Ukraine - Electricity Market Development Project

Document of The World Bank Report No. 15450-UA STAFF APPRAISAL REPORT UKRAINE ELECTRICITY MARKET DEVELOPMENT PROJECT SEPTEMBER 16, 1996 Infrastructure Operations Division Country Department IV Europe and Central Asia Region  CURRENCY EQUIVALENTS Currency unit = karbovanets, abbrev. Krb' US$1 = 188,000 karbovanets (as of February 1996) WEIGHTS AND MEASURES atm atmosphere MJ Megajoule (106J) bcm billion cubic meter mt million metric tons Gcal Gigacalorie (109 cal) MW Megawatt (106W) GW Gigawatt MVA Megavolt Ampere kg kilogram PJ Petajoule (1015J) km2 square kilometer psi pounds per square inch koe kilograms of oil equivalent t metric ton kV kilovolt tce tons of coal equivalent kW kilowatt toe tons of oil equivalent kWh kilowatt hour TWh Terawatt hour (10'2Wh) m 3 cubic meter CALORIFIC VALUES I Unit of Fuel Gcal Coal (ton) 5.0 Wood (ton) 2.0 Natural gas (OOOm3) 8.5 Mazut (ton) 9.7 Diesel (ton) 10.2 Gasoline (ton) 10.5 Kerosene (ton) 10.3 Liquified Petroleum Gas (ton) 10.8 Crude oil (ton) 10.0 CONVERSION FACTORS I Gcal = 4.187 GJ = 3.968 million Btu = 1,163 kWh I tce = 7 Gcal, and I toe = 10 Gcal I kWh of hydro and nuclear energy output converted to primary thermal equivalent at 250 grams of oil equivalent. ABBREVIATIONS EBRD European Bank for Reconstruction and Development EMA Energomarket Members Agreement EU European Union GDP Gross Domestic Product GOU Government of Ukraine IDC Interest During Construction IMF International Monetary Fund MOU Memorandum of Understanding NDC National Dispatch Center NERC National Electricity Regulatory Commission PCU Project Coordination Unit PIU Project Implementation Unit PSP Pump Storage Plant UCPTE Union for the Coordination of Production and Transport of Electricity (West European Grid) USAID United States Agency for International Development VAT Value-Added Tax FISCAL YEAR January I - December 31 A new currency, the hryvnia, was introduced in September 1996, with karbovanets exchanged into hryvnia at a conversion rate of 100,000 to 1.  UKRAINE ELECTRICITY MARKET DEVELOPMENT PROJECT CONTENTS Page No. LOAN AND PROJECT SUMMARY ................................. i I. SECTOR BACKGROUND A. Country Context .1 B. Overview of the Energy Sector .1 C. Power Industry Conditions and Priority Needs. 3 D. Government Policy and Strategy in the Power Industry. 7 E. Bank Strategy and Experience .11 Ii. THE PROJECT A. Project Concept and Objectives ........................ ... 13 B. Project Description ........................... 15 C. Project Context ........................... 20 D. Environmental Aspects ......... .................. 20 E. Cost Estimates and Financing . ........................... 21 III. FINANCIAL AND ECONOMIC ANALYSIS A. Electricity Prices .24 B. Past Financial Performance of the Implementing Agencies .27 C. Future Financial Performance of the Implementing Agencies .29 D. Economic Costs and Benefits .31 E. Sensitivity Analysis .33 IV. IMPLEMENTATION A. Institutional Arrangements .................................. 34 B. Implementation Responsibilities ............................... 35 C. Implementation Schedule ................................... 36 D. Procurement . ........................................... 37 E. Disbursement .......................................... 39 F. Accounts and Audits ................... 41 G. Monitoring and Evaluation .42 H. Operation .42 V. PROJECT RISKS AND BENEFITS .44 VI. SUMMARY OF RECOMMENDATIONS AND LOAN CONDITIONS .46  ANNEXES 1. Electricity Demand Forecast and Least Cost Power Investment Program 2. Nuclear Safety Issues 3. Draft Statement of Power Sector Policy 4. Detailed Cost Estimates 5. Financial Statements and Projections 6. Collection Agreement 7. Economic Analysis 8. Project Implementation Schedule 9. List of Procurement Packages 10. Estimated Schedule of Disbursements 11. Performance and Monitoring Indicators 12. Supervision Plan MAP IBRD Map No. 27976 Main Power Stations and Transmission Lines This report was prepared by Laszlo Lovei (Task Manager, EC41N), with contributions from Istvan Dobozi (Senior Energy Economist, EMTIE); Sue Lysy (Senior Financial Analyst, EC4IN); Vladislav Vucetic (Power Engineer, EC4IN); Olivier Gourlay (Power Engineer, EC4IN); Thomas Kearney (Operations Officer, EC4IN); William Lane (Environmental Specialist, EC4IN); Galina Mikhlin (Legal Counsel, LEGEC); and Nicholay Chistyakov (Disbursement Officer, LOAEL). Norsiah Sumardi assisted with the production of the report. The peer reviewers were Marc Heitner (EMTIE) and Jose Maria Bakovic (IENPD).  UKRAINE ELECTRICITY MARKET DEVELOPMENT PROJECT Loan and Project Summary Borrower: Ukraine. Beneficiaries: Dniproenergo, Donbassenergo, Tsentrenergo, Zakhidenergo and National Dispatch Center. Poverty: Not applicable. Loan Amount: US$317.0 million. Loan Terms: Payable in seventeen years, including five years of grace, at the standard interest rate for LIBOR-based US$ single currency loans. Conmitment Fee: 0.75% on undisbursed loan balances, beginning 60 days after signing, less any waiver. Onlending Terms: IBRD interest rate plus a mark-up of 1 percent with a maturity of 10 years, including three years of grace for Dniproenergo, Donbassenergo, Tsentrenergo, and Zakhidenergo, and a maturity of seventeen years, including five years of grace for the National Dispatch Center. Financing Plan: See paragraphs 2.22-2.24. Net Present Value: US$299 million (35 percent economic rate of retum). Map: IBRD Map No. 27976 Project ID: UA.-PA 44444 Vice President: Johannes F. Linn, ECA Director: Basil G. Kavalsky, EC4 Division Chief: Dominique Lallement, EC4IN Task Manager: Laszlo Lovei, EC4IN   UKRAINE ELECTRICITY MARKET DEVELOPMENT PROJECT I. SECTOR BACKGROUND A. Country Context 1.1 Ukraine declared its independence from the Soviet Union in August 1991. It has a land mass that is the largest in Europe (with the exception of European Russia) and a population of 52 million that ranks fourth in Europe. GNP per capita was estimated at US$ 1,572 in 1994, down from US$ 2,340 in 1991. The economy rests on industry and agriculture, which together accounted for more than 70 percent of GDP in 1991. Ukraine, despite its size, is also heavily dependent on trade, notably with the rest of the former Soviet Union (FSU). 1.2 The economic decline in Ukraine has been dramatic. Real GDP contracted by 59% percent between in 1991-1995 (although the official figures may overestimate the extent of the fall in output, since the informal economy has been expanding out of reach of government regulations and taxes). Due to loose fiscal and monetary policies, the rate of inflation reached 4,735 percent in 1993. The external situation became increasingly tenuous, reflecting a significant trade deficit with the FSU -- about US$ 3 billion in 1993 -- which was only partially offset by a trade surplus with the rest of the world. Developments in external trade were marked by a sharp contraction in trade volumes, a considerable decrease in the terms of trade as import prices of energy moved towards world levels, and a shift in the direction of trade away from the FSU towards the rest of the world. The foreign trade deficit led to the increasing accumulation of arrears on payments for energy imports. 1.3 In July 1994, Ukraine elected a new President who called for a radical break from the past in economic policies. A program of macroeconomic stabilization and structural reforms was developed and adopted. The budget deficit was reduced, monetary policy was tightened, and work was started on mass and small scale privatization. Actions were taken to liberalize the economy. The Government's economic program was supported by the IMF and the World Bank. The IMF approved, in October 1994, a first purchase under the Systemic Transformation Facility (US$ 365 million), and the World Bank approved, in December 1994, a Rehabilitation Loan of US$ 500 million. A second purchase under the Systemic Transformation Facility (US$ 365 million) and a Standby Arrangement (US$ 1,494 million) were approved by the IMF in April 1995. In the second half of 1995, however, there were slippages in the implementation of the stabilization program. A part (46%) of Ukraine's quota under the Standby Arrangement was not disbursed due to the non-observance of agreed performance criteria. The Government took a number of corrective measures in early 1996, and, in response, the IMF approved a new Standby Arrangement in May 1996. B. Overview of the Energy Sector 1.4 Energy Demand. Energy demand in Ukraine is characterized by high energy intensity in relation to industrial output and the high share of industry in final energy consumption. This is due to the high share of heavy industry (iron and steel, basic chemicals) and the low thermal efficiency of energy consumption technologies. Energy consumption per capita was about 3,000 kilogram oil equivalent (koe) in 1995, which is quite high even by Western European standards. Following a modest decline of 11% between 1985 and 1990, the energy intensity of the offical GDP increased 60% in the 1991-1995 period reaching 5.2 koe/US$, a ratio that is several times higher than in developed countries (the true energy intensity of GDP is likely to be substantially lower due to the large size of the shadow economy, and the difference between the market exchange rate and purchasing power parity).  2 Sector Background 1.5 Primary Energy Resources. Ukraine has large, practically unlimited coal resources. Donbass, the main mining basin, contains metallurgical coal, anthracite and high grade thermal coals, as well as coalbed methane gas. The unusually difficult geological conditions (thin, steeply inclined coal seams at great depth) in the central Donbass make the mining of coal costly and labor intensive. Natural gas and crude oil resources are declining, but are still significant. Remaining proven and probable reserves are 190 million tons of oil and 1,400 bcm of natural gas. The shallower and larger oil and gas pools in the Dnieper-Donetsk and Carpathian regions are rapidly being depleted. These deposits are replaced by reserves in smaller, deeper and less productive reservoirs, which are more expensive to find, to drill-up and to produce, to the point that a large part of the reserves appear to be uneconomic. Table 1.1 Primary Energy Supply and Consumption Year 1990 1991 1992 1993 1994 1995 PRODUCTION washed coal (mt) 130.7 108.7 105.4 91.0 75.9 65.6 crude oil & condensate (mt) 5.3 4.9 4.5 4.2 4.2 4.0 natural gas (bcm) 27.8 24.0 22.0 19.2 18.3 18.1 peat & wood (mt) 4.3 4.0 3.7 4.1 4.0 3.9 nuclear (TWh) 76.2 75.1 73.7 75.2 68.9 70.5 hydro (TWh) 10.3 11.5 7.8 11.2 12.3 10.1 Total Production (mtos) 116.77 102.10 97.02 88.44 78.81 73.11 IMPORT coal (mt) 21.1 12.7 11.7 8.7 7.5 16.0 crude oil (mt) 54.3 49.6 35.3 19.7 15.8 13.3 natural gas, net (bcm) 87.3 89.5 89.1 79.8 69.1 66.3 petroleum products (mt) 11.5 13.1 5.0 6.2 6.5 9.5 Total Import (mtoe) 150.56 145.13 121.88 98.06 84.79 87.16 EXPORT coal (mt) 20.0 13.7 7.8 3.5 4.6 2.4 petroleum products (mt) 11.3 8.4 6.4 1.1 1.7 1.4 electricity, net (TWh) 28.0 14.3 4.6 1.2 1.1 4.1 Total Export (mtoe) 28.30 18.83 11.45 3.15 4.28 3.63 Primary Energy Consumption(mto.) 239.02 228.40 207.45 183.35 159.32 156.64 Annual Percentaoe Channe -4.4% -9.2% -11.6% -13.1% -1.7% Notes: *A ton of oil equivalent is defined as 10 million kcal. The applied conversion factors are: coal - 0.5, crude oil - 1.0, peat & wood - 0.2, hydro & electricity - 0.25, natural gas - 0.85, petroleum products - 1.0.  Sector Background 3 1.6 Energy Supply. Domestic energy production, consisting of fossil fuels and primary electricity (hydro- and nuclear power), represented 45-50% of consumption in the 1990-1995 period (see Table 1.1). Most of the decline in domestic energy production was due to decreased coal and natural gas output. The main energy import items were crude oil and oil products, mostly from Russia, natural gas, from Russia and Turkmenistan, and coal, from Russia and Poland. The cost of fossil fuel imports reached about US$ 6 billion per year in 1993-95, creating a demand for foreign exchange that the economy was unable to meet. The difference was financed by payment arrears to Russia and Turkmenistan (the arrears were subsequently converted to debt), and balance-of-payment support from the IMF and the World Bank. 1.7 Energy Prices. Gasoline, diesel oil and fuel oil prices are liberalized. Electricity, gas, and coal prices are set by the central government. Local governments set the price of district heating, LPG, heating oil, peat and wood. Household energy prices cover 50-80% of costs, with electricity prices being the closest to full cost recovery. The difference between costs and prices is covered by subsidies from the central and local governments, and also by a non-transparent surcharge on industrial consumers (particularly for district heat). Even for electricity, there are several categories of households who are entitled to discounts, and the cost of these discounts is borne by industrial consumers. Non-payment by customers became a major problem for electricity, gas and heat suppliers in 1994-95, weakening the financial position of the utilities. In September 1995, the Government issued a resolution on the non-payment of energy bills requiring that all non-payers be disconnected, and also providing indemnity to the energy suppliers for eventual damages on the consumer side. The implementation of the resolution was unsatisfactory during the unusually cold winter of 1995/96, but it improved rapidly in mid-1996. 1.8 Sector Institutions. The main government agencies in the sector are the Ministry of Coal Industry, the Ministry of Power and Electrification (Minenergo), the State Committee for Nuclear Energy (Goskomatom) and the State Committee for the Oil and Gas Industry. In 1994-95, the Government implemented a corporatization program in the oil, gas and power subsectors, with the long term objective of privatizing most of the assets and activities except those that are considered of strategic importance (e.g., oil, gas and electricity transmission lines, nuclear plants, dispatch centers). More details are provided on the Government's program in the power industry in Section D below. The corporatization program of the coal industry was started in 1996, parallel with a program to close uneconomic mines. C. Power Industry Conditions and Priority Needs 1.9 The installed electricity generation capacity of the Ukrainian Power System (UPS) is about 53 thousand MW. It includes 14 thousand MW of nuclear capacity, located in five plants with a total of 15 units in operation. There are more than 40 thermal (fossil fuel) power plants with conventional steam cycle technology, with over 110 generating units and a total capacity of 32 thousand MW, of which four thousand MW are combined heat-and-power units. Hydro capacity is close to five thousand MW, stationed mostly in 9 plants with a total of 100 generating units. The capacity of industrial power plants was about two thousand MW. The total effective generating capacity of the system is about 50 thousand MW, due to the derating of older plants. Most older fossil fuel plants (about 23 thousand MW) use coal as their primary fuel, but need gas or mazut for co-firing. About five thousand MW of power generation as well as most of the combined heat-and-power plants run on gas or mazut as main fuels. 1.10 Electricity generation was 193 TWh in 1995, of which thermal plants produced 107 TWh, nuclear plants 71 TWh, hydropower plants 10 TWh, and industrial plants 5 TWh (see Table 1.2). Net export was 3 TWh (6 TWh export, 3 TWh import). Self-consumption of thermal plants was 9 TWh (or about 8 % of their total generation), and of nuclear plants 5 TWh (7 % of generation). After accounting  4 Sector Background for transrnission and distribution losses (23 TWh, or 12% of total generation) and net exports, net domestic electricity consumption came to 151 TWh. Within this total figure, the two largest consumer groups, industry and households, represented 54% and 18% of electricity consumption, respectively. 1.11 Electricity generation, domestic consumption and exports have all declined significantly in recent years. Between 1990 and 1995, generation decreased by 35%, gross domestic consumption by 23 %, and net exports by 88%. The decline in generation and consumption is likely to continue for some time (see Annex 1). Offically recorded GDP, however, declined even more (by almost 60% in the same period), and, as a result, the electricity intensity of GDP increased by 86% (the true increase in the electricity intensity of the economy is likely to be substantially lower due to the growing share of the shadow economy). Table 1.2 Electricity Balance (GWh) 1990 1991 1992 1993 1994 1995 Generation 296258 276775 250945 228316 201598 192620 Thermal 201682 182500 162390 135870 115848 107047 Nuclear 76179 75131 73732 75240 68848 70525 Hydro 10704 11904 8069 11210 12299 10123 Small Industrial 7693 7240 6754 5996 4604 4925 Imports* 7078 9231 5862 6449 5253 3270 FSU 7078 9231 5862 6449 5253 3270 Non-FSU - - - - - - Exports' 35048 23538 10511 7595 6277 6100 FSU 6917 8094 4739 4885 4686 1997 Non-FSU 28131 15444 5772 2710 1591 4103 Not Exports 27970 14307 4649 1146 1024 2829 Consumption 268288 262468 246296 227170 200575 189791 Industry 146150 137725 126344 108022 88554 81067 Agriculture 20453 20719 19061 18406 16758 13588 Transport 14449 13611 12482 12111 10834 10278 Communal Services 17582 17828 17219 16705 15722 14807 Households 21142 24208 24909 26898 26764 27008 Other 7460 7456 6049 5764 4876 4506 Self Consumption and Losses 41054 40891 40231 39265 37066 38537 including electricity exchange 1.12 The Ukrainian power industry was developed and operated as a part of the integrated power system of the FSU. During the last 15-20 years, investment policy favored the use of natural gas and nuclear power at the expense of coal-fired plants. The aging coal plants, whose performance was further affected by declining coal quality, have to use mazut or gas as supplementary fuels despite sharp increases in the price of imported oil and gas after the break-up of the Soviet Union. The total fossil fuel consumption of the thermal power plants consisted of 39.6 mt of coal, 14.4 bcm of gas, and 2.4 mt of fuel oil in 1995, representing, respectively, 60%, 17% and 30% of the total domestic consumption of these fuels. Due to the lack of rehabilitation and the postponement of maintenance, the availability of some of these power plants decreased from 86% in 1993 to less than 70% in 1995. There was a  Sector Background 5 corresponding sharp increase in unplanned outages (from 3 to 8 outages per year), and also in heat rates (by about 10% between 1993 and 1995). 1.13 Due to a number of factors such as insufficient payment collection and the lack of credit (see Section A in Chapter II), the thermal power generation companies encountered a severe shortage of working capital by the fourth quarter of 1995. In addition to the lack of spare parts and the postponement of maintenance, fuel inventories (which also include on-site strategic national inventories) decreased to abnormally low levels. Typical industry minimum inventory levels are 30-day supplies. In market economies, a 60-day target inventory level is common for situations where fuel supply interruptions are likely. In Ukraine, the actual 1995/96 average winter inventory was less than one-third of the 30-day standard (about 20 days for coal and 7 days for mazut). In more than half of the power stations, coal inventories are lower than 10 days. The fuel inventory crisis looks even more serious taking into account the fact natural gas, for which on site storage space does not exist, makes up about half of the total fuel consumption of the power sector, and other consumers (e.g., households) have the first call on gas reserves. 1.14 By the middle of the winter, an estimated 4,000 MW generation capacity had to be taken off-line due to fuel inventory shortage. The amount of constrained demand reached 6,000 MW (affecting 7,000 enterprises) during the 16-day coal miners strike in February 1996. Even after deducting the demand that is likely to support uneconomic production from this figure, the cost of unserved energy to the national economy must be very large. In addition, low inventories and the severe imbalance in inventory allocations among power stations make optimal economic dispatch a largely impossible task. Finally, the fuel inventory shortage adds a large element of uncertainty to the efficient operation of the wholesale market (see Section D below on the wholesale market). 1.15 Nuclear power plants account for 26% of installed generating capacity. The 15 Soviet- designed operating units include two RBMK graphite moderated reactors at Chemobyl of 2 x 1000 MW nameplate capacity. Construction of two new nuclear units in Rovno and Khmelnitsky, each 1000 MW of capacity, is in progress at varying degrees of completion. Sunk investments costs and the increasing costs of imported fossil fuels are powerful incentives to complete these units. The April 1986 Chernobyl accident brought to the forefront the issue of the safety of nuclear plants (see Annex 2). The G-7 Summit Meeting held at Naples in July 1994 called for the phased closure of the Chernobyl plant and outlined a broad Action Plan to this effect, including the completion of three new nuclear reactor units to adequate safety standards, the rehabilitation of non-nuclear power plants, energy policy reform, and energy efficiency measures. In December 1995, the Ukrainian Government and the G-7 signed a Memorandum of Understanding regarding the closure of the Chernobyl nuclear plant (see Section D below). 1.16 During the last three winters, the UPS was several times separated from the Russian electricity system for extended periods. These forced separations from the hydro plants on the Volga river that control system frequency revealed some serious structural and functional weaknesses with negative consequences on overall system operation, security, reliability and quality of power supply. Most of the plants in the UPS are base-loaded, with limited load-following capabilities, and the system lacks peaking and spinning reserve capacity. Inability of the UPS to maintain the balance of supply and demand in real time, as measured by the system frequency and power flows through the interconnections with the neighboring systems, led to the separation of all neighboring systems, causing further deterioration of system performance and reduction in export capacity. The existing peaking capacity is provided by the hydro plants that are old and in need of rehabilitation. In view of unmet load-following requirements and the high share of base-load plants, it is also necessary to enhance the regulating capacity.  6 Sector Background 1.17 The inadequate capacity to regulate frequency in Ukraine has led to frequency levels that are not only unacceptable by international standards, but also damaging to rotating electric equipment both in the consumption and generation side. Sometimes frequency drops below 49.2 Hz, while most well- operated systems would not allow frequency fluctuations of more than +/- 0.01 Hz. Owing to the damage done to electric equipment by substandard frequency, nuclear plants are normally taken out of service when frequency drops below a certain level (this is set at 49.2 Hz in Ukraine). Yet, these plants are kept on-line, even when frequency falls below the set point, because the authorities are reluctant to substitute lost nuclear power with thermal generation due to the shortage of fossil fuels. Thus the safety of the nuclear plants could be compromised. Therefore, enhancing the system's ability to better balance supply and demand, and improve frequency regulation, would have significant nuclear safety benefits. 1.18 The current control system consists of a hierarchical, four level dispatch and supervision system, and local automatic control subsystems at various facilities. At the top level of the dispatch system is the National Dispatch Center in Kiev, linked to the eight regional dispatch centers, to some hydro plants, and to 750 kV and 330 kV substations. The regional dispatch centers are connected to power plants located within their respective regions, and to the local distribution centers (27 in total). They also control the local 330 kV network and 330/110 kV substations. At the lowest, fourth level, are single generating units at the plants, and district distribution centers, connected with the local distribution centers. The system operation planning procedures are generally adequate, although there is space for improvements. Computer models are used for the analysis of system performance and optimization of regimes. The software, most of which is not portable, has been developed mainly in the central institutes of the FSU and delivered without the source codes and, therefore, cannot be maintained and upgraded locally. The real-time operation of the system is controlled manually, using telephone connections between dispatchers in central and regional dispatch centers, and plant and substations operators. The existing data acquisition and communication system is incomplete, and largely obsolete. No automatic generation control or automatic load control is used. Although these weaknesses are somewhat counterbalanced by the high technical competence of the staff, the weaknesses inevitably contribute to the low quality of electricity supply and operation inefficiencies. 1.19 The power transmission and distribution networks in Ukraine operate at levels of 0.4, 6, 10, 20, 35, 110, 150, 220, 330, 400, 500, 750 kV AC; there is also an 800 kV DC link with Russia. Transmission levels are defined as 330 kV and above, while 220 kV and lower voltage networks belong to distribution. Ukraine has interconnections with Central Europe (capacity 2000 MW), Russia (3900 MW AC, 200/250 MW DC), Romania/Bulgaria (3500 MW), Belarus (1000 MW), with a total effective power transfer capacity that exceeds 20% of the domestic generating capacity. In general, the capacity of the transmission network is sufficient, particularly under the current conditions of lower consumption and reduced electricity trade. The 750 kV network was designed to become the main transmission network, to serve Ukraine and to export electricity from Ukraine and Russia to Central Europe. As a result of the large drop in electricity exports, load on the 750 kV lines is often light, and there is a problem of compensating the reactive power the lines generate. Other than for some local interventions (building a new substation instead of the one at Chernobyl, strenghtening the 750 kV lines connecting some of the nuclear plants and the Dniester Pump Storage Plant that still have units under construction), there does not seem to be a need for major new additions to the network in the short-to-medium term. Expenditures should be focussed on the rehabilitation of older transmission and distribution lines. Technical losses in the transmission and distribution network (about 4% and 9%, respectively) are not excessive in international comparison, but have exhibited an increasing trend recently. 1.20 Electricity demand is expected to drop even further before it starts growing again, due to a number of factors such as the general economic downturn, electricity price increases and economic  Sector Background 7 restructuring. An analysis of least-cost investment options was conducted for the 1996-2010 period. The analysis assumed that the Chernobyl units would be decommissioned until year 2000, and 2700 MW of thermal capacity would be retired in the 1996-2010 period. The safety upgrade of all nuclear units was also assumed (the upgrade requires each unit be taken off line for one year). The simulation of system operation showed that the marginal cost of generation in the peak period was about 60% higher than the marginal cost of generation at the minimal load. The completion of a pump storage plant on the Dniester river was consistently part of the least cost solution, suggesting that the system needs the peaking capacity provided by hydropower plants. This preliminary analysis also indicated that completing the nuclear units that are in an advanced stage of construction is justified on the cost-of-operation basis, and that, after these units are commissioned, there is no need for additional capacity until 2008 (i.e., there will be a period of several years with significant capacity surplus in the system). Given that some of the plants are quite old, it may be more cost-effective to retire them earlier than indicated in Minenergo's current retirement plan. Those old coal-fired plants that are not retired and the hydropower plants will need to be rehabilitated. More details are provided in Annex 1. 1.21 Total power generation investment requirements until year 2000 are preliminarily estimated at US$ 3.5 billion, excluding construction costs of a new shelter for Chemobyl unit no. 4 (the unit damaged in the 1986 accident). Of this total, US$ 1.7 billion is needed for nuclear power, including US$ 0.4 billion for safety upgrades, US$ 0.4 billion for decommissioning and other works at Chernobyl, and US$ 0.9 billion for the completion of new nuclear units. The rehabilitation of thermal and hydropower plants and the partial completion of the Dniester PSP requires about US$1.8 billion. About half of total investment costs would be incurred in foreign exchange. 1.22 Ukraine has a significant power engineering and manufacturing base. The "Turboatom" and "Electrotyazhmash" fartories in Kharkov, for example, were among the largest producers of turbines and generators in the FSU, with exports to many countries. However, domestic production capability for some categories, notably high-voltage equipment, advanced power generating technology (gas turbines, modern coal-burning technology, environmental protection equipment), and instrumentation, control, communications and computing equipment, is limited or non-existent. Also, there seems to be limited expertise available in modern computer-based software and methodology for system control, as well as for least-cost investment planning and economic dispatch. D. Government Policy and Strategy in the Power Industry 1.23 In 1992-93, the Government's reaction to the increase in the price of energy imports and cost of energy supply was to rely on the methods of central planning such as price controls, cross- subsidization among consumer classes, and the rationing of energy, rather than allowing market mechanisms to regulate and balance supply and demand. The principal reason, presumably, was concern about the political risk of increased unemployment inherent in market based solutions. Another prominent concern was dependency on one supplier, Russia, for half of Ukraine's primary energy needs. 1.24 In late 1993, the Government prepared a "Concept for the Development of the Energy Sector of Ukraine for the Period up to 2010". The "Concept" was subsequently approved by the Parliament. It spelled out the following main directions for Ukraine's long-term energy strategy: (i) the development and implementation of a policy that promotes energy savings; (ii) economically and environmentally justified utilization of domestic energy sources; (iii) restructuring of the economy that reduces the energy intensity of production; and (iv) increasing reliance on alternative (renewable) energy sources. The investment program outlined in the "Concept" recognized the priority of rehabilitating  8 Sector Background capacities in the power, coal, gas and oil subsectors, however, it also included a number of ambitious expansion schemes in coal mining, oil and gas production, and nuclear power generation. 1.25 In early 1994, the Parliament passed a Law on Energy Conservation. The Law provides economic incentives for investments in energy conservation, including subsidies and earmarked loans. Specifically, it calls for the establishment of national and local extra-budgetary energy conservation funds to support energy saving initiatives (however, it failed to specify the revenue sources of the funds). The Law also contained a number of command-and-control type provisions such as penalties for "above the norm" energy use. In order to prepare the necessary regulations and to coordinate the implementation of the Law, a State Committee for Energy Conservation was established in July 1995 (a National Energy Conservation Center was established under the Ministry of Power a year earlier, in 1994). The Government approved the regulations for the operation of the national extra-budgetary energy conservation fund in February 1996. 1.26 In mid-1995, the Government prepared and submitted to the Parliament the "National Energy Program of Ukraine up to 2010". The "Program" was approved by the Parliament in early 1996. It follows the main policy directions established in the "Concept". For the power industry, the "Program" divides the next 15 years into two periods: the period of stabilization in 1996-2000, and the period of development in 2001-2010. Taking into account expected energy savings of 6-8 TWh/year in the first period and 30-35 TWh/year in the second period, the "Program" predicts that electricity generation will not reach the 1990 level before 2010. Investments in the 1996-2000 period will focus on the rehabilitation of thermal and hydropower plants. In addition to extending the life of these plants, rehabilitation would be aimed at maximizing the use of domestic coal, and improving plant reliability and environmental performance. Planned investments in new capacity in the same period would include the completion of pump storage (Dniester 2) and nuclear plants (Rovno 4 and Khmelnitsky 2) currently under construction. In order to meet the expected increase in demand for electricity after 2000, the "Program" recommends the construction of additional pump storage (Kanev), hydro (Tisa), nuclear (Khmelnitsky 3 and 4) and thermal power (about 3500 MW) capacity, while continuing the rehabilitation and modernization of existing thermal and hydropower plants in the 2001-2010 period. 1.27 Both the "Concept" and the "Program" recognize the need for various measures to upgrade the safety of nuclear power plants. The "Program" notes that the timing of the closure of the two remaining units of the Chernobyl Nuclear Power Plant will depend on the technical status of the units and the financial resources available. In December 1995, the Ukrainian Government signed a Memorandum of Understanding (MOU) regarding the closure of the Chernobyl Nuclear Power Plant. The MOU records the agreement between the Governments of the G-7 countries, the Commission of the European Communities and GOU on the "elaboration and implementation of a Comprehensive Program to support the decision of Ukraine to close the Chernobyl Nuclear Power Plant by the year 2000". The "Comprehensive Program" includes (i) the restructuring of the power sector to develop a financially sound electricity market; (ii) an investment program to rehabilitate thermal and hydro plants, complete pumped storage units and nuclear reactors in Khmelnitsky and Rovno, and to implement energy efficiency projects; (iii) nuclear safety improvements including the short term safety upgrade for Chernobyl unit no. 3, decommissioning of the Chernobyl Plant, and dealing with the shelter for Chernobyl unit no. 4; (iv) a plan to address the social impacts of the closure of the Chernobyl plant; and (v) identification and mobilization of internal and international financing to fund the above activities, with loans considered for revenue generating projects, and grants and domestic resources for non-revenue generating projects. The signatories and the international financial institutions will meet annually to monitor the implementation of the "Comprehensive Program".  Sector Background 9 1.28 In May 1994, the President of Ukraine issued Decree No. 244 "On the Market Transformation of the Power Sector of Ukraine" which stipulated the unbundling of the power sector of Ukraine and the development of a competitive national wholesale market for electricity. As a result of Decree No. 244 and other acts of government, today Ukraine's power sector is organized as follows (see also Figure 1): The 14 largest thermal power plants are owned and operated by four joint stock generation companies: Donbassenergo operates five plants (7770 MW total capacity), Dniproenergo operates three plants (8400 MW), Tsentrenergo operates three plants (7800 MW), and Zakhidenergo also three plants (4680 MW). * Two joint stock corporations own and operate the 8 hydropower stations on the Dnieper river and the three hydropower stations on the Dniester river. * A state grid company owns and operates the high-voltage network (220 kV and above). * Twenty seven joint stock companies (oblenergos) own and operate the low-voltage networks and some generation capacity in the 25 oblasts and two city administrations (Kiev and Sevastopol). * A nuclear generation company (Ukrenergoatom) has been formed on the basis of the country's five nuclear plants (although the plants have retained their status as separate legal entities). * A National Electricity Regulatory Commission (NERC) was established in 1995. NERC issues and monitors licenses for electricity generation, high voltage transmission, low voltage distribution, and tariff and non-tariff supply. NERC's task is also to promote competition, protect consumers, oversee the operation of the electricity market, regulate prices for high- and low-voltage network operators, and set the margins for tariff suppliers (i.e., oblenergos when providing service to small, captive consumers). In February 1996, GOU issued Resolution 207 "On Provisions for the Operation of the Electricity Wholesale Market of Ukraine". Resolution 207 ordered NERC, Minenergo and the Ministry of Economy to determine a mechanism for the transition of market based retail electricity prices for all groups of consumers in 1996. * Generation companies, the grid company and oblenergos signed the Energomarket Members Agreement (EMA) on March 21, 1996 (independent or non-tariff suppliers are expected to sign following the receipt of their licences from NERC). The EMA assigns the task of operating and administering the wholesale electricity market (called Energomarket) to the National Dispatch Center (NDC), a state owned company. The wholesale market started to operate on April 10, 1996. NDC's main functions include: (i) the control and financing of the high voltage grid; (ii) the purchase and dispatch of power capacity and electricity; (iii) the purchase of ancillary system services; and (iv) the administration of the settlements system (including the administration of market funds). Technical and financial market operations are govemed by a set of Market Rules described in the EMA. The price of electricity purchased from thermal (and later also from nuclear) power plants is set on the basis of a bidding process. In addition to determining in every hour the system purchase and selling prices, NDC continues to be responsible for generation plant scheduling and dispatch, and the maintenance of system stability. NDC's settlements responsibilities include creating payments orders and clearing payments among market participants.  JmLO Electicity Flows Minene 79 Payments V ~~~~Policy_ Tlhenmal Genco 4 1 _ T lhennal Gernco 3 Gneration _ _.Tlhennal Genco 2 D :ivision_ _ Tlhenual Genco I . _ t E~~~~~nergom ret t< \ y Lo~~~w Vltage _3 _ f J ~~~~~~Network_3 Hylro Genro 2 I 1 Diviion_