Nepal - Third Arun Hydroelectric Project

DoCuit of The World Bank FOR OMFCA4L USE ONLY Reprt No. P-6381-NEP MENORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT IN AN AMOUNT EQUIVALUNT TO SDR 95.5 MILLION TO THE KINGDOM OF NEPAL FOR THE ARUN III HYDROELECTRIC PROJECT AUGUST 29, 1994 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 witbout World Bank authorization.  CURRENCY EOUIVALENTS US$1 . NRs 49.48 WEIGHTS AND MEASURES 1 Kilowatt (kW) a 1,000 watts (W) 1 Megawatt (MW) . 1,000 kilowatts (kW) 1 Kilowatt - hour (kWh) . 1,000 watt - hours (Wh) 1 Megawatt - hour (MWh) = 1,000 kilowatt - hours (kWh) 1 Gigawatt - hour (GWh) - 1,000,000 kilowatt - hours (kWh) LIST OF ABBREVIATIONS AND ACRONYMS USED ABDSC - Arun Basin Development Steering Committee ACRP - Land Acquisition, Compensation and Rehabilitation Plan ADB - Asian Development Bank AHP - Arun III Hydroelectric Project BITS - Swedish Agency for International Technical and Economic Cooperation EA - Environmental Assessment FIDIC - Federation International des Ingenieurs Conseils FINNIDA - Finnish International Development Agency GTZ - German Agency for Technical Cooperation KfW - Kreditanstalt fOir Wiederaufbau LCGEP - Least Cost Generation Expansion Program MOWR - Ministry of Water Resources NEA - Nepal Electricity Authority NGO - Non-Governmental Organization ODA - Overseas Development Association PAF - Project Affected Families PFP - Policy Framework Paper POE - Panel of Experts RAP - Regional Action Program SPAP - Seriously Project Affected Families TOE - Tons of oil equivalent NEPALESE FISCAL YEAR July 16 - July 15  FOR OFFICIAL USE ONLY NEPAL ARUN III HYDROELECTRIC PROJECT Credit and Project Summary Borrower: Kingdom of Nepal Beneficiary: Nepal Electricity Authority (NEA) Amount: SDR 99.5 million (US$140.7 million) Terms: Standard, with 40 years maturity Onlending Terms: The Borrower would onlend to NEA US$136.1 million, plus US$34.3 million available under the existing Arun III Access Road Project (Cr. 2029-NEP), at a rate of 10.25% for a period of 30 years, including a grace period of nine years. The Borrower would bear the foreign exchange risk. The remaining US$4.6 million, covering the Regional Action Program, would be passed on as a grant to the Ministry of Water Resources (MOWR). Financing Plan: Local Foreign Total --------US$ Million---------- IDA Credit 2029-NEP - 34.3 34.3 Proposed Credit - 140.7 140.7 Total IDA - 175.0 175.0 ADB - 127.6 127.6 KfW - 124.4 124.4 To be determined!' - 163.3 163.3 OTHERS (France, Swedent1, Finland) - 46.3 46.3 Government 143.6 11.4 155.0 NEAS' 290.7 - 290.7 Total 434.3 648.0 1082.3 * Japan is sending its own appraisal mission to make its assessment of the project. bl Sweden has stated that it is willing to allocate up to US$30 million to the project, of which about US$17 million has been committed so far. This may result in a reduction in project financing by HMG and for NEA. s' Includes US$285.0 million equivalent of interest during construction. Economic Rate of Return: 15.4% Poverty Categorv: Not Applicable. Staff Appraisal Report: Report No. 12643-NEP Maps: IBRD Nos. 25523, 25558, 26235 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.   MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE KINGDOM OF NEPAL FOR THE ARUN III HYDROELECTRIC PROJECT 1. I submit for your approval the following memorandum and recommendation on a proposed development credit to the Kingdom of Nepal for SDR 99.5 million (US$140.7 million equivalent) and a proposed restructuring of an existing development credit for SDR 24.4 million (US$34.3 million equivalent) under the Arun III Access Road Project (Cr. 2029-NEP) to help finance the Arun III Hydroelectric Project (AHP). The proposed credits would be on standard IDA terms, with a maturity of 40 years. The implementing agency would be the Nepal Electricity Authority (NEA). The project would be cofinanced by the Asian Development Bank (ADB) (US$127.6 million) Germany, through Kreditanstalt fur Wiederaufbau (KfW) (US$124.4 million), France (US$20 million), Sweden, through the Swedish Agency for International Technical and Economic Cooperation (BITS), (US$17 million) and Finland, through the Finnish International Development Agency (FINNIDA) (US$10 million). An additional US$163 million would be financed by another cofinancier (to be determined). SECTOR BACKGROUND 2. EnerQv Resources and Use. Despite its status as the fifth poorest country in the world and its remote, land-locked location, Nepal possesses two major natural resources - scenic beauty and abundant hydropower potential. The former attracts tourism which generates over one-fifth of total export earnings. With improved rural infrastructure and urban services, including electricity, the tourism sector could contribute more. The very large economically exploitable hydro potential - rated at 25,000 megawatts (MW) - has hardly been tapped. Less than one percent (or 241 MW) has been harnessed so far. Nepal's per capita consumption of commercial energy is among the lowest recorded in the world. 3. Efficient development of its hydroelectric potential, a key component of the country's development strategy, offers the prospect of meeting most internal power needs, developing a surplus trade balance in commercial energy and mobilizing resources for development needs. Yet, insufficient and unreliable power supply has severely constrained the growth of manufacturing and services. Only 1 of the population has access to electricity, with consequent high pressure on fuelwood. Nepal is a net importer of fossil fuels, either purchased from or routed through India, and commercial energy imports absorb about 24 percent of foreign exchange earnings; the development of the hydropower potential would go a long way towards reducing dependence on energy imports. 4. Nepal's main indigenous energy resources are fuelwood and hydropower. Agricultural residues are widely used for energy, and biogas potential is high. There is also scope for the development of solar and wind energy. There are no known oil or coal deposits. In terms of use, fuelwood accounts for approximately 68% of total energy supply, followed by agricultural residues (15t), dung (8%), imported sources (8%, of which the vast majority is petroleum products and some coal) and domestic hydropower (1%). Only 9% of total energy supply is from commercial forms. Demand for commercial energy has grown during FY88-91 at an annual rate of 5%. 5. Impediments to hydropower development include difficult access to sites, complex geological conditions, extreme variation in river flows, a relatively weak hydrological data base, and heavy silt loads. The Arun river basin is one of the few identified areas with a good combination of flow and geology. Hydropower plants in the national grid range from 5 MW to 92 MW of installed capacity, and a further 12 MW are under construction. About 20 off- grid hydropower plants ranging from 45 to 1000 kW of capacity are also operating  in the country. Micro and mini schemes have a role in meeting rural needs, and the Government provides incentives for private investors to develop them. However, for the bulk of future demand, larger scale investments are needed. 6. About 107 potential hydroelectric sites in various river basin areas in the country have been identified. Of these, technical and economic screening criteria yielded 18 projects for which pre-feasibility or more advanced engineering studies have been carried out. The studied projects range from 10 MW to 10,000 MW, with almost half under 100 MW. Since 1984, engineering studies have included assessments of socio-environmental impacts. Over the past decade, these considerations have been handled with increasingly systematic attention. The volume of engineering work carried out by Nepal represents considerable effort and investment of resources. By the mid-1980s, the investigations and studies had produced eight hydro projects for Least Cost Generation Expansion Plan (LCGEP) analysis and, by the 1990s, the LCGEP had 11 hydro projects as inputs, a reasonable number of options for planning purposes. A 1994 update of the LCGEP by the Argonne National Laboratories reconfirmed that the proposed project, Arun III (AHP), is part of the least cost plan for the country's interconnected system. 7. Public and Private Sector Roles. Four main line ministries and their agencies are responsible for the energy sector in Nepal. Within the power sector, the Ministry of Water Resources (MOWR) has general responsibility for all activities related to electricity supply, including jurisdiction over NEA, which was created in 1985 to plan, construct, and operate all public power facilities in Nepal. Since the onset of democracy in 1991, several initiatives have opened the way for institutional reform and capacity building for NEA. The NEA Act of 1984 was amended in 1992 with the aim of giving it more autonomy and establishing an institutional framework for it to operate as a successful commercial entity. Recently, the number of Government officials on the eight-member NEA Board was reduced from six to three, the other members being three private sector representatives, one consumer representative nominated by HMG, and NEA' s Managing Director. Several initiatives are underway and planned to strengthen NEA's management and operations. For example, tariff adjustments, combined with reduction of consumer receivables and system losses, and trimming of 1,000 excess staff, have sharpened the performance of this young utility. NEA is recasting its organization along corporate lines based upon specific strategies to improve its commercial orientation, customer service, and financial and operational management. 8. The private sector does not have a large presence in the electricity sector at present. The new Government has been trying to change this by enacting legislation to facilitate private sector involvement in power development. Through the IFC (Report No. IFC/R94, June 8, 1994), the Bank Group is participating in the construction of the 60 MW Khimti Khola private sector hydropower generation project in partnership with Statkraft SF of Norway, ADB's private sector facility and the Butwal Power Company Ltd. (a local NGO). The purchaser of this private power supply would be NEA, but over the longer-term, power exports to India could provide an attractive market. The proposed project includes a Hydro Facility to strengthen the capacity of the private sector to undertake feasibility studies and to provide partial financing in selected cases. 9. The Government's Enercv Sector Stratecv. In 1987, ADB and IDA conducted a study of Nepal's power sectorl/ at the Government's request, on the basis of which all parties involved agreed that further attention needed to be paid to improving institutional performance, energy pricing and resource mobilization, investment planning and bulk electricity exports. The Government has also prepared a Framework for Power Sector Development aimed at evaluating !' Nepal: Power Subsector Review (January 15, 1988 - Report No. 6879a-NEP).  and recommending options for sectoral policy: the institutional framework, including the roles of public, autonomous and private entities; safety and technical standards; the strategy and responsibility for development of hydropower exports; and the investment environment for the private sector. 10. Recognizing the key role of increasing energy supplies in Nepal's economic development, the Government has given high priority to energy sector investments, especially power, in its investment program. The principal objectives of energy policy are to: (a) develop a surplus trade balance in commercial energy and promote industrialization by developing indigenous hydropower resources, (b) meet domestic energy demand at least cost to the economy, (c) reverse the deforestation trend, (d) increase the reliability and quality of electricity supply through upgrading the distribution system and reducing system losses, (e) adjust energy prices to promote efficient use while meeting social objectives, and (f) improve operational and financial performance and resource mobilization of energy sector entities. The Government has made considerable progress in meeting these objectives through forest management, addressing interfuel substitution and energy efficiency issues, collaborating with India in conducting preparatory studies for export-oriented hydro projects, allocating responsibilities to the public and private sectors for the development of the energy sector, and increasing electricity prices. 11. IDA's Sectoral Assistance Strate v. IDA's power sector strategy for Nepal is an integral component of its country assistance strategy, which was discussed and endorsed by the Associations's Board of Directors on April 12, 1994. Consistent with the Government's own objectives, the Association's strategy is to assist Nepal to: (a) develop efficiently its hydroelectric potential in a socio-environmentally responsible manner, (b) establish an institutional and regulatory framework which facilitates efficient sector development and private investment, (c) upgrade the corporate performance of NEA, (d) formulate an investment program to meet projected demand at least cost, and (e) establish mechanisms for setting tariffs that reflect the economic cost of supply. To date, IDA has supported this strategy by financing eleven energy projects, including seven related to hydroelectric schemes, three forestry projects, and a petroleum exploration promotion project which attracted one joint venture, but has not led to any discoveries. The credits have totalled US$281 million equivalent, representing about 22% of IDA commitments to Nepal. The lessons learned from past support and the Power Sector Study have been important in developing today's coordinated donor strategy. 12. IDA's Past Experience and Lessons Learned. In the power sector, four credits supported project implementation, and three supported project preparation, including the detailed engineering for the AHP. While progress on the preparatory studies has generally been satisfactory, experience with the two completed hydroelectric projects (Kulekhani and Marsyangdi) has been mixed. Physical implementation improved markedly from the first to the second project, but the institutional and financial performance of NEA was disappointing. For the 60 MW Kulekhani Project (Cr.600-NEP, approved on December 23, 1975; a supplementary Cr. 600-1-NEP was approved on May 10, 1979), the Project Performance Audit Report noted that the 21-month delay in project commissioning and the 80% cost overrun were caused by insufficient field investigations during preparation combined with overly optimistic scheduling of construction for a project of such scope (the largest in the country at the time) in the Nepal Himalayas. The project suffered from the lack of a Panel of Experts (POE), and a detailed engineering cost estimate was not completed prior to the bidding process. Although the project did not take full cognizance of soil conservation and watershed management problems, the Government subsequently took corrective action with the help of donor agencies. In spite of the foregoing, the Audit Report considered the project to have been a successful endeavor that has provided Nepal with its only significant hydropower storage facility. For the 69 MW Marsyangdi Hydroelectric Power Project (Cr. 1478-NEP, approved on May 22, 1984), implementation performance improved considerably, primarily due to the  application of lessons learned from the Kulekhani project. A POE was involved from the beginning, and bids were based on detailed engineering. The Marsyangdi project was commissioned in January 1990, within six months of its scheduled date and approximately US$90 million under budget. A major achievement was Nepal's success in sustaining project construction in spite of the 1991 Trade and Transit impasse with India. As with Kulekhani, compliance with project covenants was mixed, primarily because the Government did not implement timely tariff increases. 13. Rationale for IDA's Involvement. The successful development of Nepal's hydropower potential will enable the country to capitalize on its most important natural resource. However, given the scale of investment required to tap its potential, Nepal needs the support of the international community to help finance this effort. In 1987, the Government of Nepal asked IDA to play a lead role in this endeavor because of its knowledge of the country's power sector and commitment to its development, its experience with environmental and socio- economic issues, and its role in advising Nepal on macroeconomic reforms. In 1990, the Association served as executing agency for a major UNDP-funded study of environmental management and sustainable development in the Arun basin that went far beyond the more conventional impact studies undertaken by NEA at the time. This study culminated in the Regional Action Plan, which has become an integral part of the AHP. As lead donor for the AHP, IDA was instrumental in raising the substantial cofinancing required. The Paris Donor's Meeting, chaired by IDA in 1988 and 1993 for this purpose, also provided a venue for donor endorsement of sector development strategy as set out in the Nepal Power Subsector Review produced by ADB and IDA. 14. The sectoral principles expressed in "The Bank's Role in the Electric Power Sector: Policies for Effective Institutional, Regulatory, and Financial Reform" (June 1992, R92-193) have underpinned IDA's work in supporting Nepal's goals to establish an effective institutional and regulatory framework, with emphasis on strengthening NEA and increasing private sector participation. Nepal's regulatory framework has been modified to facilitate private sector investment in the power sector and to create an institutional framework for public and private sector companies to operate as commercial entities. As part of its effort to increase transparency in decision-making, the Government has created a Tariff Fixation Commission and has agreed to revise the Commission's regulations so that tariff levels satisfy NEA's obligations under project and financing agreements with external parties, including IDA. It would also enable NEA to automatically adjust its tariffs to reflect changes in its fuel costs. Power tariffs have more than doubled in real terms over a 30-month period. In addition to encouraging private investors, Nepal has imported specialized services to augment local capacity in developing hydro schemes and strengthening NEA. This practice is expected to continue, with adaptations reflecting growing sector complexity and growing Nepali capacity. For its part, NEA will adopt and implement a Commercialization Master Plan and Corporate Plan which will guide the utility in areas of strategic/business planning, human resource management, and customer service. The Plans will consider financial restructuring to enable NEA to sell shares to the public. NEA is also implementing the recommendations of an organizational and manpower rationalization study which has already resulted in a staff reduction of over 1000, and speeding up its action plan to reduce consumer receivables. Finally, NEA's commitment to demand and load management included an ongoing multi-faceted program under the IDA-supported Power Sector Efficiency Project (Cr. 2347 NEP, approved on March 26, 1992). These activities are to be institutionalized, with private sector involvement, to ensure sustainability. Another program supported under the Marsyangdi Project has reduced losses in the main load center by three percentage points annually, from 32% in 1991 to 26% in 1993. NEA is expanding this program to other load centers in the country (where losses have increased in recent years) and assistance in implementing the program is being provided by the Efficiency Project. These reforms will strengthen the capabilities of both NEA and the Government to  prepare, design, and supervise the construction of medium-sized hydropower projects. 15. Macroeconomic Affordability and Risk. The AHP is large relative to Nepal's economy, accounting for expenditures equivalent to about 25% of GDP spread over a 9 year period. This has raised concerns as to whether the project is affordable in the sense of being consistent with prudent macro-economic management and, more particularly, consistent with reasonable future growth in other priority types of expenditure such as primary education, primary health, family planning and rural infrastructure. Nepal's macroeconomic program is described in the Policy Framework Paper (PFP) for FY94-96, which has been agreed with the Bank and the IMF. The public investment program in the PFP includes the Government' s preferred hydropower investments (i.e., both AHP and Kali Gandaki A) and human resource and rural infrastructure investments, consistent with Nepal's absorptive capacity in these sectorsil. Hence appraisal of AHP's affordability requires an assessment of the robustness of the PFP framework and consideration of how to manage the risk of a shortfall in resources for investments in other priority sectors of the economy. 16. The key uncertainties which could affect macroeconomic prospects over the next few years are: (a) slippages in policy implementation, especially in the areas of resource mobilization and expenditure prioritization; (b) inadequate and/or delayed private sector response to changes in the policy environment; and (c) exogenous shocks. On the policy side, performance to date has been encouraging. Measures to enhance revenue mobilization were initiated as part of the FY94 budget, raising overall revenues to an estimated 11.1% of GDP in FY94 from an average of 10.5% in FY92-FY93. A good beginning has also been made to rationalize the structure of import tariffs, simplify excise and sales taxes, expand the effective income tax base and strengthen tax administration. Measures to improve the pattern of public expenditures have also been taken. A preliminary core program was adopted as part of the FY94 budget and is being implemented satisfactorily. Budgetary allocations to priority activities, including the social sectors and rural infrastructure, were significantly increased in the FY94 budget, and spending on low priority items was curbed. While policy performance under the PFP is thus off to a good start, it is critical that further progress, in line with PFP understandings, be achieved. With respect to the FY95 budget, the Government has agreed, as a condition of credit effectiveness, to formulate a satisfactory public expenditure program. The FY95 program is expected to include adequate resource allocations for the highest priority activities in the social sectors, rural infrastructure and power; it will also contain cancellations of low priority projects and tight screening of new project starts. IDA has made clear to the Government that its support for the other major near-term investment in the hydropower investment program (i.e., Kali Gandaki A) will depend on sustained progress in resource mobilization and expenditure prioritization as evidenced by actual performance in FY95 and budget provisions for FY96. The broad aggregates of the recently presented FY95 budget are consistent with the macroeconomic framework of the PFP. Furthermore, the sectoral allocation of expenditures shows a strong continued shift towards the social sectors. Altogether the Government's ability to gain and sustain support for these policies has been enhanced by the argument that such policies are needed to underpin critical investments in both the social sectors and in hydropower. Should the international community withdraw its support for the hydropower investment program, the risk of policy slippage would no doubt increase. 17. The second key factor affecting macro-economic prospects - namely, the strength of the private sector's response - is difficult to forecast. Experience 1' This analysis is presented in the report, "Nepal: Fiscal Restructuring and Public Resource Management in the Nineties," No. 12281-NEP, March 17, 1994.  -6- in other low income countries shows that lags in private investment can be substantial. Much hinges on establishing the credibility of government policies. In Nepal's case, the shortage of reliable electric power is a major impediment to expansion in both service industries (e.g. tourism) and manufacturing. Hence a credible program to alleviate this shortage would be helpful to private sector confidence, and the absence of a credible program would inhibit the response which is needed if growth objectives are to be achieved. In judging the impact of the AHP on resource availability for social sector and rural infrastructure investment, it is important to remember that medium and long-term growth in GDP is probably the most important single factor influencing the Government's capacity to support such critical expenditures. 18. Recognizing that the timing of private sector response cannot be assured and that exogenous shocks (e.g., floods) can always occur, the appraisal of the AHP's affordability considered the scale of resource scarcity that could emerge as a consequence of the project's implementation and the scope for corrective action. Since foreign exchange reserves are projected to remain at a comfortable level, the key constraint is not foreign financing but the volume of rupees available to support priority human resource needs. In the base case - corresponding to the PFP assumptions - rupee availability is sufficient to support real growth at the rate of more than 8% per annum in public expenditure on the social sectors. However, if NEA's finances were to improve in line with a nominal tariff increase of 26% in FY96 and no real tariff increases thereafter (see para. 4.17f.f. of the SAR) and the additional revenues thus made available to the Government are divided among sectors in accordance with the existing proportions of sectoral expenditures, it would be possible to support real growth at the rate of 9.5% per annum in public expenditures on the social sectors in the base case. The robustness of this conclusion has been tested through sensitivity and risk analyses. The sensitivity analysis considers a situation where GDP growth averages 3% per annum (compared to 4.5t in the base case), the revenue-to-GDP ratio increases by 0.2% per annum (in line with historical experience but below that achieved in FY94), regular expenditures grow somewhat more rapidly than envisaged in the PFP and no significant expenditure prioritization is achieved due to resistance by various affected groups. The impact - if no corrective action is taken - is to reduce the growth of social sector expenditures from 9.5% per annum to a little over 5.5% per annum. If, in addition, the AHP were to experience a cost overrun of 20% (over and above the 14% contingencies already built into the project financing plan), the growth rate would decline by another 1%. 19. The risk analysis shows an 85% probability that, even in quite adverse situations, Nepal could sustain growth of at least 5% per annum in high priority social sector programs. Moreover, the cases in which spending growth is below 5% could be brought up to that level with a very small increment of rupee resources, equivalent to less than 0.2% of current average aid disbursements to Nepal. Hence, the affordability risk of the AHP is considered manageable. THE PROJECT 20. Project Obiectives. The main objective is to increase Nepal's capacity to meet electricity demand at least cost. Other objectives are to: (a) strengthen local capacity to prepare, design and supervise the construction of environmentally sustainable hydroelectric projects; (b) support the environmentally sustainable development of the Arun Valley and assure adequate compensation or rehabilitation of the adversely affected population; (c) enhance resource mobilization and the operational autonomy and accountability of NEA; and (d) support progress toward an appropriate regulatory framework and private sector participation in the sector. 21. Proiect Description and Financing Plan. The project is the first 201 MW stage of a 402 MW hydroelectric power scheme, located on the Arun River in  - 7 - Eastern Nepal. The River originates in the Tibet region of China, which has confirmed its non-objection to the project. It is a run-of-the-river project, with most of the power generating facilities underground. The river flows from a huge catchment area (26,747 km2) that contains numerous glaciers, snow-packed mountains, and aquifers that ensure the river's firm high level discharge throughout the year. AHP will generate annually an average and firm supply of 1,690 GWh and 1,513 GWh, respectively. It represents an important addition to the national power system because the country has little water storage, and existing run-on-the-river plants depend on rivers whose flows diminish radically during the dry season, resulting in dependence upon expensive thermal generation and load-shedding. An unusual project feature is the long access road which would enable Nepal to initiate a series of projects in the Arun river valley (with total estimated capacity of 1,044 MW) and thereby to realize extensive benefits from the river basin. This approach would also confine impacts to one river system rather than scatter them among diverse sites. 22. Major project components include a 122 km access road, a 68 m dam and power intake, desanding basins and appurtenant structures, an 11.4 km headrace tunnel, a surge tank leading to a power cavern to house three 67 MW turbo- generators, a downstream surge tank and tailrace tunnel, and outlet structures. Electro-mechanical equipment includes hydraulic steel structures, turbo- generators and construction power supply. Transmission equipment includes a 120 km, 220 kV double-circuit line to a 220 kV/132 kV substation at Duhabi. In addition, the project provides for engineering consultancy services, technical assistance and training. It also includes a Hydro Facility to assist the private sector in undertaking feasibility studies of small hydro schemes and in financing and implementing viable schemes through the provision of credit at market rates and technical assistance. Finally, the project includes an environmental management plan comprised of a Land Acquisition, Compensation and Rehabilitation Plan (ACRP), an Environmental Mitigation Plan to deal with the direct impact of construction activities and a Regional Action Program (RAP) to address the projectIs induced impacts and promote sustainable development in the Arun Valley. 23. The project access road follows a valley alignment rather than the 192 km ridge route that was to be financed in 1989 under Cr. 2029-NEP. Although the ridge route would have provided more scope for temporary labor-based employment and would have linked a larger number of villages, it has been decided to change to the valley alignment. This will enable cost savings by advancing AHP commissioning by one year; shortening the transmission line by 20 km; decreasing travel distance to the dam site by 98 km under improved safety conditions; facilitating availability of construction materials; affecting fewer families (931 compared to 1,661); and impacting less on cultivated land and requiring less land. Finally, based upon socio-environmental impact assessments, the valley alignment was found acceptable. There have been no disbursements under Cr. 2029- NEP, which would be restructured to finance, inter alia, the mobilization costs of the major civil works contract for the AHP. 24. Project cost, based upon actual bid prices for the main civil works, is estimated at US$797 million (including taxes and duties estimated at US$37 million), with a foreign exchange component of US$648 million (81%). Financing is expected to be provided by IDA (through the proposed credit of US$140.7 million, plus US$34.3 million from Cr. 2029-NEP), ADB (US$127.6 million), the German Government through KfW (US$124.4 million), FINNIDA (about US$10 million), France (about US$19 million), BITS (Sweden, about US$17 million). US$163 million would be financed by another cofinancier (to be determined). The effectiveness of the cofinancing agreements with ADB and KfW and confirmation of all cofinancing needed for the project are conditions of credit effectiveness. NEA would finance US$290.5 million including part of interest during construction (US$285 million) on onlending provided by the Government. The Government would cover US$155 million and the foreign exchange risk. A breakdown of costs and the financing plan are shown in Schedule A. Amounts and methods of procurement and disbursements, and the disbursement schedule, are shown in Schedule B. A  timetable of key project processing events and the status of Bank Group operations in Nepal are given in Schedules C and D, respectively. 25. Water Richts. The AHP would use the waters of the Arun River, an international inland waterway that originates in the Autonomous Region of Tibet, People's Republic of China, and flows through Nepal to India. With regard to the immediate downstream riparian, India, Nepal's right to use the water of the Arun River is covered by an agreement between the Government of India and HMG on the Kosi Project dated April 25, 1954, as amended on December 19, 1966, which does not require formal notification regarding the project component. The Government of China, the upstream riparian, raised no objections (January 4, 1988) in response to IDA's indication that it was considering supporting development of the AHP detailed engineering studies under Cr. 1902-NEP. Because of the lapse of time since the processing of Cr. 1902-NEP, China was notified on November 14, 1993, that IDA was considering supporting development of the AHP. In a letter dated January 14, 1994, the Government of China informed HMG that it had no objections to the construction of the AHP. 26. Concern has been expressed that a potential irrigation project might be undertaken in the Changsuo Basin in Tibet that would affect negatively the flow of the Arun River at the project site. However, the catchment area of the Changsuo Basin is about 230 kM2, less than 1% of the Arun Basin catchment, so any diversion is likely to be almost imperceptible at the project site. Even if the flow in the tributary were totally cut off the impact would not be significant. In the wet season, the Arun River flow would still be more than 400 m'/second; in the dry season, the river is fed by aquifers throughout the basin as well as by glacier melt. 27. Environmental Management Plan. Because AHP does not have a large reservoir, its direct impact will be less than many hydro projects of similar capacity. The main direct social impact will be the project-affected families (PAFs) along the access road, who are to be rehabilitated under the project. The induced impacts, however, will be larger. The induced impacts of the access road in this remote valley, already under environmental pressure from the population, will be considerable. The construction of the road provides an opportunity to foster a more sustainable pattern of development. Implementation of the measures recommended in the Environmental Assessment (EA) prepared for the project would minimize negative impacts and enhance the socio-environmental conditions in the valley. From its inception in 1989, the POE for the AHP has included an environmental and resettlement specialist to ensure that project design takes appropriate account of these aspects. Additionally, the King Mahendra Trust for Nature Conservation, a local NGO, has drawn on its professional skills and in- depth local knowledge to produce a Regional Action Program (RAP). Extensive local consultation has taken place during the project design and socio- environmental studies and following the release of the EA Summary. Changes have been made in the project to accommodate the views of affected people including priority training and jobs with project contractors, and changes in the placement of the access road. The RAP, too, has been designed with the direct participation of those to be affected. Indigenous people have traditionally managed their forests on a community basis, and the RAP includes a program for forestry user groups. Further, the Government has responded to the disappointment expressed by communities on the change in access road alignment by making a commitment to build spur roads to link the communities of Khandbari and Chainpur with the access road. The EA Summary and other project information, including guidance on their rights to the people affected by land acquisition, has been distributed locally in Nepalese and English. 28. The access road, generation facilities, and transmission line have been located to avoid unnecessary direct effects. Mitigation measures have been integrated into the civil works contract, and this will be done for the transmission line (to be built at a later date). The location of temporary  - 9 - camps, borrow sites, quarry, and spoil disposal areas are subject to advance approval, and the location of environmentally sensitive areas is known in sufficient detail to guide construction. Tender documents for the civil works contract included comprehensive provisions for environmental and socio-economic considerations, and bids received reflect these requirements. An Environmental Protection and Health and Safety Plan have been included in the contractor's program of work. The engineering services contract will include responsibility for detailed reports on adherence to socio-economic and environmental conditions, which facilitate monitoring and supervising progress. NEA's Environmental Unit is being expanded to provide, inter alia, qualified people to coordinate with the local population and NGOs. Resources have been budgeted, and staff are being hired and trained before construction commences. (ADB is providing a technical assistance grant for this purpose.) 29. Induced impacts, mainly from the new road, include increased pressure on forest resources, reduced prices of certain crops within the Arun Valley, such as rice, due to lowered transportation costs (compared to the current cost of porters), and increased numbers of trekkers into the National Park. The RAP, consisting of sectoral activities in six major program areas, has been designed to address both immediate requirements of the construction process and the longer-term need for sustainable development in the Arun basin. The program areas are conservation, income generation, institutional strengthening, extension and training, infrastructure and energy development, and environmental monitoring. Before road construction is started in any area, measures will be taken to enable local communities to participate in community forestry activities and to provide opportunity for cultivation of food-crops for sale to road construction crews. In addition, environmental monitoring will be conducted, and communities will be provided with training and education. Many of these measures are already in place under the British Overseas Development Association's Nepal- United Kingdom Community Forestry Project and Koshi Hills Seed and Vegetable Project. Longer-term development needs will be addressed by setting up a new conservation area (Milke Danda), programs in agricultural and livestock development and other economic activities, development of minor roads linking nearby communities with the access road, and alternative energy programs including rural electrification and micro hydropower schemes. The German Government, through GTZ, is expected to support implementation of selected elements of the RAP including ecotourism development, small business promotion, institutional strengthening, extension and training, and infrastructure and energy development. The Government is putting in place the necessary arrangements for implementing the RAP, and donors are coordinating their efforts. 30. The Government has prepared a Land Acquisition, Compensation and Rehabilitation Plan (ACRP) on the basis of, inter alia, its Land Acquisition Guidelines. The ACRP is designed to ensure that, after a reasonable transition period, the affected population will be able to regain or enhance their previous standard of living. A comprehensive entitlement policy for all categories of affected people has been formulated to achieve this objective. While negative impacts have been minimized by locating the access road, generation facilities, and transmission line to avoid settlements and buildings wherever possible, the assets of some families will nonetheless be acquired or damaged by the project. The affected families have been categorized into two main groups: seriously project-affected families (SPAFs), and all other project-affected families (PAFs), plus formal and informal tenants and others who may be affected by the transmission line right-of-way. Household surveys indicate that about 998 families would be permanently affected of which 138 would be SPAFs. Land compensation includes land-for-land and cash compensation options, with compensation to be paid at the current market value in the area concerned. A Compensation Fixation and Rehabilitation Management Committee, chaired by the Chief District Officer, will determine compensation amounts based upon transparent criteria. Compensation and rehabilitation grants are provided, in addition, to cover lost or damaged assets, loss of income, and suffering and hardship. Grievances can be referred directly to a grievance committee which  - 10 - will meet in the project area at least every three months. Because the land to be acquired is dispersed and mostly in small parcels, resettlement sites, including civil infrastructure, are not needed. Moreover, interviews conducted with potential SPAFs indicate that they favor cash compensation and not land-for- land. JV Arun III, the supervision consultants for the project, assisted NEA in preparing the ACRP and has been contracted by the utility to carry it out. 31. Prolect Implementation. NEA would implement the access road, hydroelectric plant, ACRP and Environmental Mitigation Plan, and the Government would carry out the RAP and Hydro Facility components. A sound action plan has been prepared to promote effective decision-making and coordination and reduce the risk of cost overruns. The plan includes: (a) an Arun III Coordinating Committee, chaired by the Minister of Water Resources, to facilitate cooperation between Government agencies and NEA; (b) delineation of clear responsibilities in decision-making between NEA's Board, NEA's Managing Director, and the AHP Project Director; (c) appointment of a Project Director satisfactory to the donors, with the rank of Director-in-Chief, reporting directly to NEA's Managing Director; (d) signature of a contract with the supervision consultants following FIDIC's conditions of contract, including assistance to NEA in implementing the Dam Safety Program; and (e) award of the contract for the combined civil works lots (85% of total civil works) to help ensure that the project cost estimate is reasonable, which has been done. To minimize delays in procurement and construction, consultants assisting in bid evaluation and supervising implementation have already been appointed. Based on past experience in Nepal, construction delays could result from shortages of domestic financial resources; these shortages would be reduced by implementing measures to enhance NEA's cost recovery by reducing system losses and improving the handling of consumer accounts and collection performance. The project implementation program, prepared by the consulting engineer, was agreed upon by the POE and the major donors. The implementation program was originally based on full mobilization of the contractor for the combined Lot C1/C3 by the end of the 1994 monsoon season; it has now been extended by one year to reflect the fact that the contractor will begin mobilization during the 1995 dry season with the commissioning of the first unit planned for the first semester of 2002. 32. The Arun III Project Environmental Management Unit, a core team of environmental experts established by NEA, together with JV Arun III, will ensure that the planned environmental protection measures are enforced and complied with during construction. The Unit will act as the main contact point for NGOs and the public. To coordinate and monitor the implementation of the RAP, the Government has set up the Arun Basin Development Steering Committee under the National Planning Commission. The Steering Committee will be assisted by an Arun Basin Development Secretariat to be located in Kathmandu and an Arun Basin Implementation Office in the Basin. In addition, a local NGO or consultant, located primarily at the project site, will assist the Government in implementing and monitoring the RAP. In addition to the Environmental Management Unit and the Steering Committee, a POE, both Nepali and international, will advise on, inter alia, the RAP and resettlement implementation, and propose modifications where appropriate. The Panel will include a core of specialists in area development, resettlement, biodiversity and agriculture management; other experts will be consulted as needed. 33. In view of the project's complexity and the need to coordinate project administration among donors with various policies and procedures, the major cofinanciers intend to establish agreed procedures for administering their funds, to regulate matters related to procurement, disbursement, implementation monitoring, compliance with loan or credit covenants, and any other matters associated with the smooth implementation of the proposed project. These arrangements will be reinforced by joint supervision missions. An on-site Project Monitor will be appointed by IDA to monitor the implementation of all activities related to AHP implementation, including the RAP. The foregoing arrangements will be reflected in a Memorandum of Understanding (MOU) among the  - 11 - cofinanciers, and would be signed following approval of the respective loans and credits by the donors. 34. Proiect Sustainabilitv. Implementation of the AHP will improve the sustainability of Nepal's power sector strategy as a whole. Measures provided under the AHP will promote improvements in NEA by encouraging commercially- oriented operations. Future increases in electricity tariffs are planned to ensure that NEA will cover a reasonable share of total investments for power from internally generated sources. Institutionalization of a transparent mechanism for future tariff adjustments through creation of a Tariff Fixation Commission will contribute to sustaining progress in the financial viability of the power utility. In addition, the environmental management plan, if properly implemented, will ensure that the project's overall socio-environmental impact is positive. The project will be a training ground for NEA and locally-recruited staff in project management, operations and maintenance, thereby increasing local capacity. 35. Actions Agreed. During negotiations, agreement was reached with the Government on: (a) annual review of the macroeconomic framework for public expenditure planning and the resource envelope for the power sector, project implementation and progress made during the past year in putting into place an agreed framework for power sector development, together with the actions planned for the current year; (b) reimbursing NEA for losses on unprofitable rural electrification schemes; (c) establishing and maintaining the Tariff Fixation Commission; (d) submitting audited project accounts, including the Special Account; (e) finalizing arrangements for the operation of the Hydro Facility by December 31, 1994, and quarterly reports on its operation; (f) carrying out the RAP and maintaining appropriate institutional arrangements for the RAP and the overall project. The Government also agreed to ensure that mitigation measures are carried out sufficiently in advance of project works in affected areas; (g) entering into subsidiary loan agreements for all future on-lending to NEA; (h) providing additional equity to NEA, if necessary, to enable the utility to maintain its current ratio at 1.5 or more; and (i) NEA's role in carrying out public sector electricity projects. During negotiations, the Government and NEA agreed: (a) that the Performance Agreement between NEA and the Government will be reviewed annually and agreed recommendations implemented; (b) on implementing the Environmental Mitigation Plan and the ACRP, including that their activities would be carried out sufficiently in advance of project works in the affected areas; (c) to carry out public participation and consultation activities and to report annually on such activities starting in June 1995; (d) to establish a satisfactory monitoring, evaluation and reporting system; and  - 12 - (e) that within six months of project completion, NEA would prepare and furnish to the Association an Implementation Completion Report. During negotiations, NEA agreed: (a) to prepare and carry out a Corporate Plan satisfactory to the Association; (b) to complete and review with IDA its Commercialization Plan study and, based on the review, to submit and implement a Commercialization Plan satisfactory to IDA; (c) that unaudited accounts will be submitted to IDA within six months and audited accounts within nine months of the end of each fiscal year; (d) to implement a Materials Management Program by May 31, 1995; (e) on project implementation arrangements including, carrying out resettlement and rehabilitation activities in advance of construction, reconstituting and maintaining the POE and its functions, operating and maintaining the project facilities, and arrangements for monitoring the RAP; and (f) on actions to improve its financial management, including revaluing assets, informing IDA about debt servicing to the Government, generating internal contributions to investment; obtaining IDA approval before undertaking new investments; earning specified rates of return on revalued assets; adjusting tariffs to reflect fuel cost increases; ensuring satisfactory debt service coverage; implementing its Accounting Action Plan by September 30, 1995, reducing consumer receivables, computerization of consumer accounts, valuation of pension liabilities and an insurance action plan; and disposing of obsolete assets. Prior to credit effectiveness: (a) the Government will finalize a public expenditure program satisfactory to IDA; (b) the Government will revise the Tariff Fixation Commission's regulations to ensure that electricity tariffs and other charges are set in accordance with agreed financial covenants; (c) the Agreement amending the Development Credit Agreement for the Access Road project will be effective; (d) the effectiveness conditions of the ADB and KfW cofinancing agreements will be satisfied except for the conditions related to the effectiveness of the Development Credit Agreement; (e) confirmation of all cofinancing needed for the project; (f) the C1/C3 civil works contract will be awarded; and (g) the Government and NEA will execute a Subsidiary Loan Agreement satisfactory to IDA for onlending the proceeds of the IDA credit. 36. Program Obiective CateQories. The relevant categories for the AHP are economic management, environmental sustainability, and private sector development.  - 13 - 37. Participation and Consultation. Public participation has been an integral part of the preparation of the AHP. The Government has made unprecedented efforts, in collaboration with IDA and KfW, to ensure that all affected and interested parties have been consulted. Public participation occurred both within Nepal, particularly in the Arun Valley, and externally. During the preparation of the RAP, there were extensive consultations between local governmental organizations and user groups (including women's groups) to ensure that the AHP would lead to the sustainable development of the whole valley. This is reflected in the video, "Sustainable Development in the Arun Basin." Subsequent to IDA's appraisal mission, there have been consultations with the inhabitants of the Valley in Hile, Tumlingtar, Khandbari, Pukhuwa (power house site), Amrang, and Phyaksinda (dam site). Many of these meetings have been recorded on tape. In Kathmandu, numerous public meetings were held between Government representatives and local NGOs, and the project has been discussed in Parliament on numerous occasions. In the course of 23 public meetings, widespread support has been expressed for the project in the Valley itself because of the perceived benefits of the access road. The major issues raised were job and other income-earning opportunities, the change in the road alignment and environmental concerns. The geographical coverage of public consultation and communication in the Arun Valley in relation to the Arun III project is shown in the IBRD Map #26235. Outside Nepal, IDA and KfW have organized meetings with interested NGOs. KfW has met with NGOs based in Germany, and IDA has met with NGos in Switzerland, the U.K. and the U.S. Three meetings were scheduled with NGOs in Washington on June 10, 16 and 28, 1994 prior to the completion of negotiations between the Government and IDA on the AHP. The last meeting was attended by NGOs from Nepal, Germany, Japan, and the U.S. In addition to environmental concerns about the AHP, a number of the international NGOs and critics in Nepal have expressed a strong preference for energy sector development relying on small hydro projects as an alternative to the AHP. These alternative options were examined and the results, which were shared with interested NGOs, are discussed in the SAR accompanying this Memorandum (SAR No. 12643 dated August 29, 1994). It is important to note that in assessing the options, a majority of Parliamentarians as well as representatives of professional groups in Nepal have endorsed the Government's program. 38. Public participation during project implementation will also be important. The long implementation period means that activities will inevitably need to be shaped in light of experience gained. A local NGO or consultant, under contract to MOWR, will provide assistance to the Government in implementing the RAP and coordinating with affected people. In addition, NEA's expanded Environmental Unit will coordinate with the local population and NGOs regarding adherence to socio-economic and environmental conditions outlined in the Environmental Mitigation Plan and incorporated in the engineering services contract. PROJECT JUSTIFICATION AND ECONOMIC BENEFITS 39. The standard tests of least cost analysis and economic evaluation show that the project is part of the least cost generation expansion plan under plausible assumptions about the future. The optimal commissioning date is delayed by a few years if load growth is lower than projected or costs are much higher than projected in the base case; otherwise the least cost solution is for Nepal to proceed with Arun as soon as possible. Proceeding with Arun now is an attractive investment for Nepal in both economic and financial terms. The economic rate of return is just above 15% in the base case, and the risk of it falling below 10% is judged to be quite small (about 2%). Once commissioned, the project is projected to generate the equivalent of more than US$100 million annually in revenues, which is about ten times the project's annual debt service costs to foreign creditors. An argument has been put forward by project critics for overriding the results of these conventional approaches to project justification. The basic contention of the critics is that the rather small cost  - 14 - advantage in favor of Arun is more than offset by the lower risks and greater capacity building benefits of an alternative strategy based on a series of smaller hydro investments. A comparison of the alternative strategies for meeting Nepal's power requirements shows that what is at stake is not a choice between Arun and small, private-sector financed hydro investments. Government policy and the proposed project support both. The real choice is between Arun and other medium and large-scale hydro investments. Nepal faces important risks whichever choice is made. Proceeding with an investment program that includes Arun is probably less risky overall, and certainly more likely to have the risks well managed. Moreover, there is strong borrower commitment to this investment program, a factor which experience shows is crucial to effective implementation. 40. Least Cost Analysis. The least cost analysis for selecting power generation projects selects the generation expansion plan which minimizes the present value of the total system expansion cost. It considers thermal options as well as those hydro projects which have been examined to at least the pre- feasibility level. The projects considered range in size from the 10 MW Modi Khola project to the 660 MW Kali Gandaki II project. Certain characteristics of NepalIs power situation complicate the determination of the least cost plan. The bulk of current power supply is from run-of-the-river hydro projects which supply much less power in the dry than in the wet season. During the dry season of a typical year hydro power must be supplemented by diesel fired thermal plants and modest power imports from India. During the wet season of a typical year there is a surplus of hydro energy. In principle, this pattern could be modified through development of hydro projects providing for substantial storage, but such projects tend to be very large, expensive and/or require first-of-a-kind construction which would be very risky for Nepal. Moreover, they can pose complex issues of resettlement and relations with India. In practice, therefore, Nepal faces a choice between surplus hydro energy in the wet season or large imports of fuel to run thermal plants in the dry season. The least-cost solution for Nepal is to have surplus hydro energy in the wet season. One of the key attractions of the Arun project in this connection is its ability to generate power during the dry season at a level which is not much less than during the wet season. This explains why traditional cost comparisons based on the cost per installed kilowatt hour -- which show Arun to be relatively expensive -- are misleading. On the much more relevant measure of cost per kilowatt of power that can be supplied year round Arun is attractive. Changes in key assumptions (demand growth, costs, sales price for surplus hydro power) can delay the optimal commissioning date from 2003 to 2009, but Arun and Kali Gandaki A always remain among the first plants to be justified in the least cost expansion plan. The total plants brought in as part of the LCGEP include Kali Gandaki A (140 MW) in two stages in 2000 and 2002, Arun (402 MW) also in two stages in 2003 and 2007, followed by the Upper Arun (335 MW in 2009) and Lower Arun (307 MW in 2012), Bhote Kosi 2 (48 MW in 2014), Upper Karnali (240 MW in 2015), and West Seti B (360 MW in 2019). In the event that Nepal proceeds with Arun III and the low demand forecast materializes, the additional (discounted) cost is estimated at US$38 million. The risk of incurring this cost can be compared with the risk of delay in terms of potential unserved energy needs in the early years of the next decade and the uncertainty which attaches to Nepal's ability at some future date to mobilize the needed finance on comparably attractive terms and to receive comparably attractive bids from contractors. 41. Economic Benefits and Risks. The economic internal rate of return (EIRR) to NEA's long-term development program for meeting growth in demand for electricity is evaluated from a comparison of the economic costs of this program with its economic benefits. Benefits are valued in terms of the incremental demand that is met under the program relative to the much lower level of demand that could be served if no new supply capacity were added to the power system. Likewise, the costs are the difference between power system costs for meeting the forecast demand with this program and the system costs without any new investments in supply capacity. For the EIRR analysis, the adopted growth rate in household income up to 2015 is 2% per year, which is derived from the  - 15 - projected long-term growth rate of GNP of 4.5%, and projected population growth rate of 2.5%. On this basis the EIRR for the base case is 15.4%. 42. The major risks concerning the economic performance of the project are associated with demand, export sales, costs, and schedule. In the case of demand risk, probabilities were attached to base, low and high demand profiles based on country judgments. For export sales, probabilities are attached to the base case price and the case of zero price of exports of surplus hydro energy to India. Assessments of cost (no cost overrun, moderate cost overrun and high cost overrun), and of schedule risk (no schedule slip and positive schedule slip) are informed by experience with all Bank-financed completed hydropower projects initiated since 1965. The risk-weighted EIRR is 13.5W, which is lower than the 15.4% reported earlier for the base case, but higher than the opportunity cost of capital. The chance of the EIRR being at or below 10 is very small, at about 2%. Moreover, the risk-weighted EIRR is robust to changes in the basic probabilities, as is the result that the likelihood of falling below the opportunity cost of capital is very small. Therefore, the risk analysis shows the EIRR to be robust. 43. Assessment of Alternative Investment Strategies. Both least cost analysis and economic evaluation show that the Arun III project meets the Bank's normal standards. Nevertheless, because the project is large for Nepal, because the Bank's past experience with hydropower investments has shown a tendency for project costs to exceed estimates, and because of objections raised against the project by critics both inside and outside Nepal, the appraisal of AHP has gone beyond the standard appraisal and has given special consideration to alternative investment strategies. In particular, the possibility of meeting Nepal's power requirements through a series of smaller hydropower investments has been examined in some detail. 44. It is important to be clear what is meant by "smaller" hydropower investments. One concept emphasizes those projects which can be implemented by Nepalis on their own, without significant involvement of expatriate expertise. Nepalis have demonstrated such capacity with one project of 5 MW that is already completed and with one project of 12 MW which is currently under construction. The Khimti Khola project is much larger (60 MW), but it will be receiving strong technical support from a major Norwegian utility. 45. In 1992/93, with help from Germany, a master plan for mini-hydro projects in Nepal was prepared. A total of 33 such projects, ranging in size from 0.3 MW to 11.4 MW, were examined. Of the 33, some 13 were considered potentially suitable for integration into the national grid. These 13 projects are not seen by the Government of Nepal or IDA as being competitive with Arun III. The total installed capacity of all 13 projects is less than 50 MW and the firm (i.e. year round) energy is less than 20 MW equivalent. Since under the most optimistic conceivable assumptions, it would be several years before all these projects could be completed, they could at most contribute a fraction of one year's growth in demand for power in the medium term. 46. The Government of Nepal has for some years been encouraging the development of micro-hydro projects. As part of the effort to support the growth of private power investment in larger projects, NEA has recently concluded a 20 year energy purchase contract with Himal Power Limited, the company that will implement the Khimti Khola project. HMG has guaranteed this contract and has made clear that similar power purchase arrangements would be provided to other private power projects. Moreover, as part of the Arun project itself, the Government has decided to establish a Hydro Facility to provide funding for feasibility work on mini and micro-hydro projects and to help meet their actual financing requirements. Thus, future development of hydropower projects up to 10 MW in rated capacity, or even somewhat larger, is not jeopardized by the Arun project. On the contrary, it is being encouraged both by the policy of HMG and by the creation of a new funding mechanism.  - 16 - 47. The only realistic alternative to the hydropower investment program proposed by the Government is a series of hydro investments in the range of 10 MW to 100 MW. While these are certainly small projects by international standards, most are similar in magnitude to the two previous major hydro investments made in Nepal; namely, Khulekhani (60 and 32 MW) and Marsyangdi (69 MW). Past pre-investment studies in Nepal's major river systems have identified a large number of such potential investments. Pre-feasibility and feasibility work has been done on some 18 of the 93 sites identified. About half of the 18 are under 100 MW; these have already been taken into account in the least cost generation analysis. Hence, the effort to develop an alternative hydropower investment program has had to draw from among those projects, mostly in the 30 to 80 MW range, which had previously been screened out (on the basis of rather crude technical and economic criteria) as less attractive than those for which pre-feasibility work has been commissioned. 48. The alternative investment program thus identified has been labelled Plan B (SAR Annex 5.4). The costs of Plan B are estimated to be about 5% higher than the Government's proposed investment program under assumptions about the future considered most likely, and 5% less in the scenario where demand growth follows the low load forecast. Supporters of the Arun project argue that the cost comparisons used in this analysis understate the risks entailed in relying on reconnaissance level information for Plan B projects. Opponents of the project argue that it is only because of inadequacies in past pre-investment work that more complete information is not available for the smaller projects. For purposes of appraisal, the key points are: (a) the differences in estimated cost of the alternative investment programs favor the Government's proposed program, but the cost advantage is relatively small and is sensitive to a number of assumptions; (b) the uncertainties on the technical side and with respect to estimated costs are significantly greater for Plan B; (c) all realistic hydropower programs for Nepal over the next few years will entail investments of a size and complexity requiring an input of expatriate expertise; and (d) all of the proposed alternative investment programs envisage continued and indeed intensified support for micro and mini-hydropower investments. 49. Since the cost differences among the alternative investment programs are relatively small, and the risks relatively large, it is appropriate to consider how the risks of the alternative strategies compare. The two main risks are those relating to affordability and environmental/social costs. In addition, there are the issues of domestic capacity-building and ownership. so. In terms of the affordability analysis (SAR Section I and Annex 1.4), the conclusion reached is that the Government program can be implemented without crowding out desirable growth in spending for the social sectors. This conclusion applies even if there is some slippage in macro-economic management, the rate of GDP growth, the financial performance of NEA and a significant cost overrun for AHP. The alternative investment strategy (Plan B) is expected to have similar costs over a multi-year period: the costs over the remainder of the 1990s would be lower than under the Government's proposed program, but costs in the early part of the next decade would be substantially higher. Thus, both programs pose affordability risks, albeit with different time profiles. 51. The advantage of Plan B is that it can be more readily adapted to changing circumstances. If growth in power demand is less than projected or if rupee availability is reduced for any of a number of reasons, spending on hydropower investments can be slowed down. The disadvantage of Plan B is that it makes these adverse circumstances more likely. GNP growth requires a positive response from the private sector to the new policies the Government is putting in place. Shortage of power is inhibiting that response. A decision not to proceed with Arun and to rely instead on a series of smaller hydro projects is likely to be met with considerable skepticism by the private sector. Moreover, the likelihood of continued improvements in macro-economic management and progress in the financial strengthening of NEA would be reduced without the  - 17 - incentive/pressure associated with the challenge of the Arun III project. Overall, Plan B would gain flexibility at the cost of making a low growth, uneven performance scenario more likely. Since the rupees needed to support expanded spending in the social sectors depend above all on the rate of GNP growth and macro-performance (including future power tariff adjustments), this trade-off is not very attractive. 52. The environmental/social risks of the AHP have been extensively analyzed, mitigation plans have been developed and a high level of monitoring/assistance with implementation has been provided. Much less is known about the environmental and social risks that would be faced in Plan B. A larger number of sites would be involved and the total length of access roads would be greater. The Bank's Operational Directive (OD 4.00) states that "hydroelectric and other developments should preferably be concentrated on the same rivers if hydrological risks and other circumstances permit, in order to preserve elsewhere a representative sample of rivers in the natural state." The strategy proposed by the Government is in line with the Directive, particularly because the access road included in the Arun III project will also serve to support subsequent hydropower development in the same valley. Given sufficient time and resources, the environmental/social risks of the Plan B investments could of course be similarly investigated and mitigation plans devised. What could not realistically be duplicated, however, is the intensity of supervision and the capacity to respond to problems which has been built into the Arun III project. 53. Geographical diversification inherent in Plan B would protect Nepal against the risk of natural disaster. If diversification is measured in terms of the risk of an entire site being taken out of service (e.g. through an earthquake), then the Government's investment program would leave the system as exposed as it is currently, whereas Plan B would reduce this exposure. If diversification is measured in terms of the risk of a generator being lost to service (e.g. through a severe flood), the Government's investment program implies a reduction of risk compared to the present situation, with Plan B bringing an even greater reduction. Since the geology of the Arun III site is quite attractive, especially in comparison with the other options available in Nepal, the technical risks inherent in any single Plan B site would almost certainly be greater, thus somewhat offsetting the advantages of site diversification. 54. Comparison of the overall risks of the alternative strategies shows that both have problems requiring careful management. There is simply no low risk way to meet Nepal's power requirements over the next decade or so. Plan B offers some advantages in terms of flexibility and protection against extreme natural disasters. The Government's investment program is more likely to solve the underlying power problem in a timely manner and so is more consistent with the growth and development strategy set forth by the Government and supported by the Bank's country assistance strategy. The Government program is also more in line with the Bank's Operational Directive on the management of environmental risk and has better prospects for effective response if and when environmental problems arise during The course of implementation. On balance, therefore, consideration of risks does not justify overriding the modest cost advantage of the Government's proposed investment program. Indeed, if the affordability and environmental/social risks of the Government's program are well managed in practice, the Government's program should be more consistent with desired growth in social sector spending and with the Bank's environmental guidelines than is Plan B. 55. Critics of the Government's investment program have stressed the capacity-building advantages of an alternative strategy. As noted above, there is no conflict between either of the proposed strategies and expansion of micro and mini-hydro investments in Nepal. This is where much of the capacity-building will occur in practice. In addition, under the Government's proposed investment program, Nepali engineers and contracting firms will have opportunities to  - 18 - develop the skills needed for somewhat larger projects through participation in Khimti Khola (60 MW), Kali Gandaki (100 and 40 MW) and the Arun III project itself, where 75' of the man-months of consultant services will be supplied by Nepalis. The additional capacity-building advantage that could be obtained under Plan B by mandating a delay of several years in proceeding with Arun would appear to be modest. A more promising (and less protectionist) approach is to encourage smaller hydro investments through the Hydro Facility, and through NEA and HMG support for additional power purchase agreements. 56. Finally, there is the question of ownership as it relates to the prospects for successful implementation of the alternative investment strategies. The Government (now in a caretaker role prior to elections scheduled for November) and NEA are strongly committed to the Arun III project. While there is a vocal domestic opposition to the project, the preponderance of opinion in the Arun Valley, in the domestic press and in Parliament favors proceeding with it. The three large power tariff increases implemented by Nepal's first democratically elected government were justified as being needed to support the Arun investment and thereby to alleviate chronic power shortages. So too, at least in part, were the recent improvements in macro-economic management and NEA performance (e.g. staff retrenchment) . Realistically, therefore, one can expect strong commitment to the implementation of Arun III and strong resistance to implementation of the alternative strategy. 57. Strong domestic commitment is, as the Wapenhans Report has shown, critical to successful implementation of Bank and IDA supported projects. Commitment alone does not justify proceeding with a project if it does not pass the standard appraisal tests or poses unacceptable risks. But the Arun III project does pass these tests and the affordability and environmental/social risks are judged to be manageable. This being the case, the strong domestic commitment to the project is a major advantage both for the project itself and for the Government's proposed investment strategy. 58. Timing of Arun III. In addition to assessing alternatives to the Government's power sector investment strategy, IDA has also considered the timing of the proposal to go ahead with AHP. The basic concern was to be sufficiently confident with the Government's commitment to and capacity to achieve: (a) the macroeconomic performance, including the targets related to affordability and tariffs, (b) the needed strengthening of NEA, and (c) effective implementation of the RAP and related social actions, because IDA leverage would be less after approval of this operation. On each account the evidence has weighed in favor of going ahead now. The Government has already demonstrated considerable prudence on the macro-side, enacting revenue measures and expenditure cuts in the FY94 budget consistent with the understandings reached in the context of the PFP (94-96). Likewise, the tariff reform measures already adopted and recent NEA staff retrenchment both manifest significant Government resolve. A further year of experience on the macro-side (the FY95 budget and FY96 provisions) and with the NEA action program and tariff measures would in any case be available before a decision is required on the Kali Gandaki proposal. As for further institutional development of NEA, this is recognized as a long-term process. Another year or so could not reasonably be expected to provide a much stronger basis for going ahead. In terms of the environmental and social undertakings, the commitments are clear, preparatory actions are reaching completion, and implementation will only proceed on a defined schedule geared to the construction program. Further delay is unlikely to achieve any discernible benefit. Finally, from the perspective of the Government and prospective cofinancing partners, the project has been under preparation for over seven years, has received intense scrutiny both inside and outside Nepal, and enjoys a preponderance of support domestically. Hence, action now that IDA's appraisal standards have been met, is amply justified. 59. Risk Management. To summarize, because of its size and complexity, the AHP entails significant risks relating to (a) crowding out of high-priority  - 19 - investments in other sectors; (b) unforeseen delays in project implementation; and (c) unsatisfactory implementation of the Environmental Action Plan, including the RAP and the ACRP. Project preparation and appraisal have included thorough risk assessment and consideration of alternative investment strategies. For the implementation stage, risk mitigation and management measures are being put in place as required. With respect to the risk of crowding out other high priority investments, including the social sectors, HMG has embarked on a macro-fiscal reform program under which the Government will (a) increase revenues through fiscal measures; and (b) adopt a three-year rolling investment program starting in FY95, with a core investment program to protect investments in other high- priority sectors, particularly in the social sectors. As for the risk that NEA may fail to meet the projected share of its expenses, it is clear that the projected financial performance depends essentially on the program to increase tariffs, the projected increase in sales, and reduction in losses. Agreements in these critical areas should provide adequate cushion for NEA to meet current operational expenses and debt obligations and to shoulder a larger share of the local cost of future investments. The financial management program should also minimize future equity contributions by HMG to NEA, thereby helping free resources for other sectors. AHP implementation risks are being addressed through an unprecedented set of risk management and mitigation measures. Appointment of a POE to review project design and implementation including socio- environmental management, exceptionally thorough geological and geophysical field investigations, the advanced stage of procurement processing by negotiations, and proposed signature of the major works contract prior to credit effectiveness will combine to lower the risk of cost overruns. The risk of unsatisfactory implementation of the Environmental Management Plan is being addressed by provision of adequate financing, by technical assistance to help create necessary institutional capabilities, and by the comprehensiveness of the monitoring of NEA's and MOWR's performance through (a) reconstituting the POE and expanding it to include a more diverse set of environmental skills, (b) regular on-site supervision, and (c) a detailed annual review during project implementation. In addition, the risk that implementation of the ACRP or RAP will be delayed or fail to meet agreed standards is being addressed by (a) arrangements for close monitoring, (b) an agreement that ACRP and RAP activities would be carried out well in advance of project works that would affect the families concerned, and (c) arrangements for resolving grievances regarding payment of compensation or other entitlements that are transparent and timely. 60. Conclusion. The proposed Project forms an appropriate basis for amendment of Credit 2029-NEP of SDR 24.4 million (US$34.3 million equivalent) for the Arun III Access Road Project and for an IDA credit of SDR 99.5 million (US$140.7 million equivalent) on standard IDA terms with a maturity of 40 years to the Kingdom of Nepal. 61. Recommendation. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve it and the restructuring of the Arun III Access Road Project (Cr. 2029-NEP). Lewis T. Preston President Attachments Washington, D.C. August 29, 1994   SCHEDULE A NEPAL: ARUN III HYDROELECTRIC PROJECT Estimated Cost and Financing Plan (US$ million) Estimated Cost a/ Local Foreign Total ---------US$ Million---------- A. Hydroelectric Power Plant - Physical Works 73.3 272.8 346.1 B. Hydroelectric Power Plant - Electro-mechanical Equipment 16.2 124.3 140.5 C. Transmission Line to Grid 9.1 47.1 56.2 D. Environmental Mitigation/ Area Development 10.3 5.9 16.2 E. Technical Assistance 2.9 50.4 53.3 F. Hydro Fund 5.0 5.0 Base Cost 111.9 505.5 617.4 Physical Contingencies 14.5 58.8 73.3 Price Contingencies 22.9 83.7 106.6 Total Project Cost 149.3 648.0 797.3 Interest During Construction 285.0 0.0 285.0 Total Financing Required 434.3 648.0 1082.3 Total project cost net of taxes and duties (US$37.0 million) is US$760.1 million. Financing Plan Local Foreicn Total --------US$ Million---------- IDA Credit 2029-NEP - 34.3 34.3 Proposed Credit - 140.7 140.7 Total IDA - 175.0 175.0 Asian Development Bank - 127.6 127.6 Germany (KfW) - 124.4 124.4 To be determined b - 163.3 163.3 Others (e.g., France, Sweden ', Finland) - 46.3 46.3 His Majesty's Government of Nepal 143.6 11.4 155.0 Nepal Electricity Authority d/ 290.7 - 290.7 Total 434.3 648.0 1082.3 Japan is sending its own appraisal mission to make its assessment of the project. ~' Sweden has stated that it is willing to allocate up to US$30 million to the project; of which, about US$17 million has been committed so far. This may result in a reduction in project financing by HMG and for NEA. d/ Includes US$285.0 million equivalent of interest during construction.   SCHEDULE B Page 1 of 2 NEPAL: ARUN Ill HYDROELECTRIC PROJECT Procurement Method and Disbursements (US$ million) Procurement is being carried out according to the following table: PROCUREMENT METHOD Project Component ICe LCB Othor-' NA0' Total Comments!' A. Works C1 C3 Dom and Doxanding Basins 390.05 390.05 Lot jointly financed Camp Facilitbe (162.93)! /162.93) by ADD and IDA; Germany Access Road will jointly finance Haadrace Tunnel and Surge Lot C3-3. Tank C2 Powerhouse and Appurtenant 70.64 70.64 Structures RAPI RAP Infrastructure Program 2.00 2.00 /0.20) 10.20) B. Eoubmnt B1. ElMcaopmchankal Equipmwnt HSS1 Hydraulic Steel Structures (Dom Site) 30.68 30.68 HSS2 Hydraulic Steel Structures (Powerhouse Site) 12.65!' 12.65 El Electrical Equipment 54.83 64.83 Financed by Germany E2 Electrical Equipmont 20.85 r 20.85 ml Mechanical Equipment 39.95 39.95 CPS Construction Power Supply 11.97 11.97 Financed by FINNIDA 82. Transmission Equ4iment TR Arun-Duhabi Transmission Line 53.96 53.96 Financed by France end Germany SSS Duhcbi Substation 20.59 20.59 Financed by BITS (Sweden) B3. Other Equpmenr RAPP RAP Energy Program 2.50 2.50 12.00) (2.00) Vehicies, Equipment, Materials ! 1.15 1.15 01.0) 01.01 C. Conultancles Project Implementation Support SUPI Construction Supervision for HEP 48.49 48.49 Cotinanced by IDA, KfW end another cofinancier end Access Road /0.95) (0.95) (to be determinedl in two sublots SUP2 Construction Supervision for the 3.13 3.13 Financed by France Transmission System RAPCS RAP Consultancy Support 15.46 15.46 (1.421 01.421 POE Panel of Experts 2.38 2.38 (2.38) (2.38) HF Hydro Fund 6.20 6.20 D. MIscellaneous TA Training 4.12 4.12 (4.121 (4.12) ACRP Land Acquisition, Compensation and Rehabilitation 1.89 1.89 NEA NEA Engineering & Management 3.76 3.76 Total 564.82 4.50 216.08 11.85 797.25 (162.93) 12.20) 19.87) (175.001 t' Consulting services, tied procurement, local and intemational shopping for vehicles etc. F' Includes land acquisition, hydro fund administrative overheads and other items not subject to procurenmnt For each lot, the financing plan is based on the donorlsa financing the foreign coats and HMGINEA covering the local costs. The exceptions are the TAlconsultancies lots, where the donors cover 100% of the costs, and the RAP lots where IDA covers 29% of the foreign exchange costs. t' Figures in parentheses are IDA financed portion - General untied procurement guidelines of the cofinoncier Ito bo determinedl Vehicles and equipment materials to support the RAPCS implementation  SCHEDULE B Page 2 of 2 Disbursements (US$ million) Cateaory Amount Expenditure to be Financed C1 IC3 - Dam and Desanding Basins 110.5 54% of foreign expenditures Camp Facilities Access Road Headrace Tunnel and Surge Tank - RAP Infrastructure Program 0.2 90% Equipment, Vehicles and Materials 3.0 100% of foreign expenditures, 100% of local expenditures (ex-factory cost) and 75% of other expenditures for other items procured locally Technical Assistance and Consultant Services 7.4 100% Unallocated 19.6 TOTAL 140.7 Estimated IDA Disbursements': IDA FY 95 3e 97 98 99 00 01 02 03 04 05 Annual 21.4 11.6 20.3 29.8 22.0 17.9 20.1 14.4 10.6 6.8 0.1 Cumulative 21.4 33.0 53.3 83.1 105.1 123.0 143.1 157.5 168.1 174.9 175.0 j/ Including disbursements under Cr. 2029-NEP.  SCHEDULE C NEPAL Arun III Hydroelectric Proiect Timetable of Key Project Processing Events Time to Prepare the Project: 7 years Prepared by: Government and NEA First IDA Mission: September 1987 Appraisal Mission Departure: SePtember 22, 1993 Negotiations: June 13, 1994 Planned Date of Effectiveness: January 1995 List of Relevant PCRs and PPARs: Kulekhani Hydroelectric Project (Crs. 600- NEP and 600-1-NEP), PPAR No. 6177 dated March 8, 1986   SCHIEDU'LE D Pae. I of 2 THE STATUS OF BANK GROUP OPERATIONS fN NEPAL A. STATEMENT OF ANlK LOANS AND IDA CREDrTS r> lAa of June 30, 1994i Amourt in US4rn26m Domes canelemdonel Credit No. Year Borrower Purpose Bank IDA Unclibursed 42 credits have been fully disbursed 484.10 Of which SECALB, SALe and Program Loans b> Cr. 1789-NE? 1987 Nepal Structurel Adjustment 0.00 50.00 Cr. 2048-NEP 1989 Nepal Structural Adjustment 0.00 80.00 Sub-Total 0.00 1 0 " 00 Cr. 1478-NEP 1984 Nepal Power 11 (Marsyangdil 107.00 35.0 c> Cr. 1515-NEP 1985 Nepal Hiohways III 47.50 11.8 Cr. 1534-NEP 1985 Nepal Acricultural Manpower 8.40 3.8 Cr. 1535-NEP 1985 Nepal Industrial Development 7.50 0.8 Cr. 1570-NEP 1985 Nepal Agricuttural Extension II 7.20 3.3 Cr. 1588-NEP 1985 Nepal Telecomvnunications IV 22.00 3.3 Cr. 1715-NEP 1988 Nepal Naraysni lrriogtion III 18.20 14.2 Cr. 1814-NEP 1987 Nepal Sunseri-Motang 11 40.00 5.5 Cr. 1922-NEP 1988 Nopal Road Flood Rehabilitation 15.50 5.2 Cr. 1924-NEP 1988 Nepal Mahakali Irigartion II 41.30 15.8 Cr. 1988-NEP 1989 Nepal Municipal Dev & Earthquake 29.00 8.5 Cr. 2028-NEP 1989 Nepal Hill Community Forestry 30.50 25. Cr. 2029-NEP 1989 Nepal Arun lIl Access Road 32.80 33.4 c> Cr. 2044-NEP 1989 Nepal Engineering Education 11.40 10.8 Cr. 2047-NEP 1989 Nepal Earthquake School Rehab 22.80 14.0 Cr. 2144-NEP 1990 Nepal Bhairawa Lurnbini III 47.20 38.3 Cr. 2239-NEP 1991 Nepal Urban Water & Sanitation Rehab . 80.00 57.0 Cr. 2347-NEP 1992 Nepal Power Elficiency Improvement 8S.00 58.4 Cr. 2357-NEP 1992 Nepal 8esic & Primary Education 30.80 27.0 Cr. 2384-NEP 1992 Nepal Telecome V 55.00 54.4 Cr. 2430-NEP 1993 Nepal Sunseri Morang H-edworkx 28.00 19.7 Cr. 2500-NEP 1994 NepeJ Hioher Education 20.00 19.8 Cr. 2578-NEP 1994 Nepal Road Maintenance Reheb 50.50 50.5 Cr. 2800-NEP 1994 Nepal Population & Healh 39.00 39.0 TOTAL 0.00 1318.50 551.7 d> of which h_ been repaid 17.10 Total now held by Bank and IDA 0.00 1301.40 Arnount sold of which repaid Total undisbursed 551.7 a> No Bank loans have been made to Nepal b> Approved during or after FY80 c> Projects being restructured and/or cancelled d> The principal amounts of IDA credits are shown in US Dollar equivalent at date of nogotiations. _ shown in the Prcident's Report. Undisbursed amounts shown in US Dollar equivalent are valued at the exchange rate applicable on the date of this statement. In some c_es. therefore, the undisbursed balance indicates a dollar amount greater then the original principal credit amount expressed in dollars. Pace I  Schedule D Pea. 2 of 2 STATEMENT OF IFC INVESTMENTS (As of June 30. 19941 Col....t ed for IFC's Account Loan Equity Total Invetmnont T,YPe of Number Ftscej Year Obligor Buuiness (US$ Million) 1 Project closed 312 1975 Soaltee Hotel Ltd. Tourism 3804 1993 Softes Hotel Ltd. Tourism 0.75 0.44 1.19 1994 Himel Power Ltd. Enorgy 28.00 3.00 31.00 Total Gross Commitments 28.75 3.44 32.19 Total Commitments now held by IFC a> 28.75 3.44 32.19 TotaJ Undisbursed 0.00 a> Exchango adjustmenta account for variation in total oross commitments, less cancellations, etc., end total commttment. now held by IFC. Page 1    IBRD 25523 NEPAL ARUN HYDROELECTRIC PROJECT ACCESS ROAD, HYDROELECTRIC AND TRANSMISSION PROJECT COMPONENTS d Cysp 4v