Tunisia - Second Natural Gas Pipeline Project

Document of The World Bank HU r5fp FOR OFFICIAL USE ONLY Report No. 2878-TUN STAFF APPRAISAL REPORT TUNISIA SECOND NATURAL GAS PIPELINE PROJECT May 1, 1980 Energy Department (Petroleum Projects) Europe, Middle East and North Africa Regional Office 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 I Tunisian Dinar (DT) = US$2.5 1 US Dollar = 0.4 DT FISCAL YEAR January 1 to December 31 1c WEIGHTS AND MEASURES 1 kilometer (km) = 0.62 miles 1 metric ton (tonne) = 2,204 lb 1 ton(ne) of oil equivalent (t.o.e. or tep) = 39.7 million British Thermal Units (Btu) 0 1 tonne crude oil (36 API) = 7.45 barrels 1 barrel of oil = 42 US gallons 3 1 cubic meter (m ) = 35.3 cubic feet 1 billion cubic meters/annum = 96,700 cubic feet/day 1 million cubic meters Hassi R' Mel gas = 1000 t.o.e. 1 million cubic meters El Borma gas = 1100 t.o.e. 1 Megawatt (MW) = 1000 kilowatts 0 API = measure of specific gravity of oil 1 US gallon = 3.785 litres 1 tonne gasoline = 357 gallons I tonne fuel oil = 6.62 barrels Note: All volumes are based on 1 atmosphere pressure and 15 degrees Celsius PRINCIPAL ABBREVIATIONS AND ACRONYMS USED LNG - Liquified Natural Gas LPG - Liquified Petroleum Gas (a mixture of propane and butane) ETAP - Entreprise Tunisienne d'Activites Petrolieres SNDP - Societe Nationale de Distribution Petroliere STEG - Societe Tunisienne de l'Electricite et du Gaz STIR - Societe Tunisienne des Industries de Raffinage SITEI] - Societe Italo-Tunisienne d'Exploitation Petroliere CFTP - Compagnie Franco-Tunisienne des Petroles SEREEPT - Societe de Recherches et d'Exploitation des Petroles de Tunisie SONATRACH - Societe Nationale pour la Recherche, la Production, le Transport, la Transformation et la Commercialisation des Hydrocarbures SOFREGAZ - Societe Francaise d'Etudes et de Realisations d'Equipements Gaziers TESA - Societe Tunisie Engineering (S.A.) ENI - Ente Nazionale Idrocarburi OTC - Office de Topographie et de Cartographie  FOR OFFICIAL USE ONLY TUNISIA NATURAL GAS PIPELINE PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. I. ENERGY SECTOR ........................................ . I Energy context .... ........... .1 Energy resources ...... ................0........... 1 Supply and demand patterns ............................ 3 Development prospects ..................... . ........... 4 Sectoral organization and structure .................. . 6 Sector investments and financial resources ............ 8 Sector policies ................................ 8 Role of the Bank ... ................................... 10 II. THE PROJECT ...............................i.............. 1 Background: Developments in Algeria and Italy ...... .. 11 Institutional framework ............................... 11 Gas availability ........................... ........... 12 The intercontinental pipeline ........... .. ............ 12 Project description - Tunisia's pipeline .............. 13 Status of project preparation .................... ..... 14 Project implementation .............. .. ................ 15 Project costs ........... . .. .... ..* ......... 15 Project financing plan ............... .. ............... 16 Procurement and disbursement .......................... 16 Ecology and safety .................................... 17 Project risks ... .................... .................. 18 III. BENEFICIARY ....................................................... 19 Organization and management ........................... 19 Recruitment and training .. .......................... 19 Accounting, auditing and insurance 20.................. 20 IV. FINANCIAL ASPECTS ........ .. ............... ............. 21 Future Pricing of Natural Gas ............. ............ 21 Future Performance: The Natural Gas Accounts (Algerian Gas) ............ .................................. 22 Past Performance: STEG Electricity ................... 23 Future Performance: STEG Electricity .....*........... 23 The staff appraisal report was prepared by Messrs. E. S. Daffern, P. Moulin, and S. A. Moussa, and Miss D. Robert (Energy Department). This document hu a restricted distribution and may be used by recipients only in the performance of their official duties. ls contents may not otherwise be disclosed without World Bank authorization.  -2- Page No. V. ECONOMIC ASPECTS ................................ ........ 24 Background ........... ...... ...................................... 24 The Market * * * * * * * * * * .................. .. ...... . ... ... ....... 24 Development and operating costs ........................ 24 Value of sales . .. ......................... ............... . 25 Project profitability . ..... ........ ....... ........... 25 Benefits to the economy ... .. .... ... .. .... ............ 25 VI. RECOMMENDATIONS ..................... a .. . - - ..... ...... 26 List of Annexes :1.01 Analysis of demand 1977-78 :1.02 Demand and supply for energy 1978-1990 1.03 Refinery capacity :1.04 Sector investments and financial sources :1.05 Resource development :1.06 Petroleum prices 2.01 Project schedule 2.02 Estimated schedule of disbursements 3.01 Present organization chart 4.01 Assumptions 4.02 STEG's past performance 4.03 Projections - gas division 4.04 Projections - electricity division 5.Ol Economic analysis - I 5.i02 Economic analysis - I and II 6.01 Documents on project file Map IBRD 14849  TUNISIA I. ENERGY SECTOR Energy Context 1.01 The energy sector in Tunisia is dominated by use of hydrocarbons, mainly oil which comprises 81% of the commercial energy market, and natural gas a further 14%; the remainder is met by hydro (1%) and imported coal and coke (4%). The opportunities for greater use of hydroelectricity and coal are limited. 1.02 Tunisia is a net exporter of oil (exporting 5 million tons of crude oil and products compared with imports of 2 million tons) 1/ and relies on the income from petroleum for more than a quarter of its export earnings. Consumption has been growing at 8% per annum through the 1970's and is now 1.8 million tons per year (33,000 barrels/day); domestic production in 1978 was 5 million tons. However, production from known reserves will decline through the 1980's, and this, when taken with the expected growth in consumption, will result in a dimunition in export earnings. While recent discoveries have been promising in that they have indicated petroleum reserves and promising poten- tial in rocks of a different geological age, the exploitation of these reserves is unlikely before the mid-1980s. 1.03 The construction of the Algeria/Tunisia/Italy pipeline has opened up a new opportunity for Tunisia. Natural gas could potentially meet 50% of Tunisia's energy demand, particularly in electricity generation and heavy industry. The availability of gas from the Algeria-Italy pipeline in the early 1980s at an import cost less than imported fuel oil, could slow, but not reverse, the expected reduction in exports. Further quantities are expected to be available from Algeria in the longer term, and can be supple- mented through development of the Miskar offshore gas field. Transfer of Tunisia's heavy industry and electricity generation to a new energy source (gas) is a major undertaking, requiring development of a national energy strategy and careful appraisal of policy options and project economics. Tunisia has recognized this need and is taking steps to organize itself accordingly. Energy Resources 1.04 Proven oil and gas reserves are concentrated almost entirely in three fields. El Borma was discovered by AGIP in 1964 and is owned by SITEP 2/, a 50/50 subsidiary of AGIP and the Government. Elf Aquitaine I/ Tunisian oil is of good quality (low sulphur) and the majority is cur- rently exported at a premium. For operation of the present refinery, the country imports lower priced high sulphur crude, thus making a financial gain. 2/ Societe Italo-Tunisienne d'Exploitation Petroliere.  -2- discovered the two other major fields, Ashtart (1971) and Miskar (1974), offshore in the Gulf of Gabes. Ashtart oil is being produced under a 50/50 joint venture with ETAP, 1/ the state oil company, and Miskar is expected to be majority owned by the Government with Elf Aquitaine having a minor share. 1.05 Indigenous proven reserves are estimated to be: Proven Reserves as at December 1978 Original Cumulative Remaining 1978 in Place Production Recoverable Production Oil - million tons El Borma (42 API) 83 33 25 2.3 Ashtart (290API) 88 14 35 2.3 Others (6) 57 4 9 0.4 228 51 69 5.0 Proven Reserves Original Cumulative Remaining 1978 in Place Production Recoverable Production Gas - billion cubic meters El Borma 30 13 2 0.4 Miskar 60 - 30 - Others (6) 12 2 5 0.3 102 15 37 0.7 There is also one oil field in disputed territory near the Libyan border. 1.06 Oil production from the major fields is progressing satisfactorily. Water is being injected at both El Borma and Ashtart to enhance recovery. 1979 output is expected to be 12% above that for 1978, at 5.6 million tons, but with a fall to below pre 1978 production levels by 1986. Both fields should produce substantial but declining quantities through the 1980's and into the 1990's. The other proven oil fields will cease production between the mid-1980's and mid-1990's. 1.07 Commercial gas production is from three fields, of which the signi- ficant one is the El Borma oil field. Following a recommendation by the Bank, STEG 2/ has agreed to purchase gas from the Algerian portion of El Borma. Despite this, the El Borma gas supply is expected to cease by 1986. As discussed subsequently in Chaper II, there are no firm plans to produce Miskar gas in the 1980's. The Bank agrees with this position. 1/ Entreprise Tunisienne d'Activites Petrolieres. 2/ Societe Tunisienne de l'Electricite et du Gaz.  - 3 - 1.08 Other Resources. Hydroelectricity is currently limited to one 25MW plant, with a similar plant under construction. The lignite deposits on Cap Bon have not been explored but are not believed to be large. Coal required for the steel industry is imported. Because of the climate, crops and farming methods and location of population, the possibilities for non-commercial energy are believed to be small, although possibly significant for isolated areas. Supply and Demand Patterns 1.09 Since 1971, commercial energy consumption has increased on average by 9% per annum from 1.2 million tons oil equivalent (toe) to 2.3 million toe in 1978. GDP increased over this period at a similar rate, giving an energy/ GDP growth in line with the norm for middle-income countries. During the same period Tunisia's crude oil and gas production has increased by 1.2 million tons, permitting an increase in net exports. 1.10 The energy supply/demand situation is summarized below: Thousand tons of oil equivalent Proportion 1971 1975 1978 by Source Consumption Oil products 1096 1392 1840 81% Gas 3 231 326 14% Hydro 17 10 10 1% Coal and coke 100 98 100 4% 1216 1731 2276 100% Met by Domestic production Oil 4097 4611 5014 Gas 3 231 326 Hydro 17 10 10 Imports 700 1508 2014 Less Exports & stock changes 3601 4629 5088 1216 1731 2276 1.11 Gas oil demand has been growing at 13% annually, meeting 40% of petroleum demand and Tunisia is now dependent on imports for more than 50% of its requirements. Fuel oil, supplying 35% of total petroleum needs, is imported to the extent of 30%, and all jet kerosene is imported. The main supplying countries are Greece, Italy and Libya. The growth in gas oil demand and the substitution possibilities for fuel oil are major factors in considering future refinery options, and are the dominant factors in refinery design.  - 4 - 1.12 For most of the 1970's, data on the use made of Tunisia's energy is incomplete and is concentrated primarily on power and large scale industry. An energy use analysis for Tunisia as a whole is available for 1977 and 1978. The power and industrial sectors use all of the hydro, gas and coal, 94% of the fuel oil and 28% of the gas oil, in total 56% of total energy, a propor- tion which has been growing during the 1970's. Their share of the total is expected to grow further in the 1980's. Apart from power, the major users of energy are the construction, chemical and extractive industries. Details are in Annex 1.01. 1.13 The refinery (at Bizerte) has a nominal capacity of 1 million tons/year and has limited catalytic reforming facilities. It has operated above the nominal rating throughout the 1970's (see Annex 1.03 for an analysis of output). The refinery was designed for and operates on imported high sulphur Iraqi crudes, allowing virtually the whole of Tunisia's own crudes to be exported. Tunisia's (El Borma) Zarzaitine crude attracts a quality premium; Ashtart crude is conveniently located for export. Given that the refinery now meets only 2/3 of Tunisia's needs, and that product exports are virtually nil, there is no advantage in making modifications to the existing refinery confi- guration. The solution is to design the refinery expansion to reflect future needs. The expanded refinery (discussed below) will initially use Tunisian crude. Development Prospects 1.14 Despite the availability of a relatively large supply of energy compared to current requirements, the energy sector in Tunisia is at a turning point where decisions made now will affect the long term through the end of the century. For its industrial energy strategy Tunisia could: (i) continue to base its strategy on oil. (ii) rely on royalty gas 1/ and imports, both coming from the Algeria-Italy gas pipeline. (iii) develop its natural gas resources. The Government chose option (ii), the use of Algerian supplies. 1.15 The choice between the three above options, or a combination thereof, involve complex technical, financial, economic and political considerations, and projections on an international basis which must inevitably be speculative. The Government gave lengthy consideration to the choice and decided in favor of relying on Algerian gas for the 1980's, both on economic grounds and in relation to the longer term energy policy options. Development of Miskar at this time was seen to pose difficult energy supply problems for the later 1/ Royalties are payable by Italy for the right to transport gas by pipe- line across Tunisia. They may be taken in the form of cash or as gas.  - 5 - 1980's when production would be declining, and to involve a particularly large financial investment in a single resource. In the meantime, the Government has agreed to undertake a study on ways of using offshore associated gas. The study will emphasize the possibility of a floating power plant and will include other possible ways of using the gas. The study will be commissioned shortly and wnen completed will be discussed with the Bank. 1.16 The Government's intention is to use natural gas to the maximum possible extent, and to contract accordingly for large quantities of gas, leaving little safety margin. Consequently, to avoid excessive payments for gas not taken, it is imperative for the energy forecasts to be sufficiently accurate since the gas will be purchased on a take or pay basis. 1.17 Apart from STEG's power forecasts, Tunisia has no proven experience of energy forecasting. This should be remedied through the energy planning work with Gordian Associates discussed subsequently (paragraph 1.36). The Bank has examined and accepted the forecasts for fuel for power generation. In relation to industrial use, the Bank has examined and accepted forecasts based on existing consumers (about 30) plus new plants under construction, making no specific allowance for other new plants. This is a conservative approach to supply and demand matching. Overall consumption is expected to grow more slowly than in the 1970's, yet in relation to GDP, at a slightly faster rate. The Tunisian current (5th) Development Plan is markedly differ- ent from its predecessor in its emphasis on heavy industry. Supply and demand is summarized below. Year by year forecasts of supply and demand are included in Annex 1.02, together with a breakdown of the sources of supply. Thousand tons of oil equivalent Average Annual supply 1978 1982 1985 1990 Growth Oil products 1840 2055 1955 2690 4% (of which substi- tutable by gas) (617) (580) (165) (190) Gas 326 1025 1895 2800 20% Hydro 10 10 20 20 6% Coal & coke 100 100 100 100 _ 2276 3190 3970 5610 8% Demand Transport 769 965 1175 1640 6% Commercial/household 239 315 390 550 7% Industry 675 1075 1285 1600 7% Power 593 835 1120 1820 10% 2276 3190 3970 5610 8%  - 6 - it will be seen that, despite the tremendous increase in the use of gas, the consumption of oil products is expected to stabilize only through the middle 1980's and pick up thereafter. The prospects for further substitution by 1990 are small, and are essentially limited to the hotel industry and domestic supplies. The coal and coke and most of the gas will be imported. By 1985 almost all potential substitution of fuel oil and gas oil by natural gas will have taken place. Less than 7% of potential substitution in power and industry will remain. Natural gas will then supply 79% of power and industrial demand, coal and hydro together will supply 5%, and 9% will be away from the supply pipelines or otherwise unsuitable for convenient substitution by gas. Gas oil and heating oil, used for trucking, local shipping, agricultural pumps and smaall scale heating, will form 54% of oil products demand, gasolines and aviation fuel 16%, kerosene and LPG (used for heating, cooking and lighting 15% and fuel oil, used for shipping and for consumers away from the gas pipelines, 15% (see Annex 1.02). 1.18 Detailed analysis product by product indicates a potential gas surplus in the years 1986 to 1989, during which some royalty gas would have to be taken as cash. Should the growth in energy demand for power and indus- try average less than 6% against 10% and 7% used respectively in the forecast, it would not be possible to avoid take or pay. The possibilities will be examined in the Gordian Associates' studies. During discussion of the studies the Bank will pay particular attention to the supply/demand match for the later 1980's. 1.19 The forecasts take no account of the potential for substituting cooking and heating fuels for small scale users with natural gas. There is already a gas distribution system in Tunis supplying 20,000 households. The quantities involved in domestic supplies are small. As part of the project, the Bank will finance a feasibility study of supplying natural gas to house- holds and small scale industry, to be completed by mid-1982. Agreement was reached on this at negotiations. 1.20 Following a study by the Foster Wheeler Energy Corporation, the Government has decided to proceed with the expansion of its Bizerte refinery to an annual capacity of 4 million tons. The expanded refinery will initially use Tunisian crude, both El Borma (Zarzaitine) and Ashtart blends in roughly equal proportions, production of which will be sufficient for maximum refinery output through 1985 only. Design based on domestic crudes will improve the security of supply, and will result in low sulphur products. The refinery has been planned so as to maximize the production of middle distillates and minimize the quantity of fuel oil. Nevertheless, some imbalances are anti- cipated including significant exports of fuel oil and naphtha. The precise mix of products will depend on the crudes used in practice and, in turn, depend on further discoveries in Tunisia. Refinery product mixes are shown in Annex 1.03. Sector Organization and Structure 1.21 Initially the petroleum sector was in the hands of overseas oil companies with the state controlling refining, power and gas distribution. The Government has substantially increased its role through the establishment  - 7 - of a state oil company, joint operating companies, and the agreed acquisition of the largest distribution company. Exploration and Production 1.22 In exploration and production the primary state company is ETAP (Entreprise Tunisienne d'Activites Petrolieres), which is 100% Government owned. ETAP has wide coordinating powers for the whole sector. The other state companies in this sector are SITEP, SEREPT 1/ and CFTP 2/, each 50% Government owned. SITEP operates the El Borma field and SEREPT the Ashtart field. Apart from its earnings through royalties and taxes the Government takes approximately 50% participation in Tunisia's oil and gas production. In addition to the state companies there are fifteen external groups engaged in exploration (including two major international oil companies, the remainder being North American independents and European companies) and there are three producers. Refining 1.23 The provision of all refined products is controlled through two state industries, STIR (Societe Tunisienne des Industries de Raffinage) and ETAP. The Government through STIR owns and operates the country's only refinery. Product imports are controlled by ETAP. The new refinery will also be wholly-owned by STIR. Transmission, Distribution and Marketing 1.24 STEG (Societe Tunisienne de l'Electricite et du Gaz) is responsible for hydroelectricity and for the generation and distribution of electricity. In relation to gas, STEG has the responsibility for the transmission and distribution of El Borma gas and Cap Bon gas, and the manufacture and dis- tribution of town gas in Tunis. STEG's activities will be expanded to include the transmission and distribution of Algerian gas from the intercontinental pipeline. 1.25 The construction, ownership and operation of the Algeria-Italy gas pipeline will not involve STEG and will result in the establishment of three companies in Tunisia, whose roles are described in the next chapter. 1.26 Distribution of oil products from the refinery and the terminal of the Bizerte/Tunis products pipeline is the responsibility of the oil companies. The Government company, SNDP (Societe Nationale de Distribution de Petrole) has 40% of the market. Together Esso, Shell and Mobil have 35% and eight other companies share the balance. Government Organization 1.27 The energy sector operates under the Energy Department of the Ministry of Industry, Mines and Energy 3/. The main functions of 1/ Societe de Recherche et d'Exploitation des Petroles de Tunisie. 2/ Compagnie Franco-Tunisienne des Petroles. 3/ Recently merged with the Ministry of Commerce.  - 8 - the Energy Department have been to negotiate exploration and development agreements, to set standards for the operation of the sector and to set fuel prices and power tariffs. There was no obvious need during the late 1960's and 1970's for Tunisia to undertake more than rudimentary energy planning and coordination. The need for more formalized plan4ng was recognized in 1977 and the Government has reorganized accordingly to meet the challenge. 1.28 The Energy Department has recently been remodelled to handle long term energy planning and the study and review of the economic, financial and legal aspects of alternative energy development plans. The Department's first priority is to complete the Gordian Associates study on energy pricing and planning as required under the second power loan (IBRD 1355-TUN). 1.29 Apart from its longer term planning and its study of non-conventional energy resources, the reorganized Energy Department operates through four divisions: (1) exploration and production; (2) refining transmission and distribution; (3) gas; and (4) power, to correspond with the sector structure. Control 1.30 The Government controls the oil and gas industry in many ways. For the state companies the Government appoints the president and the board, it controls the provision of long-term finance and it controls prices. The long-term development plans of the state companies are an integral part of Tunisia's national plan. Exploration is controlled through the issue of exploration licenses, which carry with them minimum work obligations. Permits are valid for three years and can be extended three times with a reduction each time of 20% in permit area, together with commitment to further work obligations. If a field is developed a production license concession is granted for 50 years, a substantially longer period than is common in other countries. The import of petroleum products is channelled through ETAP. The Government controls the retail prices of all petroleum products and transport charges, but within these limits distribution is handled by the various distribution companies. Sector Investments and Financial Sources 1.31 At the time of adoption of the current national plan, the energy sector was expected to absorb 17% of Tunisia's total capital investments over the five years 1977-81, which is high compared with other countries at a similar stage of development. The Fifth Plan provided for $1,330 million of investment in primary energy and $500 million for secondary energy. Because of the deferral of the Miskar project, actual expenditure will be $500 million less. Further information is in Annex 1.04. Sector Policies Resource Development 1.32 The main energy source so far found in Tunisia is oil and gas. Other resources play a minimal role. The Government's policy in energy development is to increase Tunisia's production of crude oil and oil products,  and to maximize the export of oil products through substituting gas for fuel oil in the domestic market. While taxation, licensing and participation policies are broadly comparable to those in other countries, there exists in Tunisia a particularly favorable attitude to foreign participation which encourages a satisfactory level of exploration. Further detail is in Annex 1.05. Pricing 1.33 Retail prices of petroleum products are broadly characterized by two distinct pricing tiers: retail prices of lighter products, such as motor fuels, are relatively high, and generally higher than is common in the oil exporting countries; retail prices of middle distillates and fuel oil, on the other hand, have been kept low for many years through subsidies, both in order to keep down the general price level and to assist Tunisian industry. Over- all, the "reconstituted barrel" for Tunisia realises $32 which is approxi- mately world prices. A comparison of retail prices of principal petroleum products in Tunisia with those in other countries is shown in the following table: Regular gasoline Gas oil Fuel oil $/gallon $/gallon $/tonne Tunisia 1.94 0.71 60 Brazil 1.86 1.13 83 Egypt 0.35 0.12 11 Syria 0.78 0.25 90 Thailand 1.41 1.15 153 United Kingdom 2.24 1.06 234 United States 1.28 1.10 152 1.34 Revenue needed to finance refinery operations and the cost of imports comes from three sources. Firstly, Tunisia receives oil as royalties on production; secondly, part of the production of each field has to be offered to the local market at a discount, and thirdly, revenue is generated on the sale of LPG, gasolines (part of the profit on gasolines is in the form of taxes earmarked for other needs) and aviation kerosene and the export of naphtha. The first two of these are heavily dependent on future production levels. The rising proportion of imports has made it impossible for Tunisia to maintain the subsidies and prices of products have increased in recent years. Nevertheless, domestic prices for the heavier products were somewhat below world prices prior to the 1979 price explosion; price adjustments in December 1979 were also relatively small. (Annex 1.06 lists the current retail prices in Tunisia and bulk prices in Italy). 1.35 The Bank has undertaken a preliminary study of the effect of energy prices on Tunisian industrial energy demand, both of power and of oil and gas. Energy was found to form only a small proportion (6%) of the end costs of products, such that adjustment to economic prices would have little effect  - 10 - on product prices, and hence demand. In any case, most of the products exported by Tunisia have little energy input. It was noticed that there had been no discernible impact on demand as a result of major price increases in previous years. 1.36 As discussed in Chapter IV, on project grounds, it is essential to increase fuel oil prices in the short and medium term, so as to ensure that gas prices do not exceed fuel oil prices. An increase in fuel oil prices will be achieved in steps over the next few years, and discussed more fully in Chapter IV. In respect of the other energy prices, parity with international prices (or above) is the most appropriate long-term solution, but may take a decade to achieve for low volume socially sensitive products such as kerosene and gas oil (to the extent it is used for fishing and agriculture). The Gordian Associates study, which will pay particular attention to pricing, will be available during 1980. The Bank will discuss the whole report with the Government as part of its supervision of the second power loan and will seek agreement on pricing strategy at that time. 1.37 In the short and medium term, it is important to ensure a suitable relationship between the prices of industrial fuel substitutes, and to main- tain the financial viability of the institutions concerned, both suppliers of primary energy (such as STEG gas) and consumers of primary energy, principally STEG power. The principal aim for energy pricing within the present project is to focus on the domestic price of fuel oil and natural gas. Role of the Bank 1.38 The Bank has had a long standing involvement with STEG both in the power sector and in the financing of the El Borma to Gabes gas pipeline, and has made three loans totalling $34 million. All three projects have been succiessful, although the most recent currently has problems in respect of spare parts for gas turbines. In that time STEG has developed into one of the most important companies in Tunisia, setting an example in efficiency and management. 1.39 The need for a study on tariffs was identified as a result of the second power loan. As a result of further discussion with the Bank the study has been widened and is now an energy master plan study including pricing policy and is being undertaken by Gordian Associates. The Bank will review the findings with the Government. To the extent necessary to ensure the financial viability of the gas entity within STEG, fuel and gas prices will be increased in association with this project. 1.40 The Bank has been actively involved in the Tunisian gas sector for the last four years, initially with the Miskar project (see Chapter II) and the general strategy in relation to the provision of gas for Tunisian industry. The strategy led to the present project. In relation to the project, the Bank has assisted in the choice of pipeline routes, their sizing and timing. The Bank will assist with a number of related studies which will concentrate on supplies to households and small scale users.  - 11 - II. THE PROJECT Background: Developments in Algeria and Italy 2.01 The possibility of importing gas from Algeria has been an issue since the signature of the Algeria/Italy gas supply contract in 1973 and the corresponding transit agreement for a pipeline from Algeria across Tunisia to Italy. The steep increase in oil prices in late 1973 and the trend towards national control of resources led to renegotiation of the contract to an LNG-based operation. In 1977 the terms of a transit agree- ment were agreed between Tunisia and ENI, the Italian state oil company, and the gas supply was switched back to the original pipeline proposal. 2.02 In 1974 the Miskar structure was discovered, and was delineated steadily between then and 1978. During the appraisal of the Miskar project in 1977 the Bank suggested investigation of purchasing gas from Algeria as an alternative to investing $600 million in a single gas field. Negotia- tions for Algerian gas and delineation of Miskar proceeded simultaneously, providing Tunisia with two real alternatives. Provisional agreement on purchase terms at the same time as determination of the overall Miskar reserves (at a lower level than that hoped for), when taken together with risk and strategic considerations, led to a Government decision to proceed with the gas purchase. 2.03 A Bank appraisal mission in October 1979 found that, although planning for the onshore gas pipeline project was well advanced, it was suitable for Bank financing and was a project into which the Bank could make a worthwhile input. During and since that mission the project changed substan- tially, the capital expenditure planned for the 1980's has been reduced, and the gas purchase contract was clarified. Construction of the project is scheduled from the summer of 1980, and contracts for most of the materials and equipment had to be let between the dates of appraisal and Board presentation. Institutional Framework 2.04 The institutional framework for the intercontinental pipeline is complex, the arrangements differing in Algeria, Tunisia, the Sicily Channel and Italy. The Algerian state company Sonatrach will construct, own and operate the pipeline from Hassi R'Mel (Algeria) up to its frontier. In relation to Tunisia, there will be three companies established in Tunisia, whose roles in relation to the pipeline in Tunisian territory will be: (1) to construct the intercontinental pipeline; (2) to own the pipeline from commissioning; and (3) to operate the pipeline. A fourth company will own the offshore portion including that part in Tunisian waters and a fifth will own the onshore pipeline prior to commissioning. The first of these will be a subsidiary of ENI, the second Tunisian, and the third joint Italo-Tunisian with Tunisia having the majority share after five years. The fourth and fifth companies are not Tunisian. Tunisia will pay 1% of the pipeline cost to take possession, but Italy will retain ownership of the carrying capacity. In respect of the operations, responsibility will transfer to Tunisia after five  - 12 - years. Algerian interest in the overall venture takes the form of ownership of the pipeline within Algeria, and of a share in the cost of the Sicily Channel crossing. As already noted, distribution within Tunisia is the responsibility of STEG. Gas Availability 2.05 The Hassi R'Mel gas field in Algeria (discovered in 1956), which is one of the largest gas fields in the world, is the source of gas for a number of on-going major gas supply contracts and will supply Italy through the intercontinental pipeline with at least 12 billion cubic meters of gas a year for 25 years, plus about 2 billion cubic meters for Tunisia. There is a possibility of increasing the pipeline throughput to a total of 20 billion cubic meters. Supplies to Italy are expected to commence in October 1981. Discussion has already begun on the possibility of a second gas pipeline for supplying France, Switzerland and Germany. Algeria has vast gas reserves and is actively seeking to promote sales by pipeline. 2.06 The Tunisian Government is entitled to royalties on gas transitting to Italy, either in cash or in kind at the discretion of the Tunisian govern- ment. The arrangement allows maximum flexibility in Tunisia's gas supplies. In addition to the royalties, STEG will purchase from SONATRACH 700 million cubic meters a year of gas from 1982 rising to 1,200 million cubic meters on a 20 year contract. STEG has requested a further 800 million cubic meters a year (starting with 400 million in 1986) in association with Algerian plans to increase overall capacity of the pipeline to 20 billion cubic meters but has so far had no response. Purchased gas is subject to take or pay. Total gas available to Tunisia from the pipeline is below, expressed in tons of oil equivalent (one thousand cubic meters of Algerian gas are equivalent to a ton of oil). Thousands Tons oil equivalent 1982 1983 1984 1985 1986 1987 Royalty gas 200 370 525 620 800 800 Gas contract 635 490 620 1175 1200 1200 Purchase Request - - _ - 400 800 835 860 1145 1795 2400 2800 These figures exclude royalty gas on a second gas pipeline, tentatively planned for the mid-1980s. 2.07 The gas is purchased at the Algerian frontier. Its cost (because of lags in price adjustments) fluctuates in the range 60-70% of the present international price for fuel oil. It has to be taken at approximately an equal hourly rate throughout the year, which optimizes the intercontinental pipeline system but causes some extra distribution costs in Tunisia and, in the absence of gas storage, limits the extent to which the gas can substitute for oil. STEG will use its power plants, particularly that at Sousse, to equalize the hourly take.  - 13 - The Intercontinental Pipeline 2.08 The gas pipeline from Algeria to Italy (Hassi R'Mel to Bologna) will be 2500 km in length, of which 920 km are in North Africa, 160 km in the Sicily Che-'nel and 1420 km in Italy. The pipeline will be 48" in diameter in Algeria, Tunisia, Sicily and the greater part of its route through Italy, while decreasing gradually on the last section connecting it to the Northern Italian Network. The Sicily Channel has three 20" lines plus a 20" spare, the Messina Straits have three 20" lines and a 10" spare. Over the whole length of the pipeline there will be 11 compressor stations totalling 500,000 horsepower. 2.09 Tunisia has the right to use the intercontinental pipeline to transmit gas from the Algerian border through to various places in Tunisia, for which it will pay a charge of $1 to $4 per toe based on estimated total throughput and distance. It also has the right to add additional offtakes. Construction of the intercontinental pipeline is ahead of schedule and no difficulty is expected in achieving the October 1981 commissioning date. Tunisia will endeavor to take royalty gas from this date. The area of greatest risk--the Sicily Channel crossing--is progressing satisfactorily. Regardless of the progress offshore, the Algerian and Tunisian portions of the pipeline can operate independently. Project Description - Tunisia's Pipeline 2.10 Tunisia's own pipeline system will be built in stages, the first two being within the next four years. The final stage, which is essentially for security and flexibility and/or to transmit Miskar gas onshore, is not expected before 1990. The project financed by the proposed loan, namely Stage I, constitutes the initial phase in distributing gas from the Algeria- Italy pipeline to consumers in Tunisia. This stage is for pipelines to Tunis, Sousse, Gafsa and Tadjerouine (Map No. 14849). Stage II for which the Bank will finance the optimization studies, will extend the system from Gafsa to Gabes and from Tunis to Bizerte. Pipe diameters have been deter- mined on the basis of potential 1990 demand, on the avoidance of the need for installing compressors in the first two stages, and on the basis of an eventual loop connecting Sousse southwards to Gabes. Operating pressure will be about 70 atmospheres. Should the additional gas purchase (paragraph 2.06) not be obtained, it will be necessary to reassess the need and timing for the extension to Bizerte. 2.11 The first stage of the project includes the items listed below: (a) a 20" buried pipeline running from the intercontinental pipeline in the coastal region 70 km north to Tunis and 70 km south to Sousse. There will be provision for compressors to be added at a later stage. (b) an 18" buried pipeline running from a point near the Algerian border 60 km south to Gafsa.  - 14 - (c) a 90 km 8" buried pipeline from the intercontinental pipeline to Kasserine and Tadjerouine. (d) 170 km of laterals connecting the transmission lines to customers. 80% of the laterals are for the Gafsa area. (e) a cathodic protection system to prevent chemical or electro-chemical corrosion. (f) three injection terminals, including filtration and metering, at the connections with the intercontinental pipeline; block valves approximately every 20 km and at the branching point for each consumer's delivery pipe; scraper trap assemblies at both ends of each section of the network; and about 18 (stage 1) delivery terminals for pressure reduction, straining and metering. (g) Conversion of customers oil-using plant and equipment to dual firing (oil and gas). (h) consultancy services for right of way, engineering, procurement, project management, construction supervision, start-up and com- missioning. (i) other consultancy services for studies on supplies to households and small-scale industrial users and optimization of the stage II system. I(j) training of STEG employees both in Tunisia and abroad. 2.12 STEG has recommended to the Government that Stage I should also include an extension from Sousse to Djemmal. The extension would not be economic and has been omitted from the project description and cost estimates and from the proposed Bank loan. At $5 million, its construction by STEG would make little difference to the aggregate economic and financial forecasts. It is expected that the two stage II pipelines will be built in 1984. Final decisions have not yet been taken on the routing of the Gabes pipeline or on the sizing of the Bizerte pipeline. Present plans are for an 18" pipeline connecting Gafsa to Gabes, and for an 18" pipeline from Tunis to Bizerte. Status of Project Preparation 2.13 The major part of the project preparation activities has been completed. SOFREGAZ (engineering consultants, France) have undertaken route surveys, market studies and optimization studies. In association with a Tunisian company, TESA, they have completed most of the detailed design. The results of the SOFREGAZ studies are contained in a series of 14 reports issued between 1974 and 1979. Contracts have been signed with SOFREGAZ/TESA and OTC for the consultancy services. Copies of all SOFREGAZ reports will be forwarded to the Bank. STEG has agreed to forward quarterly progress reports on the pipeline construction.  - 15 - 2.14 ETAP will arrange the rights of way. As a national project land can be acquired compulsorily to meet requirements, subject to compensation in accordance with a national formula. All land should be acquired by September 30, 1980. Project Implementation . 2.15 STEG has overall responsibility and control of the project and will carry out the physical works and studies through the gas directorate. SOFREGAZ/TESA have been engaged to supervise the project and to assist STEG staff in training and in all project aspects. SOFREGAZ is an experienced consulting organization with a proven track record in managing gas pipeline construction. In conjunction with STEG, SOFREGAZ has prepared a detailed PERT analysis of the project, which is summarized in Annex 2.01. 2.16 The start-up date for supplies to Tunisia has not been finalized but is expected to be 1st November 1981 for the main part of the system. It is expected that there will be a six month period before take or pay applies. There is sufficient time to achieve completion on the scheduled date. The cost of gas, which is subject to take or pay, will be equivalent to about $200,000 per day. Project Costs 2.17 The Project is estimated to cost $88 million, of which $55 million or 63Z represents the foreign exchange component. A physical contingency of 6% was applied to all costs and reflects the thoroughness of the preparatory work. The basic project cost estimate is in 1980 prices. Price escalation has been allowed at lOZ for 1980 and 9% for 1981, except for linepipe already contracted for at a fixed price. Project engineering, management and construc- tion supervision are expected to require 420 man months, and are expected to cost $12,000 per month for expatriates and $6,000 per man month for Tunisians, Including all costs. Interest during construction is estimated at $4 million. The following table gives a breakdown of the cost. STAGE I Local Foreign Total Local Foreign Total --In Millions D.T.- ---In Millions US$-- Studies 0.9 0.8 1.7 2.2 2.0 4.2 Linepipe 0.2 4.7 4.9 0.5 11.7 12.2 Pipelaying/cathodic protection 7.4 6.4 13.8 18.4 16.0 34.4 Valves and fittings 0.1 1.4 1.5 0.2 3.6 3.8 Land and right of way 0.2 - 0.2 0.5 - 0.5 Conversion 1.1 2.0 3.1 2.9 4.9 7.8 Metering (main offtakes) 0.8 3.0 3.8 2.1 7.5 9.6 10.7 18.3 29.0 26.8 45.7 72.5 Physical contingencies 0.6 1.1 1.7 1.6 2.7 4.3 Price contingencies 1.7 2.8 4.5 4.1 7.1 11.2 TOTAL 13.0 22.2 35.2 32.5 55.5 88.0  - 16 - 2.18 A firm estimate cannot be made for the next stage of development until decisions are made on the outstanding items, i.e. the routing of the Gabes pipeline and the sizing of the Bizerte pipeline. (The Bank will finance the studies on these options, which will be completed in 1982.) For the present, it is estimated that the cost will be approximately US$61 million at current prices based on the assumptions outlined in paragraph 2.17. The cost of compressors, storage and a central dispatch system will form part of a subsiequent stage and are scheduled for the later 1980's. Project Financing Plan 2.19 The total financing required is $92 million, including $4 million of interest during construction. Financing proposed is: IBRD $37 million Export credits $12 million Equity $25 million Other borrowings $18 million Details of the allocation of the proposed Bank loan are in paragraph 2.23 below. The proposed Bank loan of US$37 million would be made to STEG with the Government guarantee at the current lending rate for 17 years including 4 years of grace. Including payments to the Government, the effective interest rate on the Bank loan will be 10%. The loan would be equal to 40% of the total cost of stage 1 and to 63% of its foreign exchange component. Export credits have been arranged for $5 million and no difficulty is expected in arranging a further $7 million for the second contract for linepipe by October 31, 1980. The initial $5 million is a condition of effectiveness. The terms expected are 5 years including grace and an interest rate of 8.5 to 10%. 2.20 The balance of the financing is to be $25 million in equity from the Government, provided as $10 million in 1980 and $15 million in 1981, and $18 million in commercial loans, to be drawn in amounts of $10 million and $8 million in 1981 and 1982 respectively. Loan terms available in Tunisia are currently 8% interest and a minimum repayment period of 7 years, which are compatible with the needs of the project. No funds are to be provided by STEG. Procurement and Disbursement 2.21 The borrower has decided that all goods and services will be procured through international competitive bidding. This practice has been followed in all procurement activities so far. To avoid delay in completion of the project, orders will be placed during the first five months of 1980 for pur- chases of linepipe, valves and fittings. Including the Stage I engineering, orders placed total US$24 million (27% of project costs). 2.22 Potential bidders for the pipelaying are subject to prequalification and the selection will be agreed by the Bank. The bid documents will permit the work to be let as four contracts or in combination. Bidders could win  - 17 - part or all of the work. Bids will be obtained from contractors in accordance with Bank guidelines. It is expected that some bidders will seek local firms to participate in undertaking the work. Contract award for pipelaying (US$39 million including contingencies) is expected in June, shortly after Board presentation. Retroactive financing will be required only for valves and fittings ($600,000). 2.23 The proposed Bank loan would meet the foreign exchange cost of pipelaying, cathodic protection and the acquisition and installation of valves and pipe fittings, supervision of conversion, power plant conversion, metering, studies and the optimization for Stage II, as below, including the foreign cost element of local contracts. Amount Allocated US$ million (1) Pipelaying and cathodic protection 17.3 (2) Valves and fittings 3.8 (3) Conversion (supervision and for power) 2.2 (4) Metering 8.1 (5) Studies (urban supplies) 0.5 (6) Optimization for Stage II 0.1 (7) Unallocated 5.0 37.0 The loan should be fully disbursed by the second quarter of 1983. The closing date would be December 31, 1983. Annex 2.02 gives the estimated disbursement schedule. Ecology and Safety 2.24 The proposed gas project does not pose serious ecological problems. The route survey took care to avoid, where possible, damage to the country- side, and once the pipelines are constructed the ecological disturbance will be virtually nil. The project will improve the air quality in Tunisia's major cities by making available a clean burning sulphur free fuel. The expanded refinery is planned to produce low sulphur fuel oil. The gas project will lead to elimination of the sulphur content and the sooting effects asso- ciated with fuel oil. It will also lead to reduction in the transportation of oil products by road. 2.25 Gas pipelines have a good safety record, and STEG's experience in more than 20 years of operating a high pressure system has been good. The Tunisian pipelines will be buried to a depth of about three feet to minimize accidental damage, and they will be located for the most part away from centers of population. STEG is arranging for a satisfactory maintenance system and proper operator training both to ensure efficiency and safety.  - 18 - Full efficiency and control will be achieved through a central dispatch and communtications system, scheduled for the late 1980's, and will be necessary once a compressor is installed. Project Risks 2.26 The Tunisian pipeline project faces no special project risks. There is suifficient lead time to construct the pipeline, an experienced consultant has been engaged, and the pipeline should be ready in good time. 2.27 The physical risk associated with the project is downstream on the intercontinental pipeline, for which the Sicily Channel crossing requires new technology. However, delays offshore should have no effect on supplies to Tunisia. There is also the risk resulting from 50% of Tunisia's energy supply coming through a single pipeline. This is not a significant factor as the major energy consumers will have dual-fired installations and will retain present oil storage tanks. Fuel oil is usually easy to obtain even when other oil products are in short supply. 2.28 There is a financial risk in that part of the gas to be delivered through the system is subject to take or pay provisions. No difficulty is expected in being ready before take or pay applies. The excess of demand over supply in the later eighties is adequate but is not large and a major downturn in the economy could present some difficulty in absorbing the minimum quantities of gas. The plans of the Government to ensure its ability to use additional gas will require careful review in the light of the growth in demand and actual progress with energy-using projects. 2.29 There is an economic risk in that the whole economic advantage of the project relies on the differential between the cost of gas and the price realizable by Tunisia when selling large quantities of fuel oil. The best advice available is that, on the basis of the present contract, the margin should be adequate at all times and there should be no prolonged difficulty in sellinlg the fuel oil. 2.30 The final risk is political in that a major portion of Tunisia's energy would be supplied by a single foreign country. It is worth noting that Tunisian territory and ports are used for transporting Algerian oil, and that in respect of this project, Tunisia is a minority partner in what is essentially a major gas supply to Italy.  - 19 - III. BENEFICIARY Organization and Management 3.01 STEG was created by a decree law in 1962 to take over the operation of seven private utility companies upon their nationalization. During its early years, STEG's efforts were concentrated on physically integrating the seven separate systems. After 1970, STEG was able to start on a systematic expansion of the integrated national power system and turn its attention to matters of organization, management and finance. 3.02 In most respects, STEG operates as an autonomous company, and has become one of the most competent and effective in Tunisia, employing more than 4,000 people. It enjoys operational freedom in the conduct of its day to day business. The limitations on its freedom are in respect of its annual capital and operating budgets, its rate schedules, and its salary scales. The latter have not proved a major problem in practice but are now less attractive than they were a few years ago. 3.03 STEG is governed by a board of eight members headed by a President Director General (PDG) all appointed by the President of the Republic. The top management consists of the PDG, his deputy, a Manager of Development and Coordination and a Manager of Administration and a number of functional directors, including one for gas. The PDG assumed his appointment on February 1st, 1980 and is reviewing the need for a simpler organization with clearer responsibilities. STEG has agreed to discuss any necessary restructuring with the Bank before implementation. 3.04 The gas directorate will have four departments covering studies, equipment, transportation and distribution. The operations will be orga- nized geographically, a Northern Division covering the Sousse/Tunis area, a Southern Division for the pipelines in the interior and the south. When introduced, the central despatch center and the compressors will both be centralized operations. Recruitment and Training 3.05 A recruitment and training program for operational personnel is now being studied. The plan is for the gas directorate to absorb existing staff employed at the Tunis gas works and their Borma pipeline and those working on the supervision and control of the construction of the pipelines. It is expected to have 130 staff, of whom almost 90% would be operators. The Bank has discussed the staffing program with STEG and has agreed on a suitable program. 3.06 The training of personnel will cover a broad spectrum of the gas industry and will be undertaken both in Tunisia and in Algeria, France and Italy. Gaz de France facilities will be used both for preliminary training in respect of construction work and for maintenance, operations and commercial aspects. Suppliers of equipment will be expected to arrange specialized  - 20 - training. Complementary to the above, STEG staff will receive training during work supervision and in the commissioning of the first phase of the network. The arrangements are satisfactory and training outside Tunisia will be completed before the pipeline becomes operational. Accotnting, Auditing and Insurance 3.07 STEG has an accounting and management information system which in most respects is efficient. The majority of its records are computerized. Its clefects are in relation to the separation between its gas operations and its power operations. Assets are not revalued. The financial accounts for the Tunis town gas system and natural gas system are integrated with the power accounts. Under Loan IBRD 724 TUN, STEG agreed to maintain separate (non-statutory) accounts for El Borma, and has done so although the accounts are not fully separate in items such as cash and are not always produced promptly. Commensurate with STEG providing no funds toward the proposed project it is recommended (1) that the annual accounts for Algerian gas be separated from the other activities (including separate cash accounts) on a non-statutory basis, (2) that the local Tunis gas activities be separated from the power accounts when Tunis is supplied with Algerian gas and at that stage! should be included with the Algerian gas accounts, and (3) that, in view of its short-term nature (to 1986) there be no basic change in respect of El Borma, although it is hoped that the accounts can be produced more quickly. The present financial covenants under loan IBRD 1355-TUN would continue to apply for STEG's power operations (including, as at present, El Borma gas, Cap Bon gas and the Tunis town gas supplies). STEG has agreed to this basis. STEG will be asked to provide detailed plans for the accounting arrangements by 1 July 1981. 3.08 STEG's accounts are audited by Nawar & Co., an Egyptian firm of Chartered Accountants, who are satisfactory to the Bank. STEG will be re- quired at negotiations to continue to have its accounts audited independently, and to submit the audited accounts for STEG as a whole to the Bank within six months of the end of each fiscal year. In respect of its Algerian gas accounts, STEG will arrange a similar (but non-statutory) audit and submit such accounts to the Bank within nine months of the end of each fiscal year. 3.09 Injuries to third parties and accidents to personnel will be insured internationally. STEG will provide other insurance coverage through a nation- alized company. In line with normal practice in the industry, damage to pipelines as a result of explosion will not be insured. STEG has a number of years experience of arranging insurance and its general practice is acceptable. The arrangements will be kept under review during supervision.  - 21 - IV. FINANCIAL ASPECTS Future Pricing of Natural Gas 4.01 The major energy pricing problem in Tunisia is the pricing of fuel oil. Its current price at $60/ton is one-third of the price prevailing on the Italian spot market. By contrast, in 1980 prices the delivered cost of gas to be purchased from Algeria is $120/toe. Fuel oil represents 44% of oil products used in Tunisia and it receives 68% of subsidies on oil products. Both from the point of view of the national budget and also the need for the price of gas to be competitive with fuel oil, major increases are necessary in fuel oil prices and/or substantial subsidies are needed for natural gas. It is essential for the success of the project that industry and power have some encouragement to use natural gas. Gas has advantages over fuel oil, its immediate competitor, in its lack of sulphur compared with the fuel oil available in Tunisia, and in a number of other respects. It also has some disadvantages when used in equipment initially designed to burn oil. Current practice has been to charge for natural gas and fuel oil at the same price per Btu. The Government accepts the need to maintain the competitiveness of natural gas into the future. 4.02 The Government is also concerned to preserve the commercial nature of STEG and for it to operate as an efficient business guided by financial as well as other criteria. The uncertainties of international energy prices are such that, whilst the Government does not, in principle, wish to make any subsidies to STEG, it may have to provide such subsities, both in the form of cash and/or royalty gas, during the first two years of operation. From 1982 onwards, the Government will gradually increase the price of royalty gas charged to STEG, so that by the end of 1986, full import prices will be charged for all Algerian gas sold in Tunisia. 4.03 The price of gas under the purchase contract will be reviewed twice yearly in the light of changes in cost, and adjustments will be made if neces- sary. Apart from wider considerations, limitations on the funds available for subsidies make it desirable to review and adjust gas prices in Tunisia each time prices are adjusted under the purchase contract. 4.04 The result of these factors is that the price of natural gas in Tunisia will progressively increase such that, by the beginning of 1987, at the latest, the gas will be sold at not less than import parity (including all transportation costs). Fuel oil, currently selling at one-third of its international price, will at least double in price in real terms and keep pace with future increases, by the same date. Achievement of the above will be a major step toward international prices and will be important factors toward ensuring the economic and financial viability of the project.  - 22 - Future Performance: The Natural Gas Accounts (Algerian Gas) 4.05 The finances of STEG's gas division reflect problems commonly encountered with a new entity. As discussed in Chapter [II, power finances will be separate. Salient features of the financial projections for Algerian gas based on an average inflation rate of 8%, and a rate of return on revalued assets also of 8% from 1982 are summarized below. Detailed projections for gas finances are in Annex 4.03. The forecasts are based on use of the inter- continental pipeline at a fee of about $3 per t.o.e., and the project cost, financing plan, and contract quantities and costs as outlined in Chapter II. US$ Millions 1983 1985 1987 1990 Gas sales income 95 286 554 797 Purchase cost of gas 78 253 512 753 Depreciation 6 13 15 18 Other expenses 3 7 12 14 Total Costs 87 273 539 785 Net income before interest 8 13 15 12 Interest 7 9 10 4 Net profit 1 4 5 8 Current ratio 0.48 0.70 0.91 1.34 Debt service coverage 1.51 1.40 1.08 1.74 Debt/equity ratio 63/37 62/38 47/53 22/78 4.06 The purchase cost of gas (including the equivalent for royalty gas) forms over 90% of the total STEG costs for its gas activities, and is exempli- fied by an operating ratio in the range 96-98%. STEG's financial condition is therefore dictated by its day to day operations, in particular the need to ensure that: (i) all gas purchased is sold; (ii) that the average selling price for gas exceeds its average purchase cost by an adequate margin and (iii) the need to match its receipts and payments throughout the year. This will be achieved through the strategy of using power plants for balancing the demand of the natural gas network, through half yearly reviews of gas prices in the light of the latest information on gas purchase costs, and through instituting a billing system in which the terms for receivables parallel the terms for payables. Funds generated will be used in priority for gas expendi- tures. In addition to the above STEG will establish tariffs sufficient to earn a rate of return of 8% on revalued assets (revalued annually) including subsidies for 1982 and 1983, and will ensure that its internally generated funds are at all times sufficient for debt service needs, to provide adequate working capital, to meet reasonable contingencies, and to finance renewals and replacements and, as necessary, a proportion of capital expenditures. Forecasts of STEG's finances will be sent to the Bank on a regular basis.  - 23 - 4.07 The gas division's debt/equity ratio over the period 1982-90 is expected to be high initially but will become satisfactory by 1987. The debt service coverage is tight in the years up to 1987 and requires careful supervi- sion. Debt service coverage is expected to be satisfactory from 1988 and in the absence of further major investments, would rise to 1.75 times by 1990. A stage III investment program will bring down the debt service coverage substan- tially, and STEG will be asked to restrict its borrowings for its gas operations so that not in any year after 1986 will the debt service for gas fall below 1.2 times. Agreement on the main features of paragraphs 4.06 and 4.07 was reached at negotiations. Past Performance: STEG Electricity 4.08 STEG's revenue accounts, balance sheets and cash flow statements for the fiscal years ending December 31, 1977 and 1978 are as shown in Annex 4.02. During these two fiscal years, STEG has almost but not fully met the earnings covenant associated with the Bank loan 1355-TUN; 50% of the profits result from the El Borma gas operations. The results for 1979 are expected to be less satisfactory but are not yet to hand. 4.09 STEG's accounts receivable for electricity supply were still at a high level (174 days' revenues) in 1978, principally as a result of slow payment by local authorities and Government departments. Accounts payable are also high and reflect a deliberate policy of not making payments to municipalities unless first they pay their power bills. The current ratio is unsatisfactory and continues to receive attention. 4.10 Gas recovered from STEG's El Borma gas operations is charged to electricity operations at the same price as fuel oil. The income statement, however, is consolidated. Consequently, gas "profits" subsidize power opera- tions. This will not apply to, and will not be affected by, the new supplies from Algeria. No action is proposed as El Borma supplies will cease in 1986. Future Performance: STEG Electricity 4.11 STEG has agreed to separate its new gas activities from its power operations. However, forecast income statements, balance sheets and cash flow statements have been prepared for power to demonstrate the feasibility of the proposals for the gas project (see Annex 4.03). STEG expects to spend $1100 million during 1979-86 on new power plants and expansion of its system. Thirty nine percent of STEG's requirements are expected to be met from in- ternally generated funds, including customer contributions, 1% from increases in capital and 60% from borrowing; 80% from new borrowing and 20% from the drawdown of existing loans. The Bank is currently considering a loan of about US$20 million (FY82) to STEG. 4.12 Based on the expected load growth and the level of future expenses, STEG is expected to meet the rate of return covenant (8% on average net fixed assets) by increasing yearly its electricity tariffs in line with the rate of inflation.  - 24 - V. ECONOMIC ASPECTS Background 5.01 The alternative sources of industrial energy available to Tunisia are the Algerian natural gas, fuel oil and Tunisia's own gas reserves. Devel- opment of the latter has been rejected by the Government for the time being (at least to meet short-term needs) on the grounds of their relatively small size, the high capital cost, the risks involved and the difficulty of blending domestic gas production at this time into a longer term gas supply strategy. The economic analysis concentrates on the remaining choice, between importing Algerian gas and using fuel oil. 5.02 Algeria will be responsible for all costs associated with the fur- ther development of the Hassi R'Mel field and the pipeline up to the Algeria/ Tunisia frontier, and Italy will be responsible for the construction costs of the intercontinental pipeline within Tunisia. Tunisia's responsibility is therefore limited to paying for the gas at the frontier, paying 1% of the capital cost to purchase the pipeline, and paying its share of the capital charges and operating costs for that part of the trans-Tunisia pipeline it uses., 5.03 The royalties Tunisia will receive on the transit of gas to Italy are in substitution for import duties, transit fees and taxes on the con- struction and operation of the pipeline and are payable in cash or in kind at the option of the Tunisian Government. As these royalties are receivable by Tunisia regardless of whether or not Tunisia has a gas system of its own, when taken as gas they are treated in the economic analysis as having a cost equivalent to the cash which could be taken in lieu. 5.04 The gas purchase contract and royalties were discussed in Chapter II. Where royalties are taken in cash, Italy pays for the royalties at the same Algerian border price as is payable by Italy for its purchased gas. The Italians would then be fully responsible for transport costs. The Market 5.05 Between 1986 and 1989 the industrial energy market is unlikely to be able to absorb the whole of the purchased gas and the royalty gas, and up to half of the royalty gas is expected to be taken as cash. On present plans all the purchased gas and the remainder of the royalty gas will be sold in the Tunisian market (see Annex 1.02). Development and Operating Costs 5.06 The capital cost of the project is US$68 million (excluding taxes and duties), Stage II is expected to cost a further US$40 million, both at constant prices. Annual operating costs are US$500,000 rising to US$1.8 milliLon with Stage II. Transportation costs for the intercontinental pipeline will be US$1 to 4 per T.o.e. according to distance.  - 25 - Value of Sales 5.07 Gas sales within Tunisia are valued at US$180 per tonne (US$4.50 per million BTU) which is the January 1980 price of (high sulphur) fuel oil on the international markets. Initially the gas availability will reduce fuel oil (high sulphur) and gas oil imports; after the expansion of the refinery the use of gas will promote gas oil exports and will result in large fuel oil exports (low sulphur) even in the 1986-89 period when a temporary surplus of gas is expected. No attempt has been made in the economic analysis to quantify the proportion of higher-value fuels which will also be displaced. Despite the large increase in prices during 1979, no permanent reduction is foreseen in the international fuel oil prices and a value of US$180 is felt to be conservative. Project Profitability (a) Economic Rate of Return 5.08 Based on the considerations outlined above the economic rate of return on Stages I and II of the project are comparable at about 50% (Annex 5.01 and 5.02). The rate of return reflects the high added value from replacing use of fuel oil with gas which is available at advantageous terms, and acknowledges the low capital intensivity of the project. Should the contract be renegotiated such that the only saving was the differential in transmission costs to Italy and Tunisia, (which is seen as the minimum benefit in the long term), the rate of return would be 28%. (b) Pay-Back Period 5.09 On a discounted basis at 10% the pay-back period after start-up is 3 years which is unusually good for a pipeline project. (c) Net Present Value 5.10 Using a 10% discount rate and the 20 year life of the contract, the net present value of the project is US$700 million. Approximately 80% is from Stage I and 20% from Stage II. (d) Unit Cost Comparison 5.11 Taking the expected transit charge for the intercontinental pipeline, the cost of transportation through STEG's system and the gas purchase price for first half 1980, the delivered cost of gas is US$120 per t.o.e. The second half is expected to be US$140. The equivalent fuel oil price (January 1980) is US$180 per tonne. Benefits to the Economy 5.12 Apart from the project profitability the main benefit from the project is the foreign exchange saving. Taking account of an annual foreign exchange cost for debt charges of US$10 million, the substitution of gas  - 26 - for fuel oil will give a net annual benefit at full throughput of not less than US$120 million (1979 price levels) which is equal to 7% of Tunisia's exports. 5.13 The training under the project will lead to a significant transfer of technology for STEG staff. The pipeline system will be operated by Tunisians. A total staff complement of 130 is planned. In addition, the pipelaying will provide temporary employment for local labor. 5.14 The natural gas is free of sulphur and consequently will have a favorable impact on the atmospheric pollution in Tunis and other cities. The lack of sulphur will reduce STEG's operating costs for its power plants, by about $2 per tonne. VI. RECOMMENDATIONS 6.01 During negotiations assurance was obtained from the Borrowers on the following: (i) consultants will be retained for supervision of the project. Copies of their reports and quarterly progress reports will be sent to the Bank (paragraphs 2.13 and 2.15); (ii) consultants will be engaged to undertake a feasibility study of supplying gas to households and small scale industry in Tunisia's major cities, on terms of reference to be agreed with the Bank (paragraph 1.19); (iLi) export credits of $7 million approximately will be arranged by October 31, 1980 (in addition to those required for loan effectiveness (paragraph 2.19); (iv) commercial loans of $18 million will be arranged (paragraph 2.20); (v) that any restructuring substantially affecting the organization for STEG will be discussed with the Bank before implementation (paragraphs 3.03/3.04); (vi) STEG will maintain separate accounts and balance sheets (including separation of funds) for its Algerian gas activities on a non-statutory basis, and will incorporate Tunis gas activities when supplied with Algerian gas. Detailed plans will be provided to the Bank by July 1st, 1981 (paragraph 3.07);  - 27 - (vii) the financial covenants under loan IBRD 1355-TUN will continue to apply to STEG's power activities (including El Borma gas and, temporarily, Cap Bon gas and local Tunis supplies) (paragraph 3.07); (viii) STEG will continue to have its statutory accounts audited by independent auditors and will submit the accounts to the Bank within six months of the end of each fiscal year; STEG will have its Algerian gas accounts audited by independent auditors on a non-statutory basis, and will submit such accounts to the Bank within nine months of the end of each fiscal year (paragraph 3.08); (ix) the system of accounts receivable from STEG's customers that use imported gas will be compatible with STEG's overall payment obligations to all suppliers (paragraph 4.06); (x) funds generated from gas operations will not be used for other purposes without first ensuring that requirements for maintenance, debt service and capital expenditures, have been met (paragraph 4.06); (xi) the selling price of gas will cover cost, (generating an 8% rate of return on revalued assets), will be sufficient for cash and other needs, and prices will be reviewed on a semi-annual basis. Subsidies will be restricted as discussed in the report (paragraph 4.06); (xii) borrowings will be restricted so that, beginning 1988, in no year will the debt service ratio fall below 1.3 (paragraph 4.07); (xiii) the staffing and training programs (paragraphs 3.05, 3.06); and (xiv) the timing of land acquisition (paragraph 2.14). 6.02 Assurances from the Government were obtained during negotiations on the following: (i) the provision by the Government of $25 million equity over the years 1980 and 1981 (paragraph 2.20); and (ii) the pricing policy for fuel oil and natural gas and the related finances of STEG (paragraphs 4.01 to 4.04). 6.03 Firm arrangement of export credits of not less than $5 million on awarded contracts will be a condition of effectiveness (paragraph 2.19), as well as a legal opinion certifying the effectiveness and a enforceability of the royalty and gas purchase contracts (paragraph 2.06 and 2.07). 6.04 Subject to satisfactory agreement on the above, the proposed project is suitable for a Bank loan of US$37 million.  - 28 - ANNEX 1. 01 Tunisia Analysis of Demand Distributors Agriculture Transport Industry Power and other Total LPG 1977 - - - 60 60 1978 - - - 72 72 Gasoline 1977 2 - 6 10 132 150 1978 1 - 5 10 138 154 Jet Kerosene 1977 - 108 - - - 108 1978 - 114 - - - 114 Kerosene 1977 1 - 2 - 94 97 1978 1 - 2 - 102 105 Gas Oil 1977 41 118 116 26 349 650 1978 35 127 140 72 372 746 Fuel Oil 1977 1 58 336 266 1 662 1978 - 39 354 256 - 649 Total oil Products 1977 45 284 462 304 636 1731 1978 37 280 501 338 684 1840 Natural Gas 1977 - - 46 204 - 250 1978 - - 79 247 - 326 Hydro 1977 - - - 10 - 10 1978 - - - 10 - 10 Coal 1977 - - 100 - - 100 1978 - - 100 - - 100 TOTAL ENERGY 1977 45 284 606 516 636 2087 1978 37 280 680 595 684 2276  ANNEX 1.02 TUNISIA DEtUMND AND SUPPLY FOR ENERGY 1978 - 1990 000 tons Energy demands 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Oil products LPG 72 80 85 95 105 115 130 140 155 170 185 2 22 Gasolines 154 160 170 175 18C 190 195 205 215 225 235 245 2H8 Jet Kerosene 114 110 110 110 110 110 110 110 110 110 110 110 ilO Kerosene 105 110 115 120 125 135 140 145 155 160 170 180 190 Gas Oil 746 870 825 870 840 910 990 1050 1135 1220 1320 1425 1535 Fuel Oil 649 750 1040 1210 695 820 745 305 145 155 170 175 370 Total products 1840 2080 2345 T580 2055 2280 2310 1955 1915 2040 2190 2340 2690 Natural gas 326 385 330 220 1025 1025 1300 1895 2210 2400 2630 2790 2800 Coal 100 100 100 100 100 100 100 100 100 100 100 100 100 Hydro 10 10 10 10 10 20 20 20 20 20 20 20 20 Total demand 2276 2575 2785 2910 3190 3425 3730 3970 4245 4560 4940 5250 5610 Energy supply Oil Dom.estic pro- duction 5014 5640 6700 6100 5600 5080 4560 4140 3920 3700 3380 3140 2940 Imports crude 1146 1125 1125 1125 1125 1125 205 425 745 985 1185 Exports crude -5032 -5640 -6700 -6100 -5600 -5080 -1560 -15 Imports products 768 1000 1265 1500 975 1200 205 50 60 75 90 110 185 Exports products-56 -45 45 -45 -45 -45 -895 -2220 -2270 -2160 -2025 -1895 -1620 Oil consumed 1840 2080 2345 2580 2055 2280 2310 1955 1915 2040 2190 2340 2690 Natural gas Domestic pro- duction 326 385 330 220 190 165 155 100 50 Royalty gas 200 370 525 620 560* 400* 630* 790* 800 Imports 635 490 620 1175 1600 2000 2000 2000 2000 Gas consumed 1025 1025 1300 1895 2210 2400 2630 2790 2800 Coal imports 100 100 100 100 100 100 100 100 100 100 100 100 100 Hydro product- . on 10 10 10 10 10 20 2 20 20 20 20 20 20 Total supply 2276 2575 27v,. 2910 3190 3425 3730 3970 4245 4560 4940 5250 5610 * royalty gas available is 800 (000) t.o.e. - the balance is taken as cash Note: Imports/exports include stock changes  - 30 - ANNEX 1.03 Tunisia Refinery Output 000 tons 1978 (%) 1985 (%) LPG 28 (2.5) 92 (2.2) Gasoline 160 (14.2) 332 (8.0) Kerosene 112 (9.9) 424 (10.3) Gas Oil 312 (27.7) 1481 (35.9) Fuel Oil 473 (41.9) 1100 (26.7) Naphtha 43 (3.8) 695 (16.9) 1128 4124  - 31 - ANNEX 1.04 SECTOR INVESTMENTS AND FINANCIAL SOURCES 1. The basic investment and financial forecasts are in Tunisia's Fifth Plan, and totalled US$1330 million. Provision for exploration, which of necessity must be tentative, was budgeted at $260 million, to be financed almost entirely by the foreign oil companies. US$125 million has been spent in the first two years and the expenditure over the five years is more likely to reach $400 million. The Plan provided for $290 million for a program of water injection at El Borma (in which the State has a 50% share) and the development of the small Isis offshore oil field, mainly to be financed from profits. SITEP, the operator at El Borma, has recently raised two $20 million loans towards its development. 2. The Fifth plan included provision for a $160 million (1977) expan- sion of the state refinery at Bizerte, to be financed 65% from foreign sources. The prime purpose of the refinery is to reduce the rapidly growing burden of imported petroleum products, particularly light and middle distillates. No revised cost estimate is available but no major change is anticipated. 3. The largest investment included in the Fifth Plan was the develop- ment of the Miskar offshore gas field together with an onshore distribution system. The Miskar development ($500 million) has been deferred indefinitely. The gas distribution system now estimated at $140 million, is the subject of this report. 4. The electricity industry is planned to absorb $500 million, being financed from three main sources: foreign loans, customer contributions and internal cash generation. STEG plans to maintain the growth rate of recent years. At the same time a substantial part of the investment will be for the self-generation of electricity.  - 32 - ANNEX 1.05 RESOURCE DEVELOPMENT 1. The Government seeks to encourage foreign oil companies to explore for oil and gas and over 85% of the prospective area is licensed to overseas companies. Overall the level of exploration activity has been satisfactory although rather uneven. The Energy Directorate is aware of the situation, which is being carefully watched. The Government's policy is to negotiate each concession on an ad hoc basis to allow for different techno-economic factors. In recent agreements 20% of the crude has to be offered to Tunisia at 10% below international prices and the Government has taken the right to acquire through ETAP a 50% share in any field. Discoveries have been brought onstream quickly to help the country's growth and there is as yet no explicit conservation policy for oil or gas, although the production plateau can be maintained only for a further 6 years.  - 33 - ANNEX 1.06 ENERGY PRICES Tunisian Retail Prices Italian Prices 2/ TD $ per tonne $ per tonne LPG 143/tonne 358 260 Premium Gasoline 2.2/liter 743 406 Regular Gasoline 2.05/liter 693 396 Kerosene 0.5/liter 153 375 1/ Gas oil 0.75/liter 216 ) Heating oil 63.3/tonne 158 ) 365 Medium oil 42.3/tonne 106 ) Fuel oil 24/tonne 60 182 1/ Estimated. 2/ January 1980 spot market prices.  - 34 - ANNEX 2.01 TUNISIA NATURAL GAS DISTRIBUTION PROJECT CONSTRUCTION PROGRAM 1980 1981 1982 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 03 04 ORDER DELIVERY MATERIALS AND EQU IPI ENT DELI VERY 1 DELIVERY 2 LINEPIPE| BID ANALYSIS TENDER FOR CONTRACT CONSTRUCTION NEGOTIATION PIPELAYING OFFERS CONTRACTOR'S SOUSSE TUNIS MOB ILlIZATION 1 (1) TUNIS/SOUSSE TADJEROUINE| (2) TADJEROUINE _ GAFSA (31 GAFSAF-AI- T'AKEOVER World Bank - 21507  - 35 - ANNEX 2.02 TUNISA NATURAL GAS DISTRIBUTION PROJECT ESTIMATED SCHEDULE OF DISBURSEMENTS Cumulative disbursement at end of quarter 1980/81 US$000 September 30, 1980 4,000 December 31, 1980 10,000 March 31, 1981 15,000 June 30,1981 20,000 1981/82 September 30, 1981 23,000 December 31, 1981 28,000 March 31, 1982 32,000 June 30, 1982 34,000 1982/83 September 30, 1982 35,000 December 31, 1982 36,000 March 31, 1983 36,500 June 30, 1983 37,000  ANNEX 3.01 - 36 - "FOCIETE TUNISIENNE DE L'ELECTRICITE ET DU GAZ (STEG) ORGANISATION CHART BOARD