of each component] Ref. PAD II.D., Technical Annex 4 The project has five components: (i) mechanisms to support the closure o f inefficient small coal- fired generation units; (ii) demonstration o f power plant efficiency improvements; (iii) transition to efficient generation dispatch; (iv) technical assistance for project implementation; and (v) project management. Which safeguard policies are triggered, ifany? Ref. PAD IKF., TechnicalAnnex 10 The Bank's safeguard policies are not applicable for most o fthe project activities except for the investment activities that may have resulted from the establishment and pilot operation o f a transparent and effective financial incentive mechanism for the closure o f small unitsplant (MCSU) under Component 1 andthe efficiency improvement projects under Component 2, for which the Bank's Safeguard Policies o f EnvironmentAssessment (OP/BP 4.01) and Involuntary Resettlement (OP/BP 4.12) are triggered.  Significant, non-standard conditions, if any, for: Re$ PAD III.F. Board presentation: None. Loadcredit effectiveness: None. Covenants applicable to project implementation: The following financial and environment covenants have beenincorporatedit.,, gran the agreement: (i)CompliancewiththeMCSUOperationalManual; (ii)SatisfactoryimplementationoftheEnvironmentManagementPlans(EMP), Environment Management Framework (EMF), Resettlement Policy Frameworks (RPF) andResettlement Plan; and (iii)CompliancewiththeFinancialManagementManual.   I. STRATEGICCONTEXTANDRATIONALE A. Country and sector issues 1. Growing Energy Demand and GHG Emissions. China is the world's second largest energy user. Since 1990 energy consumption has been increasing on average at 5.8% per year, growing from 987 million tons of coal equivalent (tce) in 1990 to about 2.46 billion tce in 2006l. China's greenhouse gas (GHG) emissions are now comparable to the United States. This i s due mostly to the consumption o f coal for electricity production. Carbon dioxide (C02) emissions in China are projected to double over the next decade and as a result China will experience the largest absolute growth in these emissions over this period. Therefore, efforts to curb C02 emissions resulting from the generation o f electricity are o f paramount importance to the Climate Change Agenda. 2. Predominance of Coal in China's Energy Mix. China's rising energy demand has been met largely by domestic coal. Coal consumptionreached about 1.7 billion tce in 2006, accounting for 69% o f the country's total energy consumption. Various projections show that coal will still constitute 60% or more of China's primary energy consumptionby 20202. 3. Coal has also been the predominant source o f electricity generation in China. Thermal power generation capacity reached 484 GW in 2006, amounting to about 78% o f the 622 GW total installed capacity and generating 83% o f the 2,834 TWh total electricity output in China. O f this thermal generation capacity, 422 GW was coal-fired, accounting for about half o f the country's 2006 total coal consumption. The Government o f China (GOC) i s seeking to diversify generation resources, mainly through scaling-up renewable energy and nuclear power. However, even with this diversification policy, coal will remaintheprevailing fuel source for the foreseeable future. 4. SignificantEnvironmentalConsequences. The rapidexpansion of installed thermal power generation capacity and its primary reliance on coal has contributed significantly to adverse environmental impacts in China. Emissions of sulfur dioxide (S02), C02 and nitrogen oxides (NOx) from burning bituminous coal cause serious atmospheric pollution and are partially responsible for ground level ozone (smog), acid rain, poor surface water quality and climate change. 5. Low Efficiency of Coal-firedPower Generation.China's coal-fired power plants consume considerably more coal per kWho f electricity suppliedthan the international average. In2006 coal- fired generation in China consumed an average 366 gce/kWh compared to a 300 gce/kWh benchmark in Japan or Europe3. The main factors contributing to China's low power generation efficiency are: (a) Large share of generation by inefficient small 4units. In 2006, coal-fired power generatingunits o f 100 MW and below had a combined installed capacity o f 115 GW. This was equal to more than 27% o f the total coal-fired power generation capacity in China. With a typical heat-rate o f between 400 and 800 gce/kWh, these small units significantly underperform in comparison to medium and large size coal-fired generation units. For 'China Statistic Year Book 2007 2Sustainable Energy inChina: The Closing Window of Opportunity, World Bank, 2007 3With units of 6 M W andbigger Refersto units of 100M W and smaller 1  example 200 MW units consume about 360 gce/kWh, while units 300 MW and larger consume between 325 and 335. gce/kWh . Notwithstanding the much higher coal consumption, these inefficient small thermal units, under the existing generation dispatch practices, have similar utilization factors to the larger, more efficient units. (b) Generation dispatch not optimized for achieving maximum efficiency. Unlike most other electricity systems in the world, Chinese power generation dispatch practices do not favor more efficient or lower variable cost generation7. Instead, all thermal units are scheduled to operate for a similar number o f hours per year, regardless o f efficiency or fuel consumption cost. The underlying cause o f this practice is the regulated energy-only generation prices' for electricity supplied to grid companies. The energy-only price for a coal-fired generation investment project i s approved based on an annual operational hour assumption, usually around 5000 hours. On a year-ahead basis, each generation unit i s planned with a proportional allocation o f the energy required to supply the demand forecast, leading to similar annual operational hours. Throughout the year, the dispatch center schedules generation in accordance with the operational hours target assigned to each unit. This causes significantly greater average coal consumptionper MWhof electricity production than ifthe dispatch hadprioritizedthe more efficient coal-fired generation units. (c) Small combined heat and power units operating for power generation only. Small units for combined heat and power (CHP) supply operate at a higher overall efficiency when providing both power and heat. For this and other reasons, small CHP units supplying heat are exempt from government-mandated closure, ifthese units comply with a specified ratio o f heat-to-powerg generation over the course o f a year. However, operation for power generation only must be restricted accordingly. The small CHP units that do not comply with the required annual ratio o f heat-to-power are liable to be closed down. Nonetheless, despite government regulations, many small CHP units in China continue to operate solely for power generation even when more coal-efficient capacity i s available for substitutive generation, since the regulatory entities and system dispatchers do not have effective measures to monitor the heat supply by the CHP units. An effective monitoring system o f heat supply by the small CHP units would facilitate enforcement o f government regulations and lead to improvements inthe overall system efficiency inpower generations. (d) Old mid-sized coal-fired units operating at relatively high coal consumption rate. Mid-sized coal-fired generation units built in the 1990s are operating at coal consumption rates higher than the rates o f units with newer technologies and have significant potential for efficiency improvement during their generation life expectancy through rehabilitation and retrofit. These potential gains could be achieved through: (i)rehabilitation and retrofit o f more than 100 sets o f 200 to 300 MW units built inthe 1990s; (ii) conversion o f more than 81 5Conclusions o f a sample survey carried out by Chinese government authorities in2007. Utilization factor = annual energy generated(availab1e capacity x number o fhours inthe year). 7International practice of merit order dispatch schedules available thermal generation units to minimize total generation variable costs (mainly fuel costs). 8The grid company pays a generator only for the energy (kWh) injected to the grid. State Council Document [2000]1268: Heat-to-Power Ratio over the year (GJ: kWh*(3600 GJkWh)) x 100%must be equal to or above 100% for units smaller than 50 MW and 50% for units between 50 to 200 MW. 2  sets o f 300 MW units in northern China from solely power generation into CHP operation"; and (iii) heat recovery from the cooling systems of condensing-type power generation waste units for district heating. 6. Government Strategies. Chinese authorities at the highest levels have recognized that a business-as-usual approach in the energy sector will lead to unacceptable environmental consequences and strain the coal supply chain on an unprecedented scale. The Government initiatives intended to improve efficiency and reduce coal consumption inChina are contained inits 1lth Year Plan (2006-2010), issued in early 2006 that calls for a 20% reduction o f energy Five consumption per unit output o f gross domestic product (GDP) by 2010; and in the Medium and Long Term Energy Conservation Plan issued in 2004 by the National Development and Reform Commission (NDRC), which targets a reduction o f energy intensity from 2168 tce per RMB 10,000 o f GDP output in2002 to 2.25 tce by 2010 and 1.54 tce by 2020. 7. Specific GOC strategies to improve coal-fired thermal power generation efficiency include: (i) ofinefficientsmallcoal-firedunitsandtheadditionofnewhigh-efficiencylarge-sized closure thermal units' ';(ii)introduction o f efficient generation dispatch, known as the Efficient Fuel Saving Dispatch (ESD); (iii)adoption o f new clean coal technologies such as integrated gasification combined cycle (IGCC); (iv) investment in energy efficient systems and the rehabilitation o f existing generation units; and (v) scale-up o f renewable power generation. 8. The GOC's strategy for reducing the capacity share of inefficient small coal-fired generation units seeks to close down 50 GW of these units by 2010. Plant closure goals for 2010 were negotiated in 2007 and NDRC signed agreements with 30 provincial governments and 7 major power companies for their closure goals. Early results have been favorable, with 14.38 GW o f small units closed by the end o f 2007, exceeding the national 2007 target o f 10 GW. However, most o f the units closed belonged to large power generation companies which have the financial, institutional and technical capacity to address the financial and social impact o f such closures. Those units remaining to be closed in 2009 and 2010 are smaller and mostly owned by municipal and county level small power companies. These companies are less likely to be able to address the financial and social impact o f closure inthe allotted time without additional financial support. 9. Another element o f the GOC's strategy for improvin thermal power sector efficiency i s the replacement o f existing dispatch practices with the ESDlf.This requires generation dispatch to follow a merit order o f units, determined by their efficiency and emission levels. The ESD will commence with pilots in 5 selected provinces, with the intention later o f being implemented nationally. The change in dispatch practice will significantly reduce coal consumption for power generation. However, this will also have a critical impact on the financial viability o f less efficient units (due to the reduction in generation), rendering these units unable to recover fixed costs at current generation tariffs. Additionally, the ESD pilot requires new technical regulations on access, disclosure and verification o f generation efficiency data that to date has not been available at dispatch centers or used for dispatch. Although the start up o f the pilot was scheduled to commence 10A 2006 survey commissionedby NDRC and conductedby the China Electric PowerEngineering Consultants Group Corporation identified 81 units of 300 MW power-only condensingturbine power plantsthat were within a 15 kmof cities with substantial industrial and district heat demand. 11 Most of new units added in2008 are 600 MW and larger,with super-critical and ultra-super-critical technologies. I2A simulation study conductedfor one provincialpower grid as part ofthe project preparationwork shows that the ESDcould reduce coal consumptionby about2.2 milliontce per year inthat province during the period 2007-2011. 3  by early 2008, it has been delayed until adequate regulation and financial compensation mechanismsare implementedto address the associated technical and financial barriers. B. Rationalefor Bankinvolvement 10. Continuedprogress on improving coal-fired power generation efficiency i s vital ifthe GOC's plan for a 20% reduction in GDP energy intensity by 2010 is to be realized. The success of the power sector efficiency strategy i s closely linkedto the removal o f the key barriers identifiedabove. Drawing from its international experience and knowledge o f similar undertakings,the Bank is well positioned to assist in resolving the policy and technical issues associated with the GOC's sector strategy. 11. The Bank has assisted Russia and Poland in closing small mines. The experience acquired in addressingthe social and financial barriers related to the mine closure could be applied in China. The Bank has also supported thermal power plant rehabilitation in many countries and has accumulated significant expertise in the planning and implementation of such projects. Project examples include: (i) the rehabilitation o f the Elbistanthermal power plant in Turkey, consisting o f four 320 MW units consuming local lignite; (ii) the Thermal Power Plant RehabilitationProgram in India, involving three power plants with a total o f 640 MW capacity; and (iii)an Energy Sector Management Assistance Programme (ESMAP) study assessing the potential for rehabilitation or retirementof coal-firedpower plants inUkraine. 12. The proposed project continues and expands the Bank's support o f the Government with its efforts to develop policies that will help achieve environmental sustainability o f the energy sector. These efforts have included lending projects, analytical and advisory activities and economic and sector work (see Annex 2). More recently the Bank has been working with the Government on the development o f a new investment framework which will promote clean energy and energy efficiency by combining carbon finance, Global Environment Facility (GEF) funds and the newly established Climate Investment Funds into lending operations. The GOC has requested this GEF project, and considers that it will provide a good opportunity to benefit from the Bank's experience inits efforts to improve the power sector efficiency inChina. C. Higherlevelobjectivesto whichthe projectcontributes 13. Consistentwith the Bank's new Country Partnership Strategy. The project will directly support Pillar 3 of the Bank's new Country Partnership Strategy (CPS) for China (2006-2010) by managing resource scarcity and addressing key resource and environmental constraints to China's future growth. Demonstrating more efficient ways of using coal, creating a more competitive electric power market and addressing climate change as the means to build a resource-efficient society, are explicitly stated objectives o f the CPS. These objectives are also fully aligned with a major, and long-standing, GOC objective o f reducing energy intensity and the resulting negative impact of coal use. 14. Consistent with the Bank Climate Change Strategy. The Bank is finalizing its Strategic Framework on Climate Change and Developmentfor the World Bank Group (SFCCD). Within the SFCCD, the Bank attaches great importance to partnerships and i s taking specific steps to enhance coordination and/or collaboration among the United Nation agencies, GEF, multilateral development banks, bilateral donors, the private sector, research institutions and civil society groups. The Bank's operational response to climate change focuses on six key areas: (i) integrating 4  climate actions in development strategy; (ii) mobilizing concessional and innovative finance; (iii) facilitating the development o f innovative market mechanisms; (iv) leveraging private sector finance; (v) increasing support to technology acceleration; and (vi) stepping-up policy research, knowledge and capacity building. This project i s consistent with the SFCCD, as it will integrate actions in both the reform and development o f power sector policies. This includes the closure o f inefficient small units, facilitating the pilot implementation and transition to efficient generation dispatch practices, supporting the development o f power generation efficiency technology in China and enhancing energy efficiency policy research, best practices establishment, knowledge sharing and capacity building. This would be achieved through collaboration among government agencies, utilities, power companies, research institutions, GEF,international donors and the Bank. 15. Consistentwith the Bank's Strategy in PromotingCarbon Reduction. The Bank, as the trustee o f various Carbon Funds, i s also a world leader in mitigating climate change. The Bank has achieved this by market-based GHG emission reduction purchase transactions through the Clean Development Mechanism under the Kyoto Protocol under the United Nations Framework Convention on Climate Change (UNFCCC). Since ratifying the Kyoto Protocol, China now has a strong interest in benefiting from the Bank and GEF support and from carbon finance. The Bank has already approved the Project Idea Note for one o f the three sub-projects under the Component 2 o f the project - Waste Heat Recovery at Beijiao Thermal Power Plant in Shandong. There are strong financial and technical barriers to investment in projects for the recovery o f heat dispipated in plant cooling systems. The expected carbon finance from sales of carbon credits produced by emission reductions will help to off-set the cost o f investment inthese new improved technologies, andperhaps more importantly, will demonstrate their viability. A practical success story will helpto encourage publidprivate enterprises to invest in heat recovery from similar plants for district heatingin small and mid-sized municipalities inChina. 16. Consistent with the Strategic Objective of the GEF Interim Strategy (Summary of Negotiations on the Fourth Replenishment of the GEF Trust Fund, dated August 25, 2006). The project will support the retrofit o f power plants, includedunder that strategy. 11. PROJECTDESCRIPTION Total GEF CPF Total GEF CPF (US$m) (RMB Ym) 1 M C S U - capitalization 20.00 5.00 15.00 140.00 35.00 105.00 2 Goods 72.64 7.61 65.03 508.49 53.24 455.24 3 Services 9.29 5.83 3.46 65.03 40.78 24.25 4 Project management cost - 0.41 1.92 1.51 13.41 2.86 10.55 Total Base Cost 103.85 18.84 85.01 726.92 131.88 595.04 5 Contingency for exchange rate 5 . 1 1 0 . 8 6 4 . 2 5 Total Cost 108.96 19.70 89.26 726.92 131.88 595.04 Financing Requirement 108.96 19.70 89.26 726.92 131.88 595.04  B. Projectdevelopmentobjective andkey indicators 18. The project development objective is to reduce coal consumptionand GHGemissionper unit o f electricity production in ShanxiProvince, Shandong Province and Guangdong Province inChina, through (i) mitigating the financial barriers o f closing inefficient small-sized coal-fired units; (ii) demonstrating the viability o f investmentsinefficiency improvements in existing mid-sized thermal units; and (iii)developing effective regulations to implement the pilot ESD programs and conducting studies to support the transition to efficient generation dispatch. The project will support pilot programs and demonstration sub-projects in three provinces that have significant potential for power sector efficiency improvements- Shanxi, Shandong and Guangdong. 19. Key performance indicators include: (i) efficiency o f and GHG emission from coal- average fired electricity generation in Shandong, Shanxi and Guangdong provinces; (ii) Cumulative capacity o f small coal-fired power generation units closed in Shandong and Shanxi; (iii) thermal efficiency o f and GHG emission reduction from the units #1-4 of Yangguang Thermal Power Plant in Shanxi; (iv) thermal efficiency o f and GHG emission reduction from the units #7-8 at Huangtai Thermal Power Plant in Shandong; and (v) thermal efficiency o f and GHG emission reduction from the units #2-5 at Jinan Beijiao Thermal Power Plant in Shandong (see Annex 3). C. Projectcomponents 20. The project has five components: (i) mechanisms to support the closure of inefficient small coal-fired generation units; (ii)demonstration o f power plant efficiency improvements; (iii) transition to efficient generation dispatch; (iv) technical assistance for project implementation; and (v) project management (see Annex 4). 21. Component 1: Mechanisms to Support the Closure of Inefficient Small Coal-fired Generation Units (GEF Grant US$9.50 million and counterpart funds US$26.92 million). This component will support the closure o f inefficient small thermal units and GHG emission reduction inShandong (4,300 MW) and Shanxi (2,870 MW),by 2010. Bothprovinceshave adequate capacity reserve and committed investment in new generation capacities, which will ensure reliable power and heat supply along with the closure. The capacity of small units to be closed exceeds, by 300 MW and 200 MW respectively, the current provincial targets agreed with the NDRC. Out o f the total target, the GEF project i s expected to support the closure o f 2,910 MW in 2009 and 2010 (1583 MW in Shandong and 1327 MW in Shanxi). The component will support the establishment and pilot operation o f a transparent and effective financial incentive mechanism for the closure o f small units (MCSU). This will assist the small county and municipal power companies in Shanxi and Shandong to recover part o f the costs o f closure, mainly the cost o f addressing the social impact o f the closure; establishing CHP On-line Monitoring Systems to facilitate enforcement o f government regulations for CHP unit operation; and establishment o f bulletinsystems to enable the trading of emission allowances entitled by small units closed on schedule. These revenues can be complementary to the MCSU to partially offset the closure costs; and monitoring and evaluation (M&E) and knowledge sharingto facilitate replication o f successful experiences inother provinces o f China. 22. Component 2: Demonstration of Power Plant Efficiency Improvement (GEF Grant US$3.59 million and counterpart funds US$52.77 million). This component will demonstrate plant efficiency improvement and GHG emission reduction through three different types o f investment 6  activities: (i)conversion o f mid-sized power generation only units into CHP units, at Huangtai Thermal Power Plant in Shandong; (ii) waste heat recovery at thermal power units and utilization for district heating, at Jinan Beijiao Thermal Power Plant in Shandong; and (iii) improvement of power generation efficiency resulting from plant energy audit recommendations, at Yangguang Thermal Power Plant in Shanxi. Eachproject has been designedto improve the efficiency o f power and heat supply during the remaining life expectancy o f the generation units. The thermal efficiency baseline and target values o f these demonstration projects are presented inAnnexes 3 and 4. To ensure successful demonstration, sustainability and replication, support will also be provided for: (i)monitoring and assessment o f the effectiveness o f the three demonstrative projects, knowledge sharing and publications; and (ii)establishment o f standard plant energy audit procedures and processes for identification and assessment o f efficiency improvement investment activities and best practices o f plant operation and maintenance (O&M). 23. Component 3: Transition to Efficient GenerationDispatch(GEF Grant US$4.07 million and counterpart funds US$3.23 million). This component will reduce system-wide coal consumption and GHG emission for power generation by supporting the transition from current system dispatch practices to an efficient generation dispatch optimized for coal savings. Firstly, support will be provided for the pilot implementation o f ESD inGuangdong Provincial Power Grid, including development or improvement o f the detailed regulations required to commence the piloting. This will cover regulations for ESD financial compensation mechanisms, methodology and procedures for monitoring thermal efficiency and emission levels o f units required to prepare the ESD merit order, and procedures for information disclosure to improve the ESD transparency and monitoring; and a simulation system to test improvements inthe GuangdongProvincial Power Grid. Subsequently, the component will provide continued support for the improvement o f the approach and regulations for generation dispatch and replication to other provinces. This will include: (i) a comprehensive assessment o f the pilot ESD in all o f the five pilot provinces after their first 12 months o f operation, to identify recommendations on further improvement o f the dispatch approach and regulations; (ii)key studies on generation pricing and tariff reform to phase out the ESD financial compensation mechanisms and to make the development o f power markets compatible with the transition to efficient generation dispatch; and (iii)knowledge sharing and consensus building to support the improvement o fthe dispatch approach, regulations and replication. 24. Component 4: Technical Assistance for Project Implementation (GEF Grant US$1.27 million and counterpart funds US$0.59 million). This component will support the hiring o f international and local consultants for operational management, technical advisory, procurement and financial management (FM) at various implementing agencies (IA) to support project implementation, M&Eand replication o f successful experience and practices (see Annex 4). 25. Component 5: Project Management (GEF Grant US$0.41 million and counterpart funds US$1.5 1 million). This component will provide budget support for the incremental operating costs o f various IAs resultingfrom the project implementation (see Annex 4). D. Lessons learnedreflectedinthe projectdesign 26. Key lessons learned during Bank supported mine closure projects in Russia and Poland are relevant for this project and include: (i) financial resources must be available to address the social impact o f closure; and (ii)financial aid must reach the target groups. These lessons have been incorporated in the design o f the MCSU under Component 1, regarding the institutional arrangement for disbursement and monitoring o f the MCSU. The Bank has supported several power 7  sector reform projects in China. Key lessons learned are that the ownership and commitment of central government agencies and the major power companies, consensus building and a gradual approach are essential to the success o f changes inpower sector practices. Both Components 1 and 3 fully take these lessons into account. International experience and best practice for plant rehabilitation have been incorporated in the design o f the investment projects for plant efficiency improvement under Component 2. An example of this is from Turkey where lignite power rehabilitation projects have been supported. The methodology o f screening and determining the scope o f rehabilitation through a standard energy audit has been introduced during the project preparation and the project design was based on audit recommendations. InIndia, similar ongoing rehabilitation projects supported by the GEF, IBRD, ESMAP and Policy and Human Resource Development Fundo f Japan suggest the same experience. The Turkey and India projects prove that good O&M practice i s cost effective in enhancing plant efficiency and has been incorporated into the project design. E. Alternatives considered and reasons for rejection 27. Initially, support was considered solely for the retrofit o f power plants to improve efficiency. However, based on extensive consultation and field surveys conducted during the project preparation, the project focus was enlarged to support other key GOC initiatives that have significant sector-wide impact on efficiency improvement - closure o f inefficient small coal-fired units and transitioning to efficient generation dispatch - to ensure achievement of the project development objective. 28. To achieve improvements in plant efficiency, the emphasis was initially placed on assisting plant owners to rehabilitate old 300 MW units by focusing on the turbines and auxiliary systems as well as technology transfer support to local equipment manufacturers for the manufacturing o f highly efficient and reliable power plant auxiliary equipment. However the planned support to local manufacturers was dropped as it was believed that technology development would be more effective if it was market-driven. 29. For closure of small units, the options considered included assistanceto resolve the associated technical issues, but during project assessment it was discovered that the grid companies have adequate capacity. Project design then focused on support for enforcement o f government regulations and incentive mechanisms to address related social and financial barriers, targeting the most difficult small unitsthat are unlikely to be fully closed by 2010without this additional support. 30. For transition to efficient generation dispatch, initial consideration was given to funding the pilot ESD systems intwo o f the five pilot provinces. To facilitate successful replication and to scale upthe impact, the project support was changed to preparingdetailed regulations requiredto start the ESD piloting, testing the improvement of the ESD to maximize coal savings and assisting in replication. This includes a system for detailed dispatch simulation in one province to test the improvement in parallel to the actual pilot implementation o f ESD, and a comprehensive assessment o f the ESD pilot in all the five provinces. Additionally the project will undertake key studies to support the transition to efficient generation dispatch and power market development in the mediumand long term. 8  111. IMPLEMENTATION A. Partnershiparrangements(if applicable) 31. The GEF will finance about 18.1 % o f the total project cost, estimated at US$108.96 million. The remaining 81.9 % will be co-financed by central government agencies including the Ministry o f Finance (MOF), NDRC, State Electricity Regulation Commission (SERC) and Shandong and Shanxi Provincial Governments with budget allocations and in-kind contributions, Guangdong Power Grid Corporation (GDGP)13 in Guangdong and three power plants in Shandong and Shanxi with loans from local banks (see Annex 5). United States Agency for International Development (USAID) supported the energy audits of the three power plants under Component 2 during the project preparation and has agreed to continue its support for the introduction o f international technologies and experience in plant efficiency improvement during the project implementation. The agency will finance international consulting services andworkshops. B. Institutionalandimplementationarrangements 32. The project implementation will be carried out over four years by the central and provincial government agencies, GDGP in Guangdong and three power plants in Shandong and Shanxi. The institutional arrangements for project implementation have followed the normal fwnctions o f the government agencies and project entities (see Figure 1). Project management/coordination units have been created at both national and provincial levels so as to allow internal and external coordination, operational and logistical support to the project implementation, M&E and reporting, without major interruptionto each IA's normal operating functions (see Annex 6). 33. According to the institutional and implementation arrangements illustrated inFigure 1below, all IAs have comparative advantages and sufficient technical capacities to manage their respective project activities. However, the capacity assessments conducted by the Bank's task team indicated that the newly created project management/coordination offices did not possess the capacity to provide the necessary operational support to the various IAs in procurement (see Annex 8), financial management (see Annex 7) and safeguard management (see Annex 10). See Section IV for the major conclusions of the capacity assessmentsand actions for capacity enhancement. 13A subsidiary of China Southern Grid Corporation. 9  Figure 1: InstitutionalArrangement for Project Implementation 'ower Market Regulation Dept. .Information Disclosure *Assessmentof ESD Pilot .Transition to PowerMarket .Unit Efficiency Verification Tariffi & FinancialR e g n l a t i o n ~ I E l e c t r i c i t yPricing Division Dept. .Study on Tariff Mechanism *CompensationMechanism I ?.M&E of MCSU NationalI 1 -M&E of Plant Eff.Imurovement *Support to NationalIAs *FinancialManagement Shanxi PCO Shanxi PEO Provincial Economic Commission Guangdong CHP On-line Monitoring Provincial Provincial Economic Commission Closing down Small Units Dispatch CHP On-line Monitoring .Monitoring & Evaluation Center .Monitoring and Evaluation .ESD Pilot Provincial Development Commission Provincial EnvironmentalBureau *CHP On-line .Closing down Small Units t .Enabling SO, Trading Monitoring Provincial Environmental Bureau .Enabling SO, Trading Yangguang ThermalPower Plant Huangtai Thermal Power Plant .Investment in Efficiency .Conversion into CHP Improvement Jinan Beijiao Thermal Power Plant .Waste HeatRecovery C. Monitoringand evaluationof outcomedresults 34. Project implementation monitoring will be carried out through normal review o f procurement, Financial Management Reports (FMRs), annual audits o f the project accounts, periodic progress reports, external monitoring reports, and regular supervision missions by the World Bank. 35. Comprehensive M&E will be implemented for the project in accordance with GEF M&E Guidelines. The agreed indicators, baseline values and responsibility for data collection and monitoring are described in Annex 3. Monitoring o f interim outcome indicators will be carried out through periodic progress reports from the IAs, external monitoring reports from consultants and the Bank's supervision missions. Technical assistance designed under the project will ensure sufficient capacity indata collection, monitoring, reporting and outcome evaluations. 36. The M&E results will provide critical input to the central government agencies for decisions on adjustments o f national policies and regulations and set up o f benchmarks and good practices for replication to the rest o f the country. The evaluation o f results and impact o f various pilot programs will bemanaged by the central government agencies to ensure ownership andreplication. Financial resources are allocated to support the evaluation and replicationunder the project. 37. A mid-term review will be carried during the project implementation to assess the effectiveness o f the project design and realism o f the project development objectives. The review results will be used for adjustments, ifneeded, o f project designand implementation arrangement. D. Sustainabilityandreplicability 38. Sustainability. The project activities have been designed to increase operational efficiency and thus reduce the operational cost o f power generation, contributing to the sustainability o f the 10  power sector. There are clear indications o f GOC ownership and commitment to closing down small units and implementing fuel efficient generation dispatch to reduce coal consumption in electricity production. The central government has issued several new sector regulations during the project preparation, signed agreements on closure targets with the provincial governments and major power companies and issued in 2007 the ESD principles and called for an ESD pilot in 5 selected provinces. The project-supported activities are complementary to the GOC's own initiatives. 39. The investment projects for plant efficiency improvement will lower operation costs and increase financial viability, consequently enhancing the financial sustainability o f the thermal power plants. The project will also support the improvement o f plant O&M practices which are critical to maintain the efficiency levels after the project completion. 40. Replicability. The GOC is strongly committed to scale up the impact o f coal saving in the power sector. The GOC has adopted a phased approach to lower the energy intensity in power generation by issuing new sector policies and regulations on the closure o f small units, issuing the ESD regulations to initiate the transition to efficient dispatch and piloting the ESD in selected provinces to test their effectiveness. The project will utilize international experience and contribute to the government's own initiatives, including technical assistancefor assessment o f the pilot programs and their replication. 41. The potential for replication o f successful project experience i s substantial. Many provinces are facing similar challenges in addressing the financial and social impacts o f closing inefficient small units. The central government intends to continue the closure o f the remaining less efficient small thermal units during 2010 to 2015. Replication o f efficient generation dispatch practices to other provinces in China i s part o f the central government's current strategy and the provinces are expecting to benefit from the experience and lessons o f the ESD pilot. The GOC and independent evaluations have confirmed that: (i) are about 100 sets of 200-300 MW units, constructed in there the 199Os, which could have their efficiency improved by up to 10% through dedicated investment activities; and (ii) are over 81 sets o f 300 MW units innorthern China that have the potential there to be transformed into CHP. When financially viable, waste heat recovery would be applicable to most o f the coal-fired condensing type units in northern China where use o f the recovered heat i s needed locally. 42. The assessmento f the MCSU and ESD pilot will leadto recommendations for improvements to central government policies and regulations to support replication. Assessment o f plant efficiency improvement projects will demonstrate cases that are financially viable and also provide recommendations on standardized methodology and procedures for identification o f the scope, implementation and M&E o f efficiency improvement investments. This i s vital to achieving effective replication o f efficiency improvements to other power plants. Domestic commercial bank financial intermediaries, supported under the on-going China Energy Efficiency Financing Project, are keen to develop and sustain viable commercial energy conservation lending businesses. These would substantially increase investment in industrial energy conservation. In 2008, the MOF increased its current budget o f US$3.2 billion to US$4.0 billion for energy saving and emission reduction investment project incentives. It i s keen to identify and promote appropriate energy efficient industrial technologies. At the request o f MOF, the Bank is providing technical assistance on the use o f this current budget for project identification and appraisal, determination o f subsidy levels and evaluationo f impacts on energy efficiency improvement and emissionreduction. 11  E. Criticalrisks andpossible controversialaspects Risks Risk mitigationmeasures Risk rating I with mitigation To project development objecth Weakening of government 0Improvedenergy efficiency has been set as one of the highest priorities of Low commitment to promote energy the 1lth Five-Year Plan and reaffirmed by officials at the highest level of efficiency inthermal power the government sector The GOC has issued regulations and signed agreements for the closureof inefficient small units and launchedthe ESD pilot during the project preparation Weak enforcementcapacity of 0Technical assistancedesigned under the project to strengthen the related Modest the provincial governments provincial governments' capacity of monitoring and enforcingrelated energy conservationand environmental policies, regulations & standards 0Strong support by the Bank's task team throughout the preparationand implementation stages To component results Component 1: 0Agreement for funding reachedbefore project implementation Modest Government funds for MCSU 0GEF Grant ear-marked for MCSU disbursement only when government not inplace funds made available Paymentunder the MCSUnot 0Preparationand approval of an MCSUOperational Manual is acondition Modest fully madeto affected plants or for disbursement offunds for output-basedpayment not usedfor intendedpurposes 0Clear and detailed requirementson use of funds, disbursement procedures, FM, auditing, andreporting laiddown inthe Operational Manual 0Annual auditing and periodic reportingby IAs 0Close F Msupervision by MOFMationalPMO andthe Bank's task team Closure of small units impeded 0Provincial governments' commitment to closure defined inthe agreements Modest due to affected interests of local with the central government governmentsand social impacts 0MCSU to support mitigation of social impacts 0Technical assistanceto facilitate generation of additional revenues under existing governmentpoliciesto complementthe MCSU Compliance with government's 0Government's policies instructingsatisfactory settlement of workers Modest policies regarding satisfactory affectedby the closureof small unitsare in place at the central, provincial settlement of workers affected by and municipal levels and are systematic, comprehensiveand adequate the closureof small units 0These governmentpolicies include adequate financing andinstitutional arrangements for implementation and monitoring 0Additional financial resources, as output-basedpayments, will be provided to the targeted owners of small unitsunder the MCSU as an incentive to the closure and compliance with the governmentpolicies 0An independent third-party monitor will be engagedto check compliance to governments' policies 0Compliance to the governmentstaff settlement policies is a condition for the disbursement of the output-based payment Compliance to the 0An independent third-party monitoringwill beengagedto check Low EnvironmentalManagement complianceto the EMF Framework (EMF) during the 0Complianceto the EMF is a condition for the disbursement of the output- processof closure basedpayments Component2: 0Design of turbine rehabilitation activities by original suppliers Low Technical risk of not achieving 0Technical due diligence and support by both international and local expected efficiency gains consultants in project design, implementation and supervision Inadequate safeguard 0EMPs and RPFs prepared, agreed andbudgeted by power plants Low management 0Hiring experience environmental and social specialist for implementation and monitoring 0Close supportand supervision by the Bank's task team 12  Component 3: Supportto central government agencies and GDGP to prepare regulations Low ESDnot implemented inthe and implement (i) a financial compensationmechanismsupporting the pilot province due to the pilot ESD; and (ii)detailed requirementson information disclosure complementarypolicies and required for the pilot implementation of ESD regulations to address associated Strong support by international consultants andthe Bank's task team financial impactsand technical throughout the implementation stage requirementsnot inplace Delays inESD implementation Technical assistanceto develop adequatefinancial compensation High due to affectedinterests of mechanisms to addressfinancial impactsdue to change indispatch generationand grid practices companies Component 1-3: Efforts to reach consensusand legal agreementswith central government Modest Successful experience inpilot agencies for the replicationbefore project implementation provinces not replicated in other Central government agenciesto be responsibleandtake the lead of impact provinces assessment and replication Supportto central and provincial governmentagencies to build capacity for replication Overall risk rating Modest F. Loadcredit conditions and covenants 43. The following financial and environment covenants have been incorporated into the grant agreement: (9 Compliance with the MCSU Operational Manual (see section below); (ii) Satisfactory implementation of the Environment Management Plans (EMP), Environment Management Framework (EMF), Resettlement Policy Frameworks (RPF) and ResettlementPlan; and (iii) Compliance with the Financial ManagementManual. IV. APPRAISAL SUMMARY A. Economic and financial analyses PowerPlant with Fixed cost increased Coal saving InvestmentProjects EIRRbase by 10% reducedby 10% Combined Huangtai 20.4% 17.6% 13.7% 11.3% Jinan Beijiao 26.8% 24.3% 24.5% 22.2% Yangguang 78.7% 71.5% 72.8% 66.2% Aggregate EIRR 30.5% 27.5% 26.3% 23.7% 13  45. Because o f the lack o f the details about implementation plans and incurred costs by the local parties, it i s impossible to carry out the cost-benefit analysis for components 1 and 3. The potential economic gains o f the MCSU and the pilot ESD, however, were estimated inorder to justify the use o f the GEF Grant to create the incentive mechanisms to help overcome the implementation barriers and to initiate the transition to efficient generation dispatch. The estimates show that the economic gains o f coal savings o f the MCSU-supported closure o f small units and the pilot ESD would be significant and can welljustify economically the GEF involvement. (see Annex 9). 46. Summary of Financial Analysis: Financial analysis indicates that all three investment projects for plant efficiency improvement in Component 2 are financially viable, with the financial internal rate o f return (FIRR) ranging between 23.7% and 88.7%. Results o f the sensitivity analysis also show the strong financial performance o f each project. The conclusions are summarized inthe table below (see details inAnnex 9). Investment cost Efficiencygain Projects FIRRbasecase increasedby 10% reducedby 10% Combined Huangtai 23.7% 21.5% 17.5% 15.8% JinanBeijiao 17.0% 15.3% 14.7% 13.1% Yangguang 88.7% 75.7% 74.4% 63.4% B. Technical 47. Mechanism to Support Closure of Small Units. A sample social economic survey was carried out during project preparation to identify the major barriers related to the closing o f small units. Accordingly, the MCSU has been designed based on findings of the survey (see Annex 1). Government funds will top up the GEF Grant to provide adequate financial resources to the pilot implementation o f the output-based MCSU to help the two pilot provinces, Shandong and Shanxi, achieve the targeted closure o f inefficient small coal-fired units by 2010 (see Annex 7). Experience and lessons learned in China and other countries, in which the Bank-supported mine closure programs faced similar financial and social issues, were considered in the design o f the MCSU pilot. 48. Investments for Power Plant Efficiency Improvement. The technical proposals have adopted proven measures and audit methodologies according to international standards. The IAs have adequate technical capacity for project implementation. Technical capacity within China and abroad for equipment manufacturing, design and implementation o f these projects i s also adequate. International experience and best practice for plant rehabilitation and O&M have been used in project design andpreparationand will be employed during implementation, M&Eand replication. 49. Transition to Efficient Generation Dispatch. International experience and best practice will be usedfor the development and implementation of a dispatch optimization model, to runoff-line in parallel with the on-line pilot ESD model developed by GDGP in accordance with the current government regulations. It will be operated to test potential improvements to the ESD pilot. Dispatch optimization models for minimizing variable cost and fuel consumption are well proven and widely used internationally, though are still not used in China. Guangdong Provincial Power Grid Dispatch Center has extensive grid operation experience and adequate capacity to manage the development and operation o f the off-line simulation model. For the off-line optimization model 14  and assessment o f the pilot ESD, international dispatch experts will be hiredto guide the modeling and suggest possible improvement usingprovenpractices. C. Fiduciary 50. Procurement. Procurement for this project will be carried out in accordance with the World Bank's Guidelines: Procurement under IBRD and IDA Credits, May 2004, as revisedOctober 2006 (the Procurement Guidelines) and Guidelines: the Selection and Employment of Consultants by the World Bank Borrowers, May 2004, as revised October 2006 (the Consultant Guidelines) and the provisions stipulated in the Grant and Sub-grant Agreements. The Bank's procurement capacity assessmentrates the overall procurement risk as "average". 51. Procurement plans have been prepared by various IAs in compliance with the Government's and Bank's procurement guidelines and requirements and will be updated periodically during the project implementation. The IAs will be responsible for carrying out the procurement o f GEF Grant-supportedcontracts in line with the procurement plans. The National Project Management Office (PMO) will support all the central government IAs and GDGP inprocurement o f GEF Grant- supported activities. Shanxi Provincial Project Execution Office (PEO) and Shandong Provincial PMO will supportprocurementfor all GEF Grant-supported activities intheir respective provinces. 52. To enhance the procurement capacity o f the national PMO, the GEF Project Preparation Grant (PPG) has been used to hire a procurement specialist at the National PMO. The specialist, who has completed training on the Bank's procurement process and procedures, has also managed all PPG-supported services and goods procured during project preparation. The specialist will continue to manage procurement during project implementation. Due to their limited experience o f Bank-financed procurement, each of the provincial PMO/PEO will hire a Tendering Agent (firm) which i s experienced in Bank-financed procurement. The PEO and PMO will also hire a procurement specialist to manage the Tendering Agent and coordinate with the National PMO and the Bank. Procurement training for Bank-financed projects will be provided to all the IAs by the Bank's task team before commencement o f project implementation. 53. The Bank's task team will provide procurement guidance and support whenever needed, carry out the requiredreviews and clearances with due diligence during the procurement process and will conduct close procurement supervision throughout project implementation. 54. Funds Flow. The GEF Grant will be provided to MOF under a grant agreement. A Designated Account (DA) will be set up within the Fund Division, International Department o f M O F to manage the GEF Grant. MOF will disburse the grant proceeds either to various IAs or suppliers/contractors directly from the DA under sub-grant agreements. A separate DA will be set up inShandong Provincial Finance Bureau (SDFB) and Shanxi Provincial Finance Bureau (SXFB) respectively to manage the GEF Grant proceeds transferred to the separate DAs, including the ear- markedcontributions to the MCSU. MOF budget allocations for the MCSUwill be disbursedto the Provincial Governments through normal government budget distribution channels. After the targeted small units are closed and compliance with associated social and environmental requirements verified, proceeds o fthe Grant ear-marked for the output-based paymentto the closure of small units will be disbursed directly to various power plants inline with a MCSU Operational Manual. A detailed MCSU Operational Manual will be developed in the first year o f project implementation following the table o f contents agreed during project preparation (see Annex 7). 15  The agreed funds flow and institutional arrangements for FM, disbursement, monitoring and reporting are shown inFigure2 below. Figure 2: Withdrawal Application and FundsFlow Flow Chart for the Proiect Activities Executed at the National Level and in Guanedone Province The DA managedby World FundDivison of ContractorI Bank +--- MOF Supplier - The DAsmanagedby World FinanceBureau SupplierI Bank 4--- ofShanxi1 + Small Units Shandong I LFlowofFunds ---+ Flow of Withdrawal Applications 55. Financial Management. In line with the funds flow illustrated above, the FM under the project will follow relevant Government and Bank requirements. The Bank's FM capacity assessment rates the overall FMrisk as "average". 56. At the national level, the FundDivisiono f MOF will execute the DA's FMand, together with the National PMO, will be responsible for FM and disbursement for activities implementedby the central government agencies and GDGP. The National PMO will support the FM inbookkeeping, accounting, assisting the Central Government IAs and GDGP in preparation o f statements o f expenditure (SOE) and withdrawal applications, supporting the Fund Division in disbursements processing, financial monitoring, external auditing and reporting. At the provincial level, SDFB and SXFB will be responsible for the FM and disbursement of the DAs at the two provinces and, together with the Provincial PMO/PEO, will be responsible for FM and disbursement for activities implemented by the provincial government agencies, the three power plants and the output-based payments to local power companies according to the capacity o f small units closed. The Shanxi Provincial PEO and Shandong Provincial PMO will work ina similar manner as the National PMO in FM for all the project activities in their respective provinces. The Financial Departments o f GDGP will be responsible for FM associated with the ESD pilot in Guangdong. For financial management monitoring, the MOF, SDFB and SXFB will be responsible for auditing and FM reporting. The National PMO, Shandong Provincial PMO and Shanxi Provincial PEO will prepare and submit to the Bank FMRs periodically as agreed and audit reports within six months after the end of each fiscal year of the government. FMR standard format was prepared during project preparation. 57. The Fund Division o f MOF, SDFB and SXFB have adequate experience and capacity in performing their responsibilities stated above as they have been managing a number o f DAs o f Bank-financed projects. The National PMO will hire an experienced part-time accountant 16  throughout the project duration for FM. Shanxi PEO and Shandong PMO will each hire a qualified and experienced part-time accountant for the supporting FM functions which are similar to those o f the accountant at the National PMO. The Financial Department o f GDGP has adequate FM capacity. Training on FM and disbursement for Bank-financed projects will be provided to all the IAs by the FM specialist and disbursement specialist o f the task team to all the IAs prior to project implementation. 58. The Bank's task team will provide guidance and support to the FM whenever needed, carry out required reviews and clearances with due diligence and will conduct close FM supervision throughout the project implementation. D. Social 59. The project is expected to achieve a positive social impact inthe project areas and China in general. The project will result incoal savings and GHG emission reduction. It will have a positive .social impact by increasing the coverage o f heat supply, reducing air pollution, avoiding other environmental damage associated with coal use and will improve the quality o f life for people inthe project areas. The investment activities under Component 1 and 2 will also bring some negative social impacts, while negative social impacts from other components o f the project are not envisaged. . 60. Component 1. Closure of small coal-fired units to be supported by the pilot MCSU will lead to cases o f plant workers losing their jobs. To ensure settlement o f affected workers i s properly addressed during the closure process, the central, provincial and local governments have issued a number of policies and regulations (see detailed review of these policies and regulations in the project file). The policies and regulations focus on proper settlement o f affected workers and include definition o f responsibility, preparation o f settlement plan for affected workers, process for consultation, institutional arrangement for implementation and supervision and measures to channel additional financial resources to the affected power plants. The policies and regulations are systematic and comprehensive. Compliance with these policies and regulations would lead to satisfactory settlement o f affected workers. 61. MCSU pilot under Component 1 has been designed to test the effectiveness and adequacy o f the output-based payment as additional financial incentives to the targeted plant owners to close down on schedule small coal-fired generation units in Shandong and Shanxi Provinces. This will help the plant owners recover part o f the cost o f closure, including the cost o f settlement o f affected workers. Compliance to the current government policies and regulations regarding settlement o f affected workers will be specified inthe MCSU Operational Manual as a condition for approval o f the output-based payment per MW closed. The pilot provinces, eligibility criteria for selection o f beneficiary power plants and targeted small units, proposed rate of the output-based payment per MW closed, procedures and process for verification of the closure and disbursement o f the output- based payment, fund flow, financial management and auditing, institutional arrangements for implementation, supervision, monitoring and verification, financing plan, detailed social and environmental compliance requirements and arrangement for impact assessment .and replication have been agreed among all the parties involved and will be specified in details in the MCSU Operation Manual i s to be finalized at the beginning o f the project implementation and is subject to review and approval by M O F andthe Bank. 17  62. Component 2. The plant efficiency improvement projects involve civil works inthe case of Huangtai and Jinan Beijiao Thermal power plants. The project activities at Yangguung Thermal Power Plant in Taiyuan City, Shanxi Province do not entail civil works outside the plant, and therefore the Bank's social safeguard policies are not applicable. 63. The project activities at Huangtui Thermal Power Plants in Jinan City, ShandongProvince will include construction of a heat exchange station and installation of district heating pipes outside the plants inurbanandperi-urban areas. As a result of the project, a secondarybranchpipeswill be planned and implemented inline with the expected future demandgrowth. The direct adverse social impact, as identified by the field social surveys and interviews conducted in late 2007 by a consulting firm experienced inBank-financed projects, i s mainly due to temporary disturbance with the installation o f heat supply trunk pipelines along existing roads requiringno land acquisition, as well as landacquisition (1,300 m2)for constructiono fthe exchange station. 64. Other impacts linked to the project activities at Huangtai are associated with the construction of a 9-kilometer new road, along which trunk pipes for heat supply by Huangtai will be installed. The road construction had already commenced, and more than 50% o f land acquisition and associated resettlement work had been completed prior to the Bank's involvement in the project. The field social surveys concluded that the resettlement completed for the road construction had followed applicable laws and regulations and the affected communities, households and enterprises were satisfied. It has been agreed that the residual resettlement work will follow the same compensation rates, settlement standards, procedures and management methods as the portion already implemented(see Annex 10). 65. Applying relevant domestic laws and Bank's safeguard policies and procedures, a Resettlement Plan for the trunk heat pipes and heat exchange station and a RPF for the future secondary branch heat pipeshave beenprepared. 66. The project activities at Jinan Beijiao Thermal Power Plant will include retrofitting the turbines and cooling system within the plant facilities and heat supply pipes outside the plant. The direct adverse social impact, as identified by the field social surveys in November 2007, i s mainly due to temporary disturbance with the installationo fheat supply pipelines along existing roads. The detailed routing o f the pipes will be determined in late years of project implementation. N o land acquisition i s required for these project activities. Applying relevant domestic laws and Bank's safeguard policies and procedures, a RPF for the heat supply pipeline project has beenprepared. 67. All these documents were prepared in both Chinese and English languages. The Chinese versions were disclosed via an announcement in local newspapers and the English versions at the World Bank Infoshop, at the same time inJanuary 2008. 68. As the power plants have limited capacity, qualified social specialists will be hiredby each plant to support the implementation o f the RPFs and Resettlement Plan. Safeguardstraining will be provided to the power plant staff before and during the project implementation. 69. A third-party agent will be engaged for external monitoring o f activities under both Component 1 and 2. The social specialists of the task team will provide timely support as needed andcarry out regular supervisionwith due diligence throughout the project implementation. 18  E. Environment 70. While the project i s expected to bring significant global and local environmental benefits by reducing coal consumption in the power sector in China, the project activities supported by Component 1 and 2 will also result in some negative environmental impacts. The project is classified as a "Category B" project according to the magnitude o f the environmental issues involved, the coverage area andthe nature o f the project activities. 71. Component 1. The closure o f small coal-fired units to be supported by the pilot MCSU will bring significant environmentalbenefits incoal consumption and emission reduction^'^. Itwill also bring negative impacts, which may include noise and dust during the dismantling process and pollutions due to improper treatment o f wastes. N o serious adverse or irreversible environmental impacts were envisaged from the dismantling. Since specific units to be closed and supported by the pilot MCSU inthe two pilot provinces, Shandong and Shanxi, cannot be identified until mid 2009, an EMF has been prepared to provide guidance on identification o f potential negative impacts, preparation o f mitigation measures and arrangements for implementation, supervision and internal and external monitoring. Compliance with this EMF will be specified in the MCSU Operational Manual as a condition for approval o fthe output-based payment under the MCSU (see Annex 4): 72. The draft final EMF, containing basic information on Component 1 project activities, inboth Chinese and Englishversions, has been disclosed at Shandong Provincial PMO, Shanxi Provincial PEO, EA Institutes inthe two provinces, as well as the World Bank InfoShop inNovember 2008. 73. Component2. The EIA shows that the investment activities will result insignificant benefits to the natural and socio-economic environment inthe project areas as well as global environmental benefits, including avoided coal handling and combustion due to efficiency improvement inpower generation as well as the dismantling o f distributedcoal-fire boilers and with consequent reductions inemissions ofPMlo, SOX,NOx and COz. No serious adverse or irreversible environmental impacts were envisaged. All adverse environmental impacts identified are limited and can be avoided or mitigated to acceptable levels, provided the mitigation measures developed in the EMPs are properly implemented (see Annex 10). 74. Environmental assessment (EA) documents, including Environmental Impact Assessment (EIA), EMP and Environmental Audit Report were prepared for each power plant efficiency improvement project in Component 2, in accordance with the relevant Chinese national requirements and the Bank's safeguard policies and procedures. The EA documents have covered: (i)baseline environmentalandsocio-economic conditions; (ii)alternatives consideredunderthe project design; (iii)environmental auditing and public consultation; (iv) potential impacts, mitigation measures and monitoring; and (v) information disclosure. As the power plants have limited capacity, qualified environmental specialists will be hired by each plant to support implementation o f the EMPs. Safeguards training will be provided to the power plant staff before and duringthe project implementation. 75. Basic information on Component 2 project activities, major anticipated adverse and positive impacts and mitigation measures have been disclosed to the public through bulletins, posters, as well as local newspapers. The draft final EIA reports, EMPs and Environment Audit Reports, in l4Unitsto beclosedcannotbe installedinother provinces,as regulationsonly allow installing generationof size 300 MW or more. 19  both Chinese and English versions, have also beendisclosed at the PMOs/PEO, power plants, EA Institutes, as well as the World Bank InfoShop inJanuary 2008. 76. A third-party agent will be engaged for external monitoring of project activities under both components. The environmental specialists of the task team will provide timely support as needed for ongoing safeguard management and to carry out regular supervision with due diligence throughout the project implementation. F. SafeguardPolicies 77. The Bank's safeguard policies are not applicable for most of the project activities except for the plant efficiency improvement projects under Component 2, for which the Bank's Safeguard Policies of Environment Assessment (OP/BP 4.01) and Involuntary Resettlement (OP/BP 4.12) are triggered. Safeguard Policies Triggered Yes No : Environmental Assessment (OP/BP 4.01) X NaturalHabitats (OP/BP 4.04) X Forests (OP/BP 4.36) X PestManagement(OP 4.09) X Physical Cultural Resources(OP/BP 4.1 1) X Indigenous Peoples (OP/BP 4.10) X Involuntary Resettlement (OP/BP 4.12) X Safety of Dams (OP/BP 4.37) X Projects on International Waterways (OP/BP 7.50) X Projects inDisputedAreas (OP/BP 7.60) X G. Policy Exceptions and Readiness 78. The project is in compliance with the GOC, Bank and GEF policies and procedures without exceptions. 79. Incompliance with OP/BP 6.00 on Bank Financing, Bank Management approval is obtained on December 18, 2008 for the MCSU output-based payment, which may partially be used by the beneficiary plant owners for severance payment to plant workers to be laid off due to the project- supportedclosure o f inefficient small coal-fired power generationunits. 80. The project meets readiness criteria for implementation. For Component I, the pilot provinces, eligibility criteria for selection of beneficiary power plants and targeted small units, proposed rate of the output-basedpayment per MW closed, procedures and process for verification o f the closure and disbursement of the output-basedpayment, fund flow, financial management and auditing, institutional arrangements for implementation, supervision, monitoring and verification, financing plan, detailed social and environmental compliance requirements and arrangement for impact assessment and replication have beenagreedwith various government agencies basedon the findings of the social economic survey completed during the project preparation. These will be specified in details in the MCSU Operational Manual, for which a table of content has been prepared and agreed with various government agencies involved (see Annex 4). For the on-line CHP monitoring system, detailed system design has been completed, bidding documents drafted and a simulation system developed for Shandong Province during the project preparation. A 20  detailed project proposal, including the draft terms o f reference for study on SO2 emission allowance trading has been prepared for Shandong Province. For Component 2, a detailed procurement planhas been preparedby the IAs and agreed with the Bank. A tender agent has been hired by Shandong PMO and the procurement for the two power plants inthe province i s underway following the Bank's Procurement Guidelines.Most o f the contracts for investmentactivities to be co-financed by the GEF Grant will be completed in late 2008 or early 2009. Retroactive financing with the GEF Grant proceeds will be needed. For Component 3, the GDGP has prepareda detailed procurement plan and agreed with the Bank. A detailed simulation and optimization model has been developed for Guangdong Power Grid, during the project preparation, to examine the potential coal savings and environmental benefits o f efficient generation dispatch. Above activities are on the critical path o f the project implementation schedule and are either under implementation to be compatible with the fast transition and changes inthe power sector and the plans o fthe power plants for major overhauls, or ready for implementation. The National PMO, Shandong Provincial PMO, Shanxi Provincial PEO and project task teams of the various IAs in Shandong, Shanxi and Guangdong provinces have been established worked effectively for the project preparation. The institutional arrangement will continue to function for project implementation. Counterpart financing has beenagreed. 21  Annex 1:Country and Sector or ProgramBackground CHINA: ThermalPower EfficiencyProject 1. China, with a total population of more than 1.32 billion, has achieved rapid economic development. Its GDP, which reached RMB 24,669 trillion in 200715,has grown at an average of 9.7% over the pasttwo decades. A. EnergySector Overview 2. Energy Productionand Consumption. Reflecting the fast growth of the economy, energy consumption inChina has increased from 987 million tce in 1990 to about 2.46 billion tce in2006. China has made remarkable progress indeveloping its energy resources during the last two decades and is now the second largest producer of commercial energy in the world. In 2006, the total commercial energy production reached 2.21 billion tce, an increase of 7.4% over that of 2005, includingcoal productionof 1.7 billiontce (Table 1.1). Table 1.1: TotalProductionof Energyand Its Composition Source: China Statistic Year Book 2007 3. China is also the world's second largest energy user. On average, energy consumption inthe country has increased at 5.8% annually since 1990, a rate more than three times faster than the world's average annual increase and is showing no sign of abating. In 2006, China's total energy consumption was about 2.46 billion tce, an increase of 9.6% over 2005 (Table 1.2). Coal consumption reached 1.7 billiontce in2006, accounting for about 69.4% ofthe total. Table 1.2: Total Consumptionof Energyand Its Composition Source: China Statistic Year Book 2007 15Source: National Bureau of Statistics of China. 22  4. Based on a number o f forecasts, primary energy demand in 2020 will vary between 2.5 and 3.2 billion tce. The highor low figure depends on many factors, but primarily on whether effective energy conservation policies and measures can be implemented. In view o f the energy resources available in China, coal i s expected to continue the dominance of energy composition. The participation other cleaner energy resources will depend on how successfully China can exploit hydropower, renewable energy, natural gas and coal bed methane. Even with an aggressive fuel diversification policy, coal i s expected to remain the dominant energy source for the foreseeable future. All projections show that coal will still account for 60% or more of China's primary energy consumption in2 0 2 0 ~ ~ . 5. Predominanceof Coalin China's EnergyMix. China's rising energy demand hasbeenmet largely by domestic coal. Coal consumption reached about 1.7 billion tce in2006, which accounted for 69% of the country's total energy consumption. The Government is carrying out aggressive plans to diversify energy resources, mainly through scaling-up renewable energy and nuclear power. Even with this diversification policy, coal will remain the dominant fuel source for the foreseeable future. 6. Environmental Consequences. The increased generation of coal-based energy is both a corollary o f economic growth and a major source of pollution. Rising coal consumption in China has contributed to increasingly serious environmental damage, both at the local and global level. In particular, the combustion o f bituminous coal i s causing serious atmospheric pollution from air- borne particulates, especially emissions of SO2 and C02. S02, which transforms into sulfate small particles, i s affecting buildings, cultural heritage and crop production, as well as human health. Currently China's SO2 emission i s the highest in the world. The former State Environmental Protection Agency stated that a total o f 25.5 million tons o f SO2 was emitted in 2005, with coal combustion accounting for over 90%. 7. According to a report by the World Health Organization, seven o f the world's ten most polluted cities are in China and it is estimated that air pollution inmajor urbanareas contributes to 178,000 premature deaths and 346,000 respiratory hospital admissions per year, o f which SO2 i s a major contributor. About one-third o f China's territory, mainly the densely populated and industrial southern region, has been affected by acid rain. Economic losses from pollution are conservatively estimated to be between3% and 7% o f GDP. B. InstitutionalArrangementsandRegulationof the PowerSector in China 8. Power Sector Structure and GenerationOwnership. Since the mid-l980s, the GOC has started to move the power sector away from a centrally administrated electricity industry toward a market-oriented industry. 9. To promote effective generation competition, the GOC initiated the separation of generation assets from transmission in 2002. Five large generation companies (Huaneng, Datang, Huadian, Guodianand China Power) and two grid companies (State Grid, China Southern Grid Corporation) were created from the former State Power Company. Separation o f generation assets from transmission has not yet been fully completed. Both grid companies s till retain ownership o f generation facilities, mainly pumped storage units for reserve ancillary services and peaking. The l6Sustainable Energy inChina: The ClosingWindow of Opportunity, WorldBank, 2007 23  remaining generation capacity that i s not owned by the five large generation companies or the grid Companies is owned by local government corporations, quasi-private and private companies. 10. For power transmission and distribution, the State Grid Company operates the grid covering 26 provinces, autonomous regions and major cities directly under the jurisdiction of the Central Government. This accounts for 88% of the country's territory. The China Southern Grid Corporation operates the grid covering five provinces in southern China. The grid companies are responsible for grid expansion planning, development and operation of the power grids, power generation dispatch, wholesale power purchase and resell ate regulated tariffs, and the development and operation of regional power markets. The grids under both companies are integrated with transmission lines of various voltage levels. 11. Under the two grid companies, each province has a Provincial Grid Company that typically owns and dispatchesthe transmission network and all or most of the distribution network within the boundaries of the province. There are various organizations for the distribution services. In most areas, distribution is fully integrated with the provincial grid companies. Inother cases, particularly inrural areas, distribution is carried out by local county-owned power companies that operate their distribution system and dispatch and buy generation connected to its network (i.e. generation not dispatched by the Provincial Grid Company). These local power companies sometimes also build their ownpower plants, mainly small hydro, to meet local demand. 12. Regulation of the Power Sector in China. Regulation of the power sector in China is divided between the NDRC and SERC. NDRC is responsible for several regulatory functions including pricing methodologies, transmission projects and new power plant approvals. SERC i s responsible for the design and oversight of generation markets. SERC also provides inputs to NDRC on pricing and market reform issues. C. Key EnergySector Issues inChina 13. Fast Growing Demand. China has been extremely successful in the past two decades in increasing its energy supply to meet the need of a fast growing economy. However, China faces many great challenges in the next 20 years to be able to supply the energy neededto quadruple its GDP and build a stable and prosperous society by 2020. Despite rapid demand growth, China's per capita energy consumption is still at less than one fifth of the Organization for Economic Cooperation and Development countries' average, and accordingly has significant scope to expand along with the economy. 14. Predominanceof Coal in Power Generation.Coal has also beenthe predominant source of electricity generation in China. By the end of 2006, China's installed capacity for electricity generationexceeded622 GW and electricity generationreached2,834 TWh. Among the generation facilities, 484 GW or 78% consisted of thermal power units, generating 83% of the total electricity output. Coal-fired generation capacity amounted 422 GW, accounting for about 50% of the total coal consumption inChina. 15. Low Efficiency of Coal-firedPower Generation.China's coal-fired power plants consume considerably more coal per kWhof electricity suppliedthan the international average. In2006 coal- fired generation in China required an average 366 gce/kWh (units 2 6MW) compared to a 300 gce/kWh benchmark in Japan or Europe. The main factors contributing to China's low power generation efficiency are: (i) large share of generation by inefficient small units; (ii)generation 24  dispatch i s not optimized for achieving maximum efficiency; (iii)small CHP units which are operating for power generation only; and (iv) old mid-sized coal-fired units operating at a relatively high coal consumption rate. 16. Large share of generation by inefficient small units. In2006 there were 115 GW o f coal- fired generation units sized 100 MW and below, accounting for more than 27% o f the total coal- fired generation capacity in China. With a typical heat-rate between 400 and 800 gce/kWh, these small units significantly underperform compared to medium and large sized coal-fired generation unitsinChina. For example 200 MW units consume about 360 gce/kWh, while 300 MW and larger unitsconsume 325 to 355 gce/kWh17 (see Table 1.3 below). Table 1.3: Installed Capacity and Average Efficiency of Coal-Fired Generation in China Year 2002 2006 Gross CO2 Installed Gross co2 Installed Coal-fired Generation Heat-rate Emission Capacity Heat-rate Emission Capacity (gce/kWh) Rate (GW) (gce/kWh) Rate (GW) (kg/MWh) (kg/MW h) TotaVAverage 357 977 249 367 1,004 422 600 MW SUnit Size 328 897 18 326 892 82 300 MW S Unit Sizee600 326 - 350 892 - 357 95 325- 355 889 971 - 154 MW 100 MW 5 Unit Size<300 340 - 390 930 1,067 - 82 340 390 - 930 1,067 - 113 MW Unit Sizee6 MW na na na na na na 17. Generation dispatch not optimizedfor achieving maximum efficiency. The overall low efficiency o f coal-fired power generation in China i s also attributable to its generation dispatch practice. Unlike most other electricity systems in the world, Chinese power generation dispatch practices do not favor more efficient or lower variable cost generation units18. Instead, all thermal generation units are scheduled to operate for a similar number o f hours per year, regardless o f their efficiency or fuel consumption costs. The underlyingcause o f this practice i s the regulated energy- only generation prices for electricity that i s supplied to grid companies. The energy-only price for a coal-fired generation investment project i s approved based on an assumption o f annual operating hours. This i s usually around 5000 hours. On a year-ahead basis, each generation unit inoperation receives a proportional allocation o fthe demand forecast, thus leading to a similar number o f annual operational hours. Throughout the year, the dispatcher follows the operational hours target allocated to each unit to schedule generation and operate the system. Actual operational hours at the end o f the year may vary depending on demand, but the difference between forecasted and actual demand tends to be allocated proportionally to ensure that all units end with a similar deviation to the allocated annual operational hours. The result is significantly greater average coal consumption per MWh o f electricity production than if the dispatch had prioritized more efficient coal-fired generation. ''International Conclusions of a survey conducted by government agencies in2007. practice o f merit order dispatch is to dispatch available generation units from higherto lower variable costs, subject to system security constraints. 25  18. Although, historically, eachthermal unit was allocated the same number o f annual operational hours independent o f efficiency, in recent years there has been a trend towards increasing the operational hours that are allocated to larger coal-fired units equipped with flue-gas desulfurization systems. However, results show that the difference between operational hours o f efficient and inefficient coal-fired units still remains limited, usually less than 10%. (i) Generation Pricing Practice. The principles o f generation tariff in China have been evolving over the past years. This has progressed from ensuring cost recovery plus a rate o f return on investment to, in some cases, benchmark provincial generation tariffs differentiated by unit size and technology 19. However, generation has always been based on an "energy-only" tariff approach, in which generators are paid for the energy injected to the grid ("on-grid generation tariff')20, Currently, the thermal generation tariff is set during the investment approval process, and is based on generation benchmark prices and an assumption o f energy to be generated2'. This energy-only generation tariff system has created a barrier to improving efficiency as changing dispatch practices would result in revenue reduction o f the less efficient units, in some cases not sufficient to recover fixed costs. Compensation mechanisms are to be implemented with the ESD pilot to address financial impacts on generation companies, as a transitional measure until new generation pricing practice i s developed and implemented. (ii) Grid Company Pricing. A change in dispatch practices could also affect the power purchase costs and the regulated tariffs at which the grid companies sell power to their customers and the risks they face as wholesale purchasers. Once a provincially dispatched generator starts commercial operation, the grid company must buy the energy supplied to the grid at the approved tariff ("on-grid tariff'). End customers retail tariffs o f the grid company are set annually and include a pass-through o f forecasted power purchase cost. This annual power purchase cost i s estimated based on a year-ahead planning, typically together with the approval o f the operational hours o f the units to be dispatched. Each power plant and even each unit inthe same plantmay have a different on-grid tariff. A generation unit with low efficiency may have a lower tariff than a more efficient unit, leading to an increase inpower purchase cost o fthe grid company and also inretail tariffs ifthe energy generated by the more efficient, but also more expensive, unit is increased. Deviations between forecasted and actual power purchase costs due to efficient dispatch may affect cost recovery o f the grid company, as annual retail tariffs are not adjusted when generation purchase costs change. (iii) Trading of Operational Hours. The annual operational hours allocated to each generation unit represents the "right" to generate the corresponding energy during the year. Inrecent years, the GOC has encouraged, and some provinces have initiated, the trading o f operational hours among generators as a step in the transition to a more efficient dispatch without negatively affecting generators' revenues or grid companies' l9This practice results inthe same or similar generationtariff for the same type/technology and size of units commissionedaroundthe same time inthe same province. 20There are some exceptions, e.g. pumpedstorage ownedby the provincialgrid companyprovidingpeaking and reliability ancillary services for system operation. 21There has been an implicit link, though not explicitly set inregulations, betweenthe practice of operationalhour allocation andthe energy assumptioninsettingthe energy-only generationtariffs. 26  purchase costs. This trading has allowed substituting operational hours o f an inefficient unit with an efficient unit, while maintaining the on-grid tariff of the substituted generation. This means that because the price at which the grid company buys the energy does not change, there is no negative impact inretail tariffs or in grid companies power purchase cost recovery. The trading is a win-win financial net result for generation, where the substituted unit benefits from a payment for the allocated operational hours without burning fossil fuel (typically, coal), and the substitution efficient unit benefits from selling more energy at a price higher than its variable production cost, paid by the substituted generation22. In summary, this trading has developed due to the value o f fossil fuel savings, as the same energy i s generated with more efficient generation, while burning less fuel. However, voluntary trading o f operational hours cannot achieve the full improvement expected from establishing a centralized efficient dispatch practice as proposed inthe newESD regulations. (iv) Efficiency Monitoring and Information Disclosure. There has been no clear regulation on system and generation information that has to or can be disclosed by the provincial grid company and most generation data tends to be considered confidential. This practice needs to change so as to implement the ESD because the Provincial Economic Commissionwill require data on the efficiency and emission levels o f unitsto be able to prepare the merit order tables for dispatch thermal generation. In addition, system and generation data disclosure and clear procedures and methodology for the verification, monitoring and reporting o f the thermal units' efficiency and emissions become essential to the pilot ESD to ensure transparency, fairness and predictability to power generation companies and investors and for the achievement o f maximized coal savings and GHG emission reduction. Standardmethodologies and procedures for measuring and verifying thermal unit efficiency, as well as regulations on the scope o f information disclosure needto be developed. 19. Small CHP units operatingfor power generation only. Small CHP units operate at high overall efficiency when providing both power and heat. For this and other reasons, small CHP units supplying heat are exempt from the government-mandated closure. However these units should supply a specified ratio o f heat-to-p~wer~~ supply duringthe year. The small CHP unitsthat do not supply the required ratio o f heat-to-power over the year shall be closed down. Nonetheless, despite government regulations, many small CHP units in China continue to operate solely for power generation even when more coal-efficient capacity i s available for substitutive generation. This occurs because the regulatory entities and system dispatcher do not have effective measures for timely monitoring o fthe heat supply by the CHP units.A CHP on-line monitoring systemwill serve as an essential tool for monitoring the heat supply and for dispatch o f the CHP units under the ESD24. This will support the enforcement of government regulations and thereby improve efficiency. 22Inmostprovinces, the trading has beenbetweenthermal units. However, inSichuanProvincethe trading has targetedmaximizing hydro generationby transferringthermal operationalhours to hydro units with surplus energy to avoid or minimize spilling. 23State Council Document [2000]1268: Heat-to-PowerRatio over the year (GJ: kWh*(3600 GJkWh)) x 100%must equalto or above 100%for units smaller than 50 MW, 50% for units between50 to 200 MW 24Under the issuedpolicy for ESD, a CHP unit's merit order list inthe dispatch depends onwhether or not the unit is actually providing heat. The ESDregulationsrequire CHP to be equippedwith heat supply on-line monitoring. 27  20. Old mid-sized coal-fired units operating at relatively high coal consumption rate. The mid- sized coal-fired units built in the 1990s are operating at coal consumption rates higher than units with new technology. These older units have the potential to improve their efficiency through rehabilitation and retrofit. Associated O&M also needs to be improved to sustain the efficiency levels. The EU-funded technical assistance project to Improve Efficiency and Reduce Environmental Impact for Fossil Fuel Fired Power Plants within China completed in May 2005 confirmed that additional efficiency gains and emission reductions could be achieved during generation life expectancy if advanced technologies were applied in these areas. This potential could be achieved through (i) rehabilitation o f more than 100 sets o f 200 to 300 MW units built in the 1990s; (ii) conversion o f more than 81 sets o f 300 MW units in northern China from solely power generation into CHP operation; and (iii)recovery o f heat wasted in the condensing and cooling systems o f condensing-type power generation units for use in district heating. This would replace distributedcoal-fired boilers. D. GovernmentStrategyfor EfficiencyImprovement 21. Participation in International Efforts to Address Climate Change. China has actively participated in international efforts to address global challenges, including climate change and degradation o f land and biodiversity. China played an important role during the negotiation o f the UNFCCC. On behalf o f the Government, the Prime Minister signedthe UNFCCC duringthe United Nation Conference on Environment and Development in 1992 and China was one o f the first countries to ratify the Conventionin 1993. China ratifiedthe Kyoto Protocol in2002. 22. Plans and Target for Coal Consumption Reduction. Chinese authorities at the highest levels have recognized that a business-as-usual approach in the energy sector will lead to unacceptable environmental consequencesand strain the resource supply chain on an unprecedented scale. The Government initiatives intendedto improve efficiency and reduce coal consumption in China are contained in its 11* Five Year Plan (2006-2010), issued in early 2006, which calls for reduction of energy consumption per unit output o f GDP by 20% by 2010. The Medium and Long Term Energy Conservation Plan, issued in 2004 by NDRC, requires reduction of energy intensity from2.68 tce per 10thousand o fGDP output in2002 to 2.25 tce by 2010 and 1.54 tce by 2020. 23. The 1lth Year Plan incorporates major objectives of energy conservation. These include: Five (i)significant increase in overall energy efficiency, both inmajor industries and for major products; (ii)building robust energy conservation systems including supportive laws and standards, policy, technical services, inspection and management; and (iii)emphasizing a new, market-oriented growth model that is also more energy efficient and environmentally friendly. This constitutes a multi-pronged energy strategy aimed at improving the efficiency o f the energy sector, bringing energy intensity in line with international good practice, developing clean coal technologies and relying more on market-based approachesto meet the objective o f sustainable development. 24. Actions to Address the Low Efficiency of Coal-fired Power Generation. Specific strategies o f the GOC to improve the efficiency o f coal-fired power generation include: (i) closing down inefficient small coal-fired units; (ii)pilot and later replication o f efficient fuel saving generation dispatch, known as the ESD; (iii) adoption o f new clean coal technologies such as IGCC; (iv) investment in energy efficient systems and rehabilitation o f existing generation units; and (v) scale-up o f renewable power generation. 28  25. ClosingDown Inefficient Small Units. The GOC's strategy for reducingthe capacity share of small generation units seeks to close down 50 GW o f the small inefficient coal-fired units by 2010. Provincial closure goals until 2010 have been negotiated and in 2007 NDRC signed agreements with 30 provincial governments and 7 major power companies on the closure goals. Early results have been promising, with 14.38 GW o f small units closed by the end of 2007, exceeding the national annual target o f 10 GW. However, most o f the units closed belonged to large power generation companies which have the financial, institutional and technical capacity to address the financial and social impact o f such closures. The units remaining to be closed in2009 and 2010 are smaller in size and mostly owned by municipal and county level small power companies, who are less likely to be able to address the financial and social impact and close these units in the time allotted without additional financial support. The major financial and social difficulties associated with closure and faced by the smallpower companies include25: (0 ImBact on Plant Staff Emplovment. The resulting unemployment o f plant staff poses the most difficult barrier to the closure o f small units. Small power companies do not have the re uired technical and financial capacity to build the large units (of at least 300 2% MW) necessary to replace the small units and re-employ the affected staff for operation. Neither do they have other businesses or the ability to provide additional training support for re-employmento f staff; (ii)DebtRepayment. Some smallthermalunitstobecloseddownstillhaveheavydebt, partially due to the regulated low generation tariffs they have been receiving since commissioning. The closure o f these small units will result in lost revenue needed to repay the debt. 26. To provide financial support to the closure, regulations entitle the small units closed down by 2010 on schedule with continued tradable operational hours for a period o f up to three years after the closure. Additionally, every unit of 6 MW and larger in Shandong province has a tradable SO2 emission allowance up to 2010. Currently there i s room for the SO2 emission allowance to be traded and used either by large existing or new efficient generation units. There is also scope for trading o f operational hours under the existing dispatch practice. Both Shandong and Shanxi have implementeda platform inthe Provincial Grid Companies to facilitate trading of operational hours among different generation companies owning generation units under their dispatch. However, small companies with a power plant at municipal or county level are outside the provincial grid company dispatch and thus unable to trade their operational hours after closure. There has been until now no trading of SO2 emission allowances in both provinces due to the lack of legal, institutional and technical enabling environment as well as uncertainty about the value of the SO2 emission allowance. 27. Pilot Efficient Fuel Saving Dispatch. In 2007, the GOC called for pilot implementation of the principles for a new efficient dispatch practice - the ESD27- in five pilot provinces, namely Henan, Jiangsu, Guangdong, Sichuan and Guizhou. The objective o f the pilot ESD is to dispatch generation to minimize fossil fuel consumption, reduce emissions and prioritize renewable energy 25See details inthe GEF PPG financed Social Economic Survey for Closing down Small Units in Shandong, Shanxi, Henan and GuangdongProvinces, November, 2007. 26With the purposeof facilitating closureof small units,government regulations issuedgive priority to the approval of new larger coal-fired generationcapacity by owners ofthe small unit capacity closed. "Asimulationstudyconductedaspartoftheprojectpreparationworkshowsthatenergysavingdispatchinone provincialpower grid alone could reduce 2.2 million tce per year during the period 2007-2011. 29  and other clean energy resources. The GOC requires the ESD pilot to include: (i) preparation o f detailed rules for system dispatch; (ii) preparation, by the Provincial Economic Commission, of merit order tables o fthermal units ineach province for the grid company dispatch center to follow; (iii)financial compensation to small units closed in line with government policies; (iv) preparation and implementation o f a Financial Compensation Mechanism to address the financial impact to power generation and to ensure sufficient peaking, frequency control and system reserve capacity for system reliability; (v) equipping all coal-fired units with flue-gas monitoring systems, installation o f on-line real-time heat supply monitoring system at all CHP units and establishment o f data communication between the dispatch center and environmental regulatory agency; and (vi) verification and confirmation o f coal-fired units' efficiency levels. However, the pilot implementation o f ESDhas beendelayed due to the following major difficulties: (i) The required Financial Compensation Mechanism not in place. Under the current energy-only generation tariffs, the ESD pilot would lead to significant financial impact. Generation unitsthat are more efficient will benefit from increased generation while less efficient units will see their revenues reduced. The Financial Compensation Mechanism to be implemented under the ESD pilot i s expected to address the financial impact to generators and ensure, among other things, the availability o f sufficient generation reserve for system reliability and security o f supply. The ESD could also affect the intended financial support to cover costs o f small units closed on schedule by the year 2010, since the practice o f allocation and trading o f operational hours would cease to exist. (ii)Newtechnicalregulationsonverification,accessanddisclosureofkevdatanotinplace. The regulations are essential for providing key data requiredfor the pilot ESD, such as unitefficiency and emissionlevel; and (iii)Inadequatemonitoring of CHP units'real-time operation. Under ESD,the dispatch merit order o f CHP will depend onwhether or not it is supplyingheat. However, systems to monitor on line their heat supply are not inplace. 28. Increasing Financial Resources for Energy Efficiency Improvement. The GOC has budgeted US$3.2 billion in 2007 to support activities to improve energy efficiency and reduce pollutant emissions. O f this, US$947.2 million was earmarked as grants to encourage major energy- efficient projects and was to be disbursed based on the value o f energy savings. The MOF budget would be doubled in 2008 and could be channeled to promote investment in thermal power plant efficiency improvement. 29. Adoption of Key Environmental Standardsfor Power Plants. The 11' Five-Year Plan sets a target to reduce the country's 2005 level o f SO2 emission by 10% by the year 2010. The revised Standards on Emissions o f Air Pollutants from Coal-Fired Plants (GB 13223-2003) limit the SO2 emission o f new power plants to below 400 mg per Nm3.New financial incentives, such as tariff premium for plants with Flue Gas Desulfurization installation have also been implemented. In addition there are also fines, including an SO2 emission fee o f RMB 633 /ton as well as heavy penalties for noncompliance o f emission caps. The enforcement i s being strengthened with measures such as installation of on-line flue gas monitoring systems at power plants. 30. To achieve the national SO2 emission control target, the former State Environmental Protection Agency had signed binding SO2 emission control targets with the seven largest SO2 30  emission provinces (including Shandong) and the major power generation companies. Government regulations also require that construction o f new generation units must obtain SO2 emission allowances and have encouraged power companies to trade their SO2 emission allowances. A further step taken inpioneering provinces, including Shandong, is to cap SO2 emission up to 2010 to each generation unit o f 6 MW or larger. This has created an environment for the small coal-fired unitsto be closed inorder to trade their SO2 emissionallowances to large operational or new units, andthus obtaincomplementary financial resources to cover the costs of closure. 31  Annex 2: Major RelatedProjectsFinanced by the Bankand/or other Agencies CHINA: ThermalPower EfficiencyProject Sector Issue Project IEG Latest Supervision (ISR) Ratings rating (BanWGEF-financed projectsonly) BanWGEF-financed Implementation Development Progress(IP) Objective (DO) Energy-efficiency and HeatReformandBuilding NA S S environmentalimprovements SO2emissionsreduction Buildingand industryenergy IUNDPChina:End-Use I NA I NA NA efficiencyandenvironmental Energy EfficiencyProject improvements Lightingefficiency andenergy UNDP:Barrier Removalfor NA NA NA saving EfficientLightingProducts and Systems 1. The project has been developed and will be implementedin close coordination with the on- going energy efficiency related international assistance program in China, thereby maximizing knowledge-sharing and incorporating lessons learnedinto the project design. The First and Second China Energy Conservationprojects focus on promoting energy efficiency through the development of energy service company industry inChina. The project management office which managedthese two projects will also provide implementation support for the project. 2. The projectwill coordinate with and take advantage of efforts under the China Energy Efficiency Financing Project recently approved by the Bank and the GOC and the United Nation Development Program (UNDP) GEF China: End-Use Energy Efficiency Project. The former has funded a technical assistance to the Establishment of the National Energy Conservation Center and the latter has a component, Capacity Building and Training for Provincial Energy Conservation Centers, under implementation. The UNDP project also will provide substantive energy audit training to selected provincial energy conservation centers. Inaddition, the project will coordinate with the International Finance Corporation (IFC)/GEF China Utility-Based Energy Efficiency Project and the projects focusing on energy efficiency improvement financed by other agencies, such as the FrenchDevelopment Agency. 32  PDO/GlobalEnvironmentalObjective ProjectOutcomeIndicators Use of ProjectOutcome Information Interim Strategy 0 Reduce coal consumption and GHG Average coal consumption YR1-3: Determineif emission per unit o f coal-fired and GHG emission per unit policies and regulations electricity production in Shandong, o f coal-fired electricity need to be adjusted; Shanxi and Guangdong Provinces output (gce/kWh) in Shandong, Shanxi and YR4: Feed into Guangdong Provinces government's power sector efficiency strategy IntermediateOutcomes Outcome Indicators Use of Intermediate Outcome Information Outcome 1 Outcome 1 Outcome 1 0 Reduced share o f generation 0 Cumulative capacity of YR1-3: Test effectiveness capacity by less efficient coal-fired small thermal unit closed o f financial incentive units inShandong and Shanxi down in Shandong and output- based mechanism Provinces Shanxi provinces YR3-4: Inform adjustments 0 Operation of c ~ On-line p o f policies and incentive Monitoring Systems in output based mechanism Shandong and Shanxi Provinces Outcome2 Outcome2 Outcome 2 Improved efficiency o f coal-fired Thermal efficiency o f YR1-4: Establish financially power and heat supply at targeted targeted plantdunits successful cases, plants benchmarks and best 0 Annual coal savings and Practices GHGemission reduction from targeted plantdunits Outcome3 ~~ Outcome3 Outcome3 0 Changed from existing dispatch 0 Pilot operation o f ESD YR1-3: Test effectiveness practices to fuel efficient generation Operation o f dispatch o f approach and regulations dispatch in Guangdong Provincial simulation system on generation dispatch Power Grid Report on assessment o f ESD pilots YR4: Inform improvements to efficient generation dispatch for replication Note:PDO-Project DevelopmentObjective. 33  M El .I L c, 0 .I C -2 Y 3 L d (Ei m YC Q) E % El E  vr m Lr 0 w .-E  Annex 4: Detailed Project Description CHINA: Thermal Power EfficiencyProject A. Background 1. Project Development Objectives. The project development objective i s to reduce coal consumption and GHG emission per unit of electricity production in Shanxi Province, Shandong Province and Guangdong Province in China. To achieve these objectives the project i s designedto address the major factors that have caused the low efficiency o f coal-fired power generation in China (see Annex 1). 2. Selection of Pilot Provinces. Shandong, Shanxi and Guangdong provinces were selected as pilot provinces because their power generation relies heavily on coal use and both Shandong and Shanxi have sufficient reserve to proceed with the closing o f small units without affecting supply reliability. In both Shanxi and Shandong Provinces, the installed power generation capacity i s mostly coal-fired. Both provinces have a significant share o f small generation units, making up 27.8% and 36.2% o f their total capacity respectively. The provinces have agreed with NDRC to close down 2,671 and 4,000 MW o f small units respectively by 2010 and are facing all the issues o f closure as discussed inAnnex 1. Additionally, Shandongi s one of the leadingdeveloped economies inthe country while Shanxi is one ofthe western provinces receiving central government subsidies for poverty reduction. This will allow the project-supported MCSU to be tested under different economic conditions. Both provinces are located in northern China and have significant potential for efficiency improvement through conversion o f units from power generation only into CHP operation as well as recovery o f residual heat from power plants to replace distributed coal-fired boilers for district heating. Guangdong Province is one o f the five provinces selected by the central government for piloting the ESD and the provincial grid has a mix o f coal, hydro, wind, nuclear, gas, oil and pumpedstorage capacities. More importantly, GDGP, which i s responsible for dispatch o f the Guangdong Provincial Power Grid, are open to new approaches in system dispatch and, during the project preparation, demonstrated clear understanding o f the system dispatch issues and strong ownership and commitment to explore efficiency improvement through systemdispatch. 3. Guangdong Provincial Power Grid. By the end o f 2006, the generation capacity dispatched by the Guangdong Provincial Power Company was mainly coal-fired (66%) plus a mix o f nuclear (1O%), hydro (2%) and other thermal, such as natural gas, liquefied natural gas and fuel oil (21%). Demandis forecasted to grow 11% in 2008 and then 10% per annumuntil 2010. O f the total 246 TWh energy supplied by the Provincial Grid Company in 2006, nearly 26% was imported from other provinces and the Three Gorges Hydropower Project, 71% was produced by thermal units (of which almost 57% was coal-fired) and 1% was producedby hydropower plants inthe province. Table 4.1: GuangdongProvincially Dispatched Generation in 2006 2006 No. of Unit Capacity (MW) Output(GWh) Coal-fired 97 26,175 139,073.7 Gas (natural gas and liquefied natural gas) 25 5,530 954.3 Fuel Oil 20 2,960 4,799.4 Nuclear 4 3,948 30,976.6 Hydro 16 875 3,296.7 Sub Total Provincial Generation 162 39,488 179,100.7 Imports 66,707.0 Total 245,807.7 36  4. Shanxi Province. By the end o f 2006, the total installed capacity and power generation in Shanxi reached27.5 GW and 152.6 TWh. Of this 26.7 GW (97.1%) and 150.3 TWh (98.4%) were derived from thermal power capacity and generation. Small therma1,unitsreached 5.8 GW (21.6%) and generated 33.9 TWh (28.7%) in2006. The average coal consumption rate for power generation inthe provincewas 373 gce/kWh in2006, higher than the national average of 366 gce/kWh. Within the provincial grid, the coal consumption rate of units sized 100 MW or smaller averaged 465 gce/kWh in 2006. The closure target of 2,671 M W represents 10% of the 2006 total installed capacity of the province. Table 4.2: ShanxiPower Generationin2006 No. Average Operation of Capacity Heat-rate Hour output - Unit (MW) (gce/kW h) (h) (GWh 1. Provincial Grid Hydro 790.02 _ _ 3,021 2,387 Thermal 19,961.25 *382 5,797 115,717 Inwhich: thermal unitsllOOMW 5,765.25 465 5,878 _ _ _ _ 33,886 - Sub-Total 20,751.27 118.104 1.1 Municipal Grid Dispatching Hydro 122.02 _- 1,800 220 Thermal (all units5100 MW) 2,496.25 513 4,903 12,240 - Sub-Total 2,618.27 _- _- 12,459 1.2 Provincial Grid Dispatching Hydro 668.00 -- 3,244 2,167 Thermal 17,465.00 368 5,925 103,477 Inwhich: thermal units 5100MW 50 3,269.00 438 5,764 21,647 - Sub-Total 18,133.00 105,644 2. Others Hydro _ _ -- _- Thermal (>lOOMW) 6,700 343 5,155 34,537 - Sub-Total 6,700 34,537 3. Province HydroIWind 790.02 -- 3,021 2,387 Thermal 26,661.25 373 5,636 150,254 - Total 27,451.27 _- -- 152,640 Note: /1unitslocatedwithin theprovincebutdispatchedfromoutsidetheprovince. 5. Shandong Province. By the end of 2006, the total installed capacity andpower generation in Shandongreached 51.8 GW and 235.1 TWh, of which 51.1 GW (98.7%) and 234.8 TWh (99.9%) were thermal power capacity and generation. Small thermal units reached 18.8 GW (36.2%) and generated 88.3 TWh (37.5%) in 2006. The average coal consumption rate for power generation in the province was 382 gce/kWh in 2006, higher than the national average of 366 gce/kWh. Within the provincial grid, the coal consumption rate of units sized 100 MW or smaller averaged 431 gce/kWh in 2006. The closure target of 4,000 M W agreed with NDRC represented 7.7% of the 2006 total installed capacity of the province, which will keep growing to meet the forecasted demand growth with timely and sufficient investment in new and larger scale generation units to replace the closed capacity and ensure sufficient system reserve. 37  Table 4.3: ShandongPowerGenerationin2006 ~No. of Capacity output - Unit 0 (GWh) 1. ProvincialGrid Hydro/wind 242 672 -- _ _ 3 13.3 Thermal 578 41,246 367 4,480 184,770.7 inwhich: thermalunitsIlOOMW 534 8,897 411 4,299 38,243.1 - Sub-Total 820 41,918 185,084.0 1.1 MunicipalGridDispatching Hydro 116 52 -- 2,960.60 153.1 Thermal 478 5,793 431 4,365 25,289.0 inwhich: thermalunitsI100MW 478 5,793 43 1 4,365 25,289.0 - Sub-Total 594 5,845 -- _ _ 25,442.1 1.2 ProvincialGrid Dispatching Wind 126 621 _ _ 258.03 160.2 Thermal 100 35,452 357 4,498 159,481.8 inwhich: thermalunitsI 1OOMW 56 3,104 371 4,174 12,954.1 - Sub-Total 226 36,073 159,641.9 2. Others h Thermal (all unitsI 1OOMW) 541 9,860 5,073 50,011.5 3. Province HydroIWind 242 672 313.3 Thermal 1,119 51,104 234,782.2 Total ....~ 1,361 51,777 235,095.5 ~ B. ProjectDescription 6. The project has five components: (i) mechanisms to support the closure o f inefficient small coal-fired units; (ii)demonstration o f power plant efficiency improvement; (iii)transition to efficient generation dispatch; (iv) technical assistance for project implementation; and (v) project management. 7. Component 1: Mechanisms to Support the Closure of Inefficient Small Coal-fired Units.The objective o fthis activity is to establish a transparent and effective output-based financial incentive mechanism, the MCSU, to support small generation companies in closing down inefficient small units and reducing GHG emission. The component will support: (i) establishment and pilot operation o f the MCSU; (ii)set up o f CHP On-line Monitoring Systems; (iii) development o f bulletin systems to enable the trading o f pollutant emission allowances; and (iv) M&E, knowledge sharing and replication o f successful experiences. 8. Activity A. Pilot Implementation of MCSU. This activity will provide technical assistance and grant support for the establishment and pilot operation of the MCSU in Shandong and Shanxi provinces. The GEF Grant will contribute to the MCSU to top up the government budget for output-based payment per MW closed for the owners o f the closed small units according to the amount o f capacity closed down. This will be calculated on a US$/MW basis and will target exclusively the small coal-fired units that are not provincially dispatched and that are owned by 38  small county / municipality companies, in line with the eligibility criteria defined in the MCSU OperationalManual. (i)Capitalization of the MCSU. The sources o f the MCSU include: (i) Grant o f US$5 GEF million ear-marked for capitalization o f the MCSU; and (ii)MOF and provincial government budget allocations for closing down small units, matching the GEF Grant with a ratio of at least 3:1. Based on the findings of the survey conducted in200728,this amount o f resources will be adequate for the MCSU to provide the minimum financial support requiredto address the financial and social barriers created when closing down the targetedsmall units inShandong and Shanxi(see sections below andAttachment 1). (ii)MCSUPilotOperation.Theprojectwillprovidetechnicalassistancetoboththecentral and provincial government agencies in preparation o f the MCSU Operational Manuals, MCSU pilot operation and M&E. The principles for provision o f output-based mechanism under the MCSU were discussed and agreed during the project preparation and outlined inthe table o f contents o f the MCSU Operational Manual (see Attachment 1). (iii)AssessmentoftheMCSUandReplication.Thisactivitywillprovidetechnicalassistance to the MOF inmonitoring the MCSU pilot operation. Itwill also assess the effectiveness o f the financial incentive mechanism infacilitating closing down the targeted inefficient thermal units to support improvements and replication of the incentive output based mechanism usingthe Government's own financial resources. 9. Activity B. Set-up of CHP On-line Monitoring System This activity will provide technical and financial support to Shanxi and Shandong provinces on a feasibility study, planning and design and implementation o f CHP heat supply on-line monitoring systems, support o f verification of small CHP to be closed down, as well as dispatching andmonitoring the operation o f CHP units. (i) Shanxi - CHP On-line Monitoring System. There were 70 sets o f CHP units o f 100 MW or smaller dispatched by the Shanxi Provincial Grid for power generation in 2006. The CHP On-line Monitoring System will include real-time heat supply data acquisition at the units, datatransmission through the existing dispatch data exchange channels andthe CDMA wireless network, computer systems for on-line monitoring at the dispatch center o f the provincial grid, and integration of the on-line heat supply data with the generation dispatch system. The power plants will finance and install the heat supply data acquisition elements at each CHP unit in accordance with the latest government regulations. The project will support consulting services and computer systems required for on-line monitoring o f the heat supply by these CHP units at the Provincial Grid Dispatch Center, including: (i)feasibility study and system configuration; (ii) detailed system design; and (iii) implementation, including hardware, standard system software, application software development, modification o f existing data communication links to power plants and integration o f the on-line monitoring with the dispatch system. The project will also support hardware and software for the Provincial Economic Commissions to access the selected CHP operation data to support enforcement o f government regulations on CHP units. 28The GEF PPG financed SocialEconomic Survey for Closing down Small Units in Shandong, ShanxiandHenan Provinces,November2007. 39  (ii)Shandong-CHPOn-lineMonitoringSystem.Therewere27CHPplantswith83CHP units, totaling 10.79 GW, on the Shandong Provincial Grid in 2006. The project will support the Provincial Dispatch Center and the Provincial Economic Commission to bring these CHP units under on-line monitoring. This system is similar to the one described above. The detailed system planning and design for monitoring the 83 CHP units and the development o f a simulation system have been completed by the Provincial Dispatch Center during the project preparation with the GEF PPG and the Government's own resources. The GEF project will support the implementation of the on-line monitoring system implementation. Based on the experiences o f the project supported on-line monitoring system, the Provincial Economic Commission will finance and implement a follow-up project to bring all the remaining CHP units(more than 500 sets) inthe provinceunderits on-line monitoring. 10. Activity C. Study and Support for Trading of Emission Allowances. This activity will support pilot programs in Shandong and Shanxi to facilitate trading o f the SO2 emission allowance entitled by the small coal-fired units closed, or to be closed down, before 2010, so as to generate additional revenues that can complement the MCSUto partially off-set the cost o f closure. (i)Bulletin System for Trading of SO?Emission Allowance. This will support, in the two provinces: (i) a study on practical government rules and procedures to facilitate the trading by small inefficient thermal units of their SO2 emission allowance; and (ii) feasibility study, implementation and pilot operation o f a bulletin system, which will facilitate the trading o f SO2 emission allowance; (ii)AssessmentofSO1EmissionAllowance Trading.Itincludestechnicalassistancetothe National PMO in assessment o f the effectiveness and efficiency o f the pilot SO2 emission allowance trading and its impact on the closure o f small units in the two provinces. The findings o f the assessment will be used for improvement o f the SO2 emissionallowance trading to be replicated inother provinces. 11. Activity D. Monitoring and Evaluation. This activity will provide technical assistance dedicatedto the M&Eo f the output and impacts o f activities underthe Component 1 inline with the indicators and data collection arrangement specified in the GEF M&E Framework (see Annex 3). The technical assistance will focus on: (i)measurement, collection and verification o f data; (ii) evaluation o f the impact on coal savings and GHG emission reduction; (iii)reporting; and (iv) training for capacity buildingon data collection and impact assessment. 12. Expected Outputs. This pilot program will support Shandong and Shanxi not only to achieve their agreed 2010 targets of closure targets (4,000 MW and 2,670 MW) on schedule but also to exceed their targets by 300 MW and 200 MW respectively. 2010 Target 2007 2008 2009 2010 Additional by 2010 1 Shanxi 2,670 1,007 536 622 505 200 2 Shandong 4,000 1,717 1000 800 483 300 40  13. Component 2: Demonstrationof Power Plant Efficiency Improvement.This component will demonstrate plant efficiency improvementand GHGemissionreduction through three different types o f investment activities: (i) conversion o f mid-sized units for power generation only into CHP units; (ii) heat recovery at thermal power units and utilization for district heating; and (iii) waste efficiency improvement at plants for power generation only following recommendations provided by plant energy auditing. To ensure successful demonstration, sustainability and replication, it will also support (iv) monitoring and assessment o f the effectiveness o f the three demonstrative efficiency improvement projects, knowledge sharing and publications; and (v) establishment o f the standard procedures and processes of plant energy auditing for identification and assessment of efficiency improvement investmentactivities and best practices o fplant O&M. This component will support the following demonstrative activities: 14. Activity A. Conversionfor CHP Operationat Huangtai. The project will support conversion of the two 330 MW units at Huangtai Thermal Power Plant in Shandong from power generation only into CHP operation to improve their overall thermal efficiency and to replace the heat supply from the two 110 MW CHP units and distributed boilers to be usedfor district heating and consequently, to reduce GHGemissions. 15. The plant has aninstalled capacity o f 2 x 110MW (#5 & #6) and 2 x 330 MW (#7 & #S). The two 110 MW units are CHP units, operating at an average annual heat-rate o f 405 gce/kWh in2007. The 330 MW units are for power generation only and operated at an average heat-rate o f 348 and 353 gce/kWh respectively in2007. The plan for efficiency improvement at the plant i s as follows: (i) conversion o f #7 & #8 units into CHP operation during 2007-2009 to allow closure o f #5 - #6 units and 77 distributedsmall boilers for district heating; (ii) building two sets o f 300 MW CHP units, one in 2009 and one in 2010 to meet both power and heat supply; and (iii)constructionduring2008-2010.of amasterheat-exchangestationandnetworkforheat supply. 16. Both the #7 & #8 units are condensing type units. Heat supply by the #7 & #8 units will be sufficient to replace the #5 - #6 and 77 distributed boilers for heat supply, with an additional 440 todh o f heat available to meet future load growth. Based on the project design carried out by a local instituteand reviewed and verified by a plant energy audit conducted by Xi'an Thermal Power Research Institute in November 2007 under the supervision o f the USAID-supported international consultant, the following activities will be implemented for effi ciency improvement under the project and the GEF Grant will co-finance 3.9% o f the total cost estimated at US$27.3 million: (i) Retrofit o f the two turbines and addition o f a steam extraction system to each o f the turbinesfor heat supply (0.65-0.90 MPa, 304