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Document ofThe World Bank

ReportNo. T7126RU

TECHNICAL ANNEX

RUSSIAN FEDERATION

ELECTRICITY SECTOR REFORM SUPPORT PROJECT

May 16, 1997

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CURRENCY EQuIVALENTS

(Figures are as of end of period)

CURRENCY UNIT = RUBLE (Rs)

1992 4151993 1,2471994 3,5501995 4,6401996 5,500April 1997 5,744

BORROWER'S FISCAL YEARJanuary I - December 31

ACRONYMS AND ABBREVIATIONS

Energo Regional Power Generation/Distribution CompanyERIU Electricity Reform Implementation UnitEU-TACIS European Union - Technical Assistance, Commonwealth of

Independent StatesFEC Federal Energy CommissionIMWG Inter-Ministerial Working Group (for Electricity Sector

Reforms)Genco Generation Company - Subsidiary of RAO EES RossiiGOR Government of RussiaGW gigawatt = million kilowattsPDL Portfolio Development LoanRAO RAO EES Rossii, Russian Unified Electric System CompanyREC Regional Energy CommissionSAL Structural Adjustment LoanTA Technical AssistanceTOR Terms of ReferenceTWh terawatt hours = billion kilowatt-hoursUS AID United States Agency for International DevelopmentUK KHF United Kingdom, KnowHow Fund

Vice President: Johannes F. LinnDirector: Yukon HuangDivision Chief: Jonathan C. BrownTask Manager: Gary Stuggins


Loan and Project Summary

Borrower: Russian Federation

Beneficiaries: Electricity Reform Implementation Unit, Electricity ReformSupervisory Council, RAO EES Rossii, Federal Energy Commis-sion, Regional Energy Commissions, Regional A/O Energos

Amount: US$40.0 million

Terms US dollar single currency loan (SCL) for 17 years, including fiveyears of grace, at the Bank standard interest rate for LIBOR-basedSCLs.

Commitmient Fee: 0.75 percent on undisbursed loan balances, less any waiver

Financing Plan:

(US$ million)

Financingy Source Foreign Local Total % of TotalPDL Loan 4.2 1.2 5.4 8IBRD 27.5 12.6 40.0 57US AID 8.7 8.7 12UK KHF 1.9 0.5 2.4 3EU TACIS 1.6 1.6 2GOR 12,1 12.1 17

Total 43.9 26.4 70.3 100Percent of Total 62 38 100

Net Present Value: not applicable

Poverty Category: not applicable

Project ID Number: RU-PE-50891

RUSSIAN FEDERATIONELECTRICITY SECTOR REFORM SUPPORT PROJECT

TECHNICAL ANNEX

I. INDUSTRY DESCRIPTION AND STRUCTURE

A. The Electricity Sector

1. The electricity sector in Russia is the second largest in the world after the United Statesin terms of generating capacity. Like the rest of the economy, the electricity sector hassuffered from economic downturn and turmoil during the transition to a market economy. Theelectricity sector accounts for approximately 15 percent of industrial production, more than theoil and gas industries combined. Measured GDP has fallen by 40 percent in real terms since1991, but the decline in electricity production is only about half as large.

2. Until 1992, the electricity sector was organized into vertically integrated companies ineach of the 72 regions (oblasts). In that year, the Government both converted the regionalcompanies (Energos) into joint stock companies and superimposed a nation-wide holdingcompany, RAO EES Rossii (RAO), over the Energos. RAO was given ownership of the highvoltage transmission grid (2.5 million km of high-voltage lines), the largest thermal andhydropower plants, the dispatch centers, and research and design institutes. RAO was alsogiven a controlling shareholding in most of the regional Energos. RAO organized its powerstations into generation company subsidiaries (Gencos). Because of opposition from regionalauthorities, some of these larger power stations were kept under regional control and remainedwith the Energos. The nuclear plants remained in the ownership of the Government, and wereplaced undLer the management of Rosenergoatom (see Table 1).

3. Geineration is predominantly thermal (70 percent), with hydro (20 percent) and nuclear(10 percent) stations comprising the balance. Regionally, however, over 50 percent of thehydro capacity is located in Siberia and the Far East, while over 80 percent of the nuclearcapacity is located in the Northwest and Center regions. Generation in 1995 totaled 843 TWh.

4. The Energos are integrated regional monopolies that distribute electricity to the finalconsumers and own the smaller generating plants typically producing both electricity and heat,on a monopoly basis, for local district heating systems. Though the size of plants owned bythe Energos is usually small, the number is large. Thus Energos manage 62 percent of thegeneration capacity.

5. With the exception of the entities owning the nuclear plants, the rest of the sector waspartially privatized (through vouchers and sales to workers and managers) but in such a waythat the Government retained a controlling interest in most of the companies either directly orindirectly through RAO (Figure 1). The resulting ownership structure is complicated. Inbrief, the Government is a 100 percent owner of the nuclear power plants and is majorityowner (currently holding approximately 52 percent) of RAO. RAO, in turn, is a 100 percent

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Table 1: Ownership and type of generation capacity.

Capacity

By Owner (MW %

RAO affiliated Generation Cos. 42,700 20%

Regional Energos' 132,800 62%

Nuclear (Rosenergoatom/Minatom) 2 21,300 10%

Captive Generation 18i500 9%

Total 215,300 100%

By Type

Nuclear 21,300 10%

Thermal 150,100 70%

Hydroelectric 431900 20%

Total 215,300 100%

Source: RAO EES Rossii'Includes plants leased from RAO2Includes plant owned by Minatom

owner of the transmission grid and dispatch system, 49 percent or larger owner of the Gencos,and 49 percent or larger owner of most of the 72 regional Energos. Two of the Energos arenot owned by RAO or the Federal Government.

6. Sector Regulation. At the Federal level, the electricity sector is regulated by theFederal Energy Commission (FEC), an independent agency established in 1995, whose sevenmembers are appointed by the President for four years. The FEC is mandated to organize thewholesale market for electricity, regulate tariffs for the sale of electricity on the wholesalemarket, and define procedures for tariff setting at the end-user level. In 1996, the Commis-sion was given a budget and has hired about 100 staff. The Commission also regulates thenatural gas transmission and oil pipeline industry. Each of the 72 oblasts also has a regionalenergy commission (REC). Many of these are not yet fully functioning. The development ofthe regulatory bodies as functioning agencies has been slow; however, activities haveaccelerated in recent months, with the appointment of additional staff and the provision oftraining to an initial cohort of key personnel.

7. Sector Problems. The power sector faces many serious problems including:

(a) Non-payment and non-cash payment. Estimates for 1996 indicate that consumers paid onlyabout 70 percent of their electricity bills (Figure 2). Of this payment, 84 per cent is by meansother than cash. These non-cash payments include barter transactions, bilateral settlements ofdebts, and various kinds of promissory notes. The causes of this problem are complex, andhave variously been attributed to: (i) failure on the part of Government to fully fund thepurchases of budget organizations (which account for 40 percent of the arrears); (ii) periodic

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Figure l: Approximate Ownership Structure.

|Government|

|52% |100%

RAO (osenergoatom*EES byossii 9 nuclear plants

49-100% 49-100%100%.

Generat ion Co's Local Distribution"*S*ns mission | (Gencos) (Energos)l l ~~~~~34 plants 72 companies

*One nuclear plant is owned directly by government**RAO ownership in 3 Energos is less than 49%

RAO or Federal Government has no ownership in 2 Energos.

legal and/or political prohibitions against allowing electricity sector companies to refuseservice to customers that don't pay; and, (iii) compensating advantages of non-cash paymentswith respect to the potential for tax avoidance, for understating income, and for extractinghigh transaction charges.

(b) Uneconomic Dispatch. A major source of inefficiency in the sector is caused by theoperation of generation plants with high variable costs instead of those with low variable costsin order to meet current demand. This has been estimated by the Russian Institute of EnergyResearc]h to increase costs by as much as US$1 billion per year. This is caused by poorcommunications and control systems at thedispatch centers, the unwillingness of some Figure 2: Form of PaymentEnergos to participate in a nationwide system ofeconomric dispatch, dispatching high cost plantsto ensure that they receive a minimum level of Unpaidrevenue, and shortages of fuel at lower cost 30%plants.

(c) Operating Inefficiency. The operating costof compianies in the sector is high. Wages are Non-Cash

among the highest in the country. Over the last Paymenfive years, employment has increased 40 Cashpercent even though production has decreased Payrsntby about 20 percent. Fuel efficiency in 11%

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generation is low both because of inadequate investment in maintenance and refurbishment.Few activities are contracted out to competitive private companies.

(d) Investment Inefficiency. The level of investment is inadequate to meet the system's needs,and the available investment funds are spent inefficiently. The sector spent over US$3 billionon new facilities in the last two years and yet brought on line only 2,700 MW of new orrefurbished capacity. The Government has allowed the industry to raise capital by charginghigher prices to current consumers and placing these extra revenues in special "investmentfunds." Thus the industry does not have to compete for capital on financial markets and, untilrecently, has been accountable to no one for its use of this money.

(e) Distorted Pricing. Even though the electricity sector enjoys low labor, fuel and capitalcosts, the price of electricity to the industrial and commercial sectors is equal to or higher thanthat of many OECD countries. This is partially due to the high level of non-payment. Pricesare increased for those who do pay to compensate for those who don't which then encouragesnonpayment. Prices are further distorted because of cross subsidies between industry andhousehold consumers. Even though the cost of supplying industrial customers is belowhouseholds, industrial prices are 60 percent above the average while household prices are 60percent below.

(f) Quality of Supply. The quality of the instrumentation and controls of the power system isnot up to the standards of the west. Frequency control is considerably below that of OECDcountries. As a result, transmission links to countries west of Russia require that a back-to-back DC converter. Furthermore, as increased use of new technology increases in Russia,consumers will demand improved quality of supply, as compensating for these problems at thecustomer end is economically inefficient.

II. ELECTRICITY SECTOR REFORM

A. History of Reform.

8. The electricity sector lags behind most other sectors in terms of economic reform.Though 70 percent of GDP is now produced in the private sector guided by competitivemarket forces, the electricity sector remains largely majority owned by the state as a regulatedmonopoly with little or no competition. Although this is the most common form of operationof electricity sectors, globally, many countries have initiated reforms to decouple thecomponents of the sector that are not natural monopolies to enable competition. TheGovernment of Russia has recently committed to adopting this approach.

9. In 1995 and 1996, the Bank supported the development of a concept for reform by theGovernment. A PHRD grant funded a team of Russian consultants supplemented by Westernconsultants, funded by USAID and the UK KnowHow Fund, to prepare a reform plan underthe guidance of a Government task force. Based on the work of this task force, the Govern-ment adopted a concept for reform and restructuring of the sector in Decree No. 426 (April28, 1997).

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10. This concept for reform of the power sector along with reforms in other sectors wouldbe supported by a proposed Structural Adjustment Loan (SAL). The SAL has been preparedin parallel with the IMF's Extended Fund Facility to ensure consistency and complementaritybetween the macroeconomic program and structural reforms. The reforms of the power sectorthat the Government has committed to under the SAL are (for details see Appendix 1):

Pricing. The Government's priority objective is to introduce pricing practices that willencourage efficient production and usage. To this end, the Government will establish by June30, 1997, principles and procedures for the pricing of electricity. The most acute pricing issueare cross-subsidies which impose artificially high costs on industry while inefficientlysubsidizing households. The FEC has submitted a detailed proposal to decrease crosssubsidies, and by the end of July 1997, the Government will introduce a two-block tariff forhouseholds.

Payment arrears. The Government's second objective is to reduce non-payment and non-cashpayments. In January 1997, the Government substantially reduced the list of "strategiccustomers" whom energy providers had to supply even if they did not pay. The Governmenthas made adequate provision in the 1997 budget to pay for energy use by the remainingstrategic customers and will ensure that no arrears to energy suppliers result from their non-payment.

Introducing competition: The third objective is to introduce competition in setting priceswhere possible. To ensure the necessary restructuring of the sector, the Government tooksteps in April 1997 to change management and improve government oversite of RAO. TheGovernment's program for the remainder of the year includes: (i) creating a non-profitWholesale Market Operator by September 30, 1997; (ii) making public, by the end of theyear, regulatory licenses for the participants in the wholesale market; and (iii) publishing aplan to create independent generation companies in sufficient number for the functioning of acompetitive wholesale market by December 31, 1997.

Strengthening regulation. The fourth objective is to develop the institutional capacity of bothFederal and regional regulatory commissions so that they can effectively regulate those partsof the sector that are unlikely to be competitive. This includes providing adequate financingand office space and ensuring that officials are not allowed to receive financial considerationfrom regulated companies.

B. Government's Reform Concept

11. The Government has adopted an ambitious concept for reform of the electricity sectorwith the objective of improving its efficiency. The key elements of the concept are thefollowing:

Wholesale Market - The Government would establish competitive markets for the wholesaletrading of power in those regions in which such a market is, or can be made, feasible bothtechnical]Ly and economically. The price of electricity on the wholesale markets would be

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based, to the extent possible, on competitive bidding. The Government would establish anindependent wholesale market operator that would organize and manage the market andmanage payments and settlements.

Restructuring - To encourage competition, the Government would restructure RAO, focusingfirst on commercialization of the different operating units within RAO, and ultimately ondivesting the State's (RAO's) shares in generation and distribution. Arrangement fordivestiture would ensure that the rights and interests of existing private shareholders in theseentities were protected.

Regulation - The Government intends to improve the quality of government regulation andcontrol. Substantial institutional capacity building is planned for the Federal Energy Commis-sion (FEC) and the Regional Energy Commissions (RECs). The FEC would both manage theintroduction of competition where feasible, ensure that the participants compete fairlyaccording to established rules, and develop sound systems of regulation for those parts ofindustry that are not competitive. The Government also intends to enact legislation requiringthe regulators to set tariffs so that: (a) electricity sector companies recover all reasonable costsof generation, transmission, and distribution; and (b) tariffs are differentiated according todifferences in cost of providing service thus eliminating cross-subsidies.

12. Most industry and government officials seem to accept the basic approach to thesereforms, namely, to privatize sector companies, introduce competition where feasible and toimprove regulation of those segments where competition is not feasible. There remain someunresolved issues, however, with respect to the appropriate schedule for implementing someaspects of the reform concept, including preconditions which must be satisfied before some ofthe changes are introduced. In addition, sector entities will need considerable institutionalstrengthening to enable them to operate effectively in the proposed new environment. Finally,as competitive markets are introduced and divestiture moves forward, the agencies responsiblefor these activities will require support in planning and effecting the transitions. TheGovernment has therefore requested World Bank assistance, in the form of a technicalassistance project, to support the realization of electricity sector reform.

III. THE PROPOSED PROJECT

A. Project Description

13. The objective of the proposed project is to lay the groundwork for improving the short-and long-term efficiency of the Russian electricity sector, thereby ensuring the reliable supplyof electricity to customers at competitive prices. In this regard, the project is directed atassisting the Government in further evaluating, elaborating and carrying out its proposedreform of the electricity sector by supporting a program of Technical Assistance (TA) toagencies and commercial enterprises involved in the reform process. The TA program wouldalso assist the Government in implementing the specific actions which it has committed tounder the SAL.

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14. The project would finance foreign and Russian advisors to work with the various sectorentities and government agencies and with the Electricity Reform Implementation Unit (ERIU)on implementation of the reform agenda. TA would fall into three broad categories: (a)assistance to the Government in further refining and developing its concept for reform andelaboraling a detailed implementation plan and schedule for realization of the reform concept,including analyzing technical and institutional barriers to meeting the objectives and identify-ing alternative solutions; (b) assistance in carrying out the activities necessary to implementthe plan; and, (c) support for the development of electricity sector entities, including corpora-tization and commercialization of operating companies and institutional strengthening of theregulators. It is envisaged that the assistance would be structured in a matrix fashion, withadvisors assigned to each of the sector entities or groups of entities, and other advisorsassigne(d to address cross-cutting issues such as training, public participation, and socialprotection on behalf of all of the sector entities. Two advisors would work directly with theERIU: one to assist in policy analysis and elaboration of the reform plan, and a second toassist in. project management and coordination. The main objectives and functions of each ofthe advisory teams are outlined below. Draft Summary Scopes of Work are attached asAppendix 2 and Terms of Reference for the four priority tasks are attached as Appendix 3.

15. ][mplementation Management and Coordination Advisors would support the ERIUin coordinating the work of other consultants, government agencies, sector companies, anddonors, and in carrying out general project management activities including scheduling,budgeting, procurement and disbursements.

16. Policy Analysis and Development Advisors would assist the ERIU in analyzingpolicy issues necessary to refine the Government's concept for restructuring the sector,develop an action plan for realizing the concept, and modify the concept and action plan asnew issues arise during implementation.

17. RAO Commercialization About five separate teams of advisors would work withRAO, to introduce efficient management practices, improve the quality of Governmentsupervision and control over the enterprise as long as it remains majority state owned, andfacilitate restructuring of the company, including possible divestiture of its subsidiaries. Focalareas of the assistance would include:

(a) Accounting and Financial Controls: This component includes establishing systems toprovide critical financial data to senior management, evaluating and modernizing the sys-tem of financial controls, developing a system of internal audits, and developing a systemof financial reporting.

(b) Economics and Investment: This component includes determining the nature and extent ofinvestment projects now in progress and proposed, implementing a system to evaluate andconduct feasibility studies, and developing an investment plan for the company.

(c) Corporate Finance: This component would develop a sound financial strategy that wouldallow the company to access capital markets. Specific tasks would include determining the

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company's cost of capital, developing relationships with various commercial and invest-ment banks that can assist in executing the financial strategy, and providing financial in-formation about the company to the investment public.

(d) Personnel and Staffing: This component includes assessing the skills and capabilities ofthe existing staff, developing a compensation and benefits plan, and developing a promo-tion and recruiting strategy.

(e) Forensic Accounting: This component would address, on a priority basis, the adequacy ofsystems in place to control fraud and corruption, to identify and rectify major shortcom-ings in the current procedures, and to assist in the development of procedures and controlsto reduce the risk of such behavior in the future.

18. Transmission Network Commercialization and Restructuring After the restructur-ing of RAO, the high voltage transmission grid is expected to be established as a separatecommercial entity. Assistance would be provided to help this entity become a commerciallyviable business. This would include developing the organizational structure for this entity,developing a business and investment plan, negotiating a regulatory license with the FEC, andnegotiating transmission service agreements with the Market Operator. The role of thetransmission company in debottlenecking electricity flows will also be addressed.

19. Generation Commercialization and Restructuring Assistance would be provided tocreate independent and viable generation companies composed of the existing generationassets. This would include developing technical and economic criteria for the creation of theGencos, proposals for grouping the plants into companies, and the licenses under which thenew Gencos would be regulated by the FEC. To ensure the viability of these new companies,assistance would be provided to commercialize their operations including developing organ-izational plans, investment strategies, accounting systems, and so forth. Extensive trainingwould be provided to managers to prepare them for more market-oriented operation.

20. Federal Energy Commission Institutional Development Assistance would beprovided to improve the internal operation of the FEC and its regulatory methodology. Withregard to operation, the Project would provide assistance for improving the organizationalstructure, internal procedures, a business and management plan, physical infrastructure forinformation gathering, and developing a policy analysis capability so that the FEC can developits own regulatory methodology. With regard to regulation, the Project would assist indrafting licenses for participants in the wholesale market (generation, transmission, distribu-tion, market operator, and nuclear plants), developing a wholesale market agreement that allparticipants in the wholesale market would follow, and developing a price-setting methodologyfor those sector components that are unlikely to be competitive (e.g. transmission anddistribution networks).

21. Wholesale Market Operator Support This organization would manage the marketaccording to established rules, coordinate with the dispatch center to assure that plants aredispatched according to market principles to the extent technically feasible, and organize the

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paymerLts and clearing function for wholesale transactions. The Project would assist indetermining: the physical infrastructure (communications, computers, software, etc.) requiredfor this task; the legal and organizational structure and funding of the new organization,including the Supervisory Council that would represent the interests of participants in themarket;: and, methodologies and algorithms to price power on the wholesale market inresponse to competitive bidding.

22. Regional Energy Commission Institutional Development To provide examples ofexcelleince for the other oblasts, RECs in approximately five oblasts would be selected formore comprehensive assistance. This would include helping them develop efficient tariffstructures, regulatory methods and procedures for local electricity markets, a model organiza-tional structure, model business plans, and regulatory methodologies and procedures. Aninformation dissemination program would be developed to transfer the lessons learned to otherRECs. The Project would also help to establish an association of RECs so that their views andinterests can be effectively presented at the national level.

23. Regional Energo Commercialization In-depth assistance would be provided to thoseEnergos in the same oblasts selected for in-depth assistance to the RECs, with lessons learneddisseminated to Energos in other regions. Assistance would cover such issues as organization,business, financial, accounting, and investment planning so that the Energos become morecommercial and thus can compete as buyers or sellers in the markets for electricity. Assis-tance would also be provided in negotiating and understanding regulatory licenses with theFEC.

24. In addition to the assistance specific to particular entities in the sector, generalassistanice would be provided to all the entities using consultants and advisors under the controlof the ]ERIU. This cross cutting assistance would be in five areas:

(a) Public Participation and Communications: The Project would assist in developing a publicrelations and communications strategy and implementing that strategy. Given the size andimportance of this reform effort, the Government must be able to explain effectively thegoads of the effort, likely benefits, and the impact on employees, consumers, federal andlocal government officials, and private shareholders with the objectives of mobilizingsupport for the program and ensuring that stakeholder concerns are adequately addressed.

(b) Coimpensation: An issue affecting all entities is the level and structure of compensation.As noted above, wages have increased faster in this sector than in others suggesting overcornpensation. However, if salaries are still below those in comparable firms in othersectors, this can lead to corruption as staff attempt to supplement their salaries. Also theregulatory agencies must assure themselves that salaries are not excessively high leading tounreasonable prices paid by consumers. The Compensation Advisor would assist in de-terirnining the optimal structure and level of compensation across all entities includingregulatory agencies.

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(c) Training: While some of the training of staff in sector organizations would be done on thejob as the staff worked closely with advisors, some formal training would also be needed.A Training Advisor would assist in conducting a needs analysis, formulating a trainingstrategy for staff in sector organizations, coordinating tailored and well-targeted trainingfor government and sector managers and staff on both cross-cutting reform issues andorganization-specific topics as needed. The Training Advisor would also be responsiblefor developing an evaluation and monitoring program to assess training effectiveness.

(d) Ethics: A widespread problem is unethical behavior, corruption, and conflicts of interestby sector employees both in government agencies and companies. The Project wouldprovide assistance in developing guidelines, principles, procedures, enforcement mecha-nisms, and training to sector organizations on improving ethical standards of staff.

(e) Downsizing and Social Assistance: Since corporatization and commercialization is likely tolead to labor retrenchment, the Project would assist in designing retraining, severance, anda variety of tailored downsizing assistance programs for sector employees. In addition, theproposed restructuring of tariffs to reduce residential subsidies could lead to instances ofhardship to low income households. Advisors would work with local governments andRECs to design and implement targeted assistance to low-income households to ensureaffordability of electricity supply.

(f) Legal: Commercialization of the sector will require significant legal and regulatory workincluding the establishment of new legal entities and competition and anti-trust legislationand the possible establishment of an Electricity Law. The Project would fund relevantlegal support during the reform process and help to establish a legal framework suitable fora more commercially-oriented electricity sector.

25. Other Bilateral financing will also be sought to support the corporatization of thenuclear power plants, to improve their efficiency and to assist them in adapting to a competi-tive market for electricity. Proposed assistance would focus on the commercialization andtraining of staff, developing a business and investment plan, finding ways to reduce costswhile maintaining adequate safety, and negotiation of licenses and contracts to supplyelectricity to the wholesale market.

B. Cost Estimate and Financing Plan

26. Cost Estimate: The total estimated cost of the technical support project is estimated atUS$70.3 million, of which approximately US$43.9 million (62 percent) is foreign exchangerequirements. Table 2 shows a breakdown of the cost by major component. Contingencies of10 percent have been included in the estimate of items to be financed by the Bank loan, and ofthe contributions by government and sector agencies with respect to counterpart staff.

27. Financing Plan: A World Bank loan for US$40.0 million equivalent would beextended to finance selected consultant contracts, as well as computer and communicationsequipment for government and operating agencies. In addition, the Federal Center for Project

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Table 2: Project Cost Estimate (US$ million)Percent

Component Foreign Local Total of Total

Technical AssistanceSupport to Operating EntitiesRAO EES Rossii 9.1 2.1 11.2 16Transmission Network Business 1.3 0.4 1.7 2Generation Companies 2.2 0.6 2.8 4Nuclear Power Stations* 0.9 0.1 1.0 1Regional A/O Energos 4.6 2.0 6.6 9

Support Ito Market and Regulatory EntitiesFederal Energy Commission 2.1 0.4 2.5 4Regional Energy Commissions 2.8 0.6 3.4 5Wholesale Market Operator 2.4 0.4 2.7 4

Cross-cutting IssuesEthics 0.8 0.8 1Public Participation and Communication 0.8 1.5 2.3 3Compensation 0.5 0.5 1Training 2.8 0.6 3.4 5Downs:izing and Social Assistance 0.7 0.5 1.2 2Legal 0.5 0.8 1.3 2

Policy D'evelopment SupportExpert Panel 1.7 1.7 2Implementation Policy Support 2.5 0.3 2.8 4

Implementation AssistanceERIU 0.3 2.0 2.3 3Implenmentation Management and Coordination 2.3 0.8 3.1 4

GoodsComputer and Communications Equipment 3.3 3.3 5

Government/Agency Support 2.7 2.7 4

Base Project Cost 41.4 15.9 57.3 81Contingency 2.5 1.4 3.9 6Taxes 9.1 9.1 13

Total Project Cost 43.9 26.4 70.3 100Note: figures may not add due to rounding*To be financed through bilateral grant funding.

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Finance has approved a Project Development Loan of US$5.4 million (under the PortfolioDevelopment Loan, L-38440) to finance further development of Terms of Reference (TORs)as well as the establishment of the project implement unit (the ERIU). Additional cofinancingwould be provided on a grant basis to undertake specific items of work from USAID (US$8.7million), the UK KnowHow Fund (US$2.4 million), and EU-TACIS (US$1.6 million), underongoing and committed programs. The beneficiaries (Government, regulatory agencies andoperating entities) would finance taxes as well as the salaries and overheads associated withcounterpart staff. Total value of the beneficiaries' contributions is estimated at US$12.1million equivalent.

IV. IMPLEMENTATION ARRANGEMENTS

A. Project Implementation

28. Project Implementation: The ERIU, which has been established to further develop andimplement the reform program in the electricity sector, would be responsible for the day today implementation of the technical assistance program, including the Bank-financed compo-nents (Figure 3). The Unit would employ a full-time Director and 10-15 local staff. TheERIU would be assisted by an Implementation Management and Coordination Advisor whowould provide support in project coordination, management and procurement. The ERIUwould operate under the oversight of the Inter-Ministerial Working Group for ElectricitySector Reforns (IMWG), which would provide overall guidance, establish priorities, approvechanges in the reform plan recommended by the rest of the reform team, and recommend tothe Government new policies, laws, or decrees needed to implement the reform plan. Aninternational panel of experts, with experience in carrying out electricity sector reform andrestructuring in other countries, would provide general policy advice and guidance to theIMWG. The Board would report to the First Deputy Prime Minister responsible for thereform of natural monopolies who would carry overall responsibility for the project.

B. Schedule

29. The project would be implemented over a three year period, beginning July of 1997and extending into mid-2000. The initial focus would be to procure the services of theImplementation Management and Coordination Advisors, to provide early assistance to theERIU, particularly with respect to scheduling and initial procurement, and to finalize and issuebid documents for four priority teams of advisors which are to be financed under the loan.Draft TORs for these four teams are attached as Appendix 3. At the same time, bilateralcofinancing programs would be directed towards institutional support for the Federal EnergyCommission, the Wholesale Market Operator, and a pilot support project in one or more of theregions to address institutional strengthening of the regional regulators and Energos.

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30. In parallel, the IMWG and ERIUwill be working with the Panel of Experts Figure 3: Project Structureto identify outstanding issues which need First Deputy Prime Minister

to be addressed before finalizing the Responsible for Natural Monopolies

reform plan, so that the necessary International Panel of Experts

research can move forward with theassistarnce of the Policy Advisor team. Inter-Ministerial Working Group

Once the proposed market and institu- for Electricity Reform

tional structures have been clarified, IEectricityReformimplemndetailed TORs would be drafted for ,institutional support and strengthening of A

other sector entities, as well as for thecross-support advisory services which are | Ad-i.r. Advisorfs) Adwisor

proposed. The ERIU, together with the MatOerator IL AO PubkPa

Management and Coordination Advisor FEC Ac|ountingl Compcdison

would then update the project schedule to r, Advisor _l Advso

reflect the timing and scope of the Transmission T k*T

remaining advisory teams. A preliminary , ir P_ AE

schedule for initial activities is attached as Gencos End*

Appendlix 4. RECS Downsrnsc |al

n q ~~~~~~~~~ ~ ~~~~~~~~~~~Energos l- dio C. Procurement

9 - Nuclear |

31. Under the Bank loan, provisionwould be made for consultant services,training, equipment, and related services, including hardware and software, to be procured inaccordance with the Guidelines for the Selection and Employment of Consultants by WorldBank Borrowers, .published by the World Bank in January 1997 (The Consultant Guidelines)

Table 3: Summary Of Proposed Procurement Arrangements(US$ million equivalent)

Procurement MethodTotal

Project Element NS' Other NBF' CostComputers and Equipment 4.2 4.2

[3.5*] [3.5]Consultants, Training & Specialized 50.4 15.7 66.1Assistance [42.0] [42.0]

Total 4.2 50.4 15.7 70.3[3.5] [42.0] [45.5]

* Numbers in brackets [ represent amounts financed by Project Development Loan and by IBRD loan.NS - National Shopping

2 NBF - Non Bank Financed

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and Guidelines for procurement under IBRD Loans and IDA Credits, published by the WorldBank in January 1995 (The Guidelines). The proposed procurement arrangements aresummarized in Table 3.

32. Goods: Goods to be procured would consist of office equipment to support effectivecommunications. The largest package is expected to be less than US$250,000, while theaggregate is estimated to be US$3.3 million. All goods would be procured through nationalshopping.

33. Consulting Services and Training: Firms and individuals would be selected forconsulting assignments in accordance with the Bank's Consultant Guidelines. A panel ofexperts would be engaged to advise the highest levels of the Government. Given that there arevery few countries that have undertaken a similar level of reforms, the number of highlyqualified experts in this field is few and their availability is limited. The Government wouldcanvas those that have had direct experience in guiding a similar reform agenda to advise themof possible problems. Hence, the Expert Panel, and any other similarly justified engagements,would be undertaken on a sole source basis. The aggregate value of individual contractswould not exceed US$2.5 million. All other consultant assignments would be contractedaccording to shortlisting procedures. The TORs for all assignments would be subject to theBank's prior review.

34. Procurement Implementation and Monitoring Arrangements: A project launch seminaris scheduled for July 1997 at which time an attempt would be made to quantify the agreedproject indicators. A procurement specialist would be engaged to work within the ERIU tocontrol the procurement process. All contracts for consulting firms at US$100,000 and forUS$50,000 or more for individual consultants, and all single source contracts, would besubject to prior review and approval by the Bank. Information on procurement would becollected and recorded by the ERIU to provide: (a) prompt reporting of contract awards by theBorrower; (b) full quarterly reports to the Bank; and, (c) changes in procurement schedules,including advertising, bidding, contract awards and completion dates. A procurementschedule outlining the target dates for the procurement milestones for the first year is attachedas Appendix 5.

D. Disbursement

35. Proposed disbursement arrangements are shown in Table 4. A Special Account (SA)would be established in accordance with World Bank procedures, with an initial allocation ofUS$500,000. When the aggregate disbursements under the Loan have reached the level ofUS$2.5 million, the initial allocation may be increased up to the authorized allocation of US$1million by submitting the relevant Application for Withdrawal. Replenishment applicationswould be submitted at least every three months, and would include reconciled bank statementsas well as other appropriate supporting documents. The minimum application size forpayments directly from the loan account or for issuance of Special Commitments would be 20percent of the SA authorized allocation; that is, US$100,000 until aggregate disbursementsreach US$2.5 million and US$200,000 thereafter. Minimum application size prior to the

- 15 -

Table 4: Withdrawal of Proceeds of the Loan(US$ million equivalent)

Amount of Percent of ExpenditureCategory Loan to be Financed

Allocated

Consultants Services and Training 33.6 100%

Computers, Equipment and Other Goods 2.8 100% of foreign100% local (ex-factory)83% of other local

Unallocated 3.6

Total 40.0 _

establishment of the SA would be US$50,000. Withdrawal applications would be fullydocumented, except for expenditures against training and (a) goods and services of consultingfirms under contracts not exceeding US$100,000 equivalent; and (b) services of individualconsultants under contracts not exceeding US$50,000 equivalent, which would be made on thebasis of SOEs detailing the individual transactions. Documentation supporting these expendi-tures would be held by the ERIU for at least one year after receipt of the audit report by theBank for the year in which the last disbursement is made and would be made available forreview lby the auditors and to the Bank on request.

36. The project would be carried out over a 3-year period. Disbursements are heavilyconcentrated in the first two years, with 32 percent of the loan amount disbursed during FY98,and a further 49 percent disbursed in FY99 (see Table 5). The project is expected to becompleted by June 30, 2000, with a closing date for the loan of December 31, 2000.

E. Supervision

37. Project Supervision: Due to the scope and urgency of this project, a significantsupervision effort is anticipated. An estimated 2-3 staff conducting on-site monitoring on aquarterly basis would be required. The possibility exists, and would need to be examined, ofa need for full-time presence in the field. In addition, semi-annual project reviews would becarried out to ensure that activities are being carried out in accordance with the overallobjectives of the Technical Assistance program, and are yielding the expected results.

- 16 -

38. Monitorable Indicators: The Borrower has agreed to establish policies and proceduresadequate to allow ongoing monitoring and evaluation of the execution of the project and theachievement of the objectives. Monitorable indicators would be agreed with the Bank.Performance indicators would include: (a) adequate staffing of the ERIU; (b) availability offunds; (c) engagement of advisors; (d) cost control of consultants; and, (e) implementation ofan effective management information system. Development indicators would include: (a) areduction in accounts receivable; (b) an increase in the proportion of cash payments; (c) theestablishment of effective regulation at the federal and regional levels; (d) the establishment ofeffective information systems for the regulator; (e) the publishing of commercial licenses forentities operating in the wholesale market by December 31, 1997; and, (f) the establishment ofan independent nonprofit wholesale market operator by September 30, 1997.

39. The Borrower has also agreed to prepare twice-yearly reports to the Bank (on March31 and September 30), outlining the progress achieved during the preceding period withrespect to the monitorable indicators, and setting out measures to be taken during the comingperiod to ensure efficient execution and achievement of objectives. The Borrower has furtheragreed to review project progress with the Bank by April 30 and October 31 of each year andtake the Bank's views into account in project implementation.

V. PROJECT BENEFITS AND RISKS

A. Benefits

40. The proposed reform initiatives are expected to result in substantial benefits to theRussian economy. These include: (a) reductions in the fuel-related cost of electricity supplyas a result of more economic dispatch of plants, (estimated at as much as US$1 billion per yearby the Russian Institute of Energy Research); (b) reductions in system operating and mainte-nance costs as a result of better regulatory oversight, improved corporate management, andcompetitive pressures; (c) increased value of the Government shareholdings in sectorcompanies as a result of reduced regulatory risk, more efficient operation, and thus improvedprofitability; (d) decreased investment needs through better use of existing assets (estimated tosave at least $1 billion per year over the medium term); (e) improved customer service; and,(f) economic benefits related to the elimination of cross-subsidies and non-payments.

41. Reforming the sector would also have environmental benefits. By improving thepricing structure, consumers would have a greater incentive to conserve on the use ofelectricity and reduce waste and inefficiency. By increasing the profitability of sector

Table 5: Cumulative Disbursements(US$ million)

FY1998 FY1999 FY2000Amount 13.0 19.6 7.4Percent of Total 32% 49% 19%Cumulative Total 13.0 32.6 40.0Cumulative Percent of Total 32% 81% 100%

- 17 -

companiies, they would be able to decrease their cost of capital. Competitive and regulatorypressures to reduce costs should increase fuel efficiency in generation.

B. Risks and Risk Mitigation

42. While the project offers substantial benefits, it carries correspondingly high risks andan equally high profile. Government commitment to reform is of recent origin and may not besustained long enough to allow full realization of the concept and hence the expected efficiencygains. This project has, therefore, been prepared quickly to respond to what is viewed as awindow of opportunity to broaden and deepen the reform agenda. Project preparation hasfocused on speed in the trade-off between speed and attention to detail. However, because ofthe unique opportunity, this approach is felt to be appropriate. The proposed project isattempting to address this risk by providing immediate and extensive support to the programand by concentrating initially on areas which would yield large, early, and visible gains interms of efficiency improvements. Risks related specifically to the technical assistance includethe difficulties in coordinating and absorbing assistance of this magnitude, and the difficultiesin predicting and monitoring the effectiveness of programs with extensive training compo-nents. Coordination has been addressed through the establishment of a high-level, knowledge-able Inter-Ministerial Working Group within the Government to oversee the project, supportedby a panel of international experts to advise on policy matters, and by an implementationadvisory team that will assist the ERIU in project coordination. Training risks would beaddressedl by providing a combination of long-term on-the-job assistance coupled with formaltraining programs, by a preliminary needs assessment, and by careful selection of trainingcandidates. Training performance indicators would be agreed at an early date and monitoredclosely. In addition, the Bank would provide extra resources to ensure adequate supervision ofthe project.

- 19 - Appendix 1Page 1

PROPOSED STRUCTURAL ADJUSTMENT LOAN

1. Objectives. The proposed SAL would assist the Government to undertake the structuralreformis necessary to the lay the foundation for renewed economic growth and to maintainmacroeconomic stabilization over the medium-term. It would also provide the financingnecessary to provide an adequate level of public services during the difficult fiscal transitionthat has characterized most centrally planned economies. It would focus on private sectordevelopment, natural monopoly regulation and restructuring, banking, and fiscal management.The following describes the reforms of the natural monopolies and, in particular, the powersector, that would be supported by the proposed loan.

2. Coordination with the IMF. The proposed SAL has been prepared in parallel with the1997 IMF Extended Fund Facility (EFF) in the context of an intensive tripartite dialoguebetween the Bank, IMF, and the Russian authorities to ensure consistency and complementar-ity between the macroeconomic program and structural reforms with the Bank and the Fundtaking the lead in the structural and macroeconomics areas, respectively. As a result, theGoverfnment's structural reform program for 1997 is equally reflected in the Letter ofDevelopment Policy for the SAL and the Statement of Economic Policies for the EFF.

3. Conte-xt. Price reforms and the competitive restructuring of natural monopoly servicesin the electricity, gas, and railways sectors will have very substantial efficiency gains withlarge, positive, economy-wide spillovers and will be critically important for medium-termgrowth. Natural monopoly reforms need to focus on four areas: (a) pricing should betterreflect cost and demand conditions; (b) arrears should be reduced and payment disciplinestrengt]ened (especially in the energy sector); (c) arms-length regulatory oversight, whereappropriate, should be enhanced; and (d) sectors should be demonopolized, i.e., policybarriers to new entry should be reduced so as to allow for the competitive provision ofservices where monopoly is not "natural." The Government has initiated reform steps in allfour areas. The 1997 reform program will concentrate mainly on price reform, continue toaddress the arrears problem and strengthen needed regulatory oversight, and develop theagenda for, and in some cases implement, the restructuring process of demonopolization.

4. Russia's power sector has an installed generating capacity of about 215 GW, nearly50% more than the peak demand. This condition resulted from the decline in demand of about20% over the past five years. The asset base is aging and considerable investment in deferredmaintenance, life extension and replacement will be needed over the next decade. Despite theover-capacity situation, supply problems persist in some regions due to the huge buildup ofpaymernt arrears. The arrears problem also manifests itself in non-payments to the Govern-ment as the power sector owes 9.5 trillion rubles to local and federal budgets and 1.7 trillionrubles to the state pension fund.

5. The power sector is largely controlled by the corporate entity RAO EES Rossii (RAO).RAO owns much of the generation system, and all of the transmission and dispatch systems.

- 20-Appendix 1Page 2

RAO also has a controlling equity stake in most of the regional electricity monopolies(Energos), which are responsible for the distribution of electricity on a regional basis. The 72Energos own the smaller generation stations and the distribution networks within their regions.Regulation has recently been established at both the federal and regional levels. However, theinstitutional capacity and independence of the regulators is weak.

6. In 1992 the Government partially privatized the power sector under its mass privatiza-tion program. RAO was established as a holding company for the Energos, with an ownershipstake of 51% in the majority of them. The remaining 49% is owned by the employees andmanagement of the Energos. Only a small share of RAO was initially privatized in 1992, withthe Government gradually selling off further stock and reducing its ownership stake to thepresent level of 52 percent. The Russian stock market has assigned a low value to all of theRussian power sector entities, relative to similar entities abroad, with a much higher valueassigned to many of the Energos than it has to RAO. Brokers ascribe this low valuation to alack of confidence in existing management, lack of transparency, weak regulation and largearrears (less than three quarters of electricity and heat bills were collected in 1996).

7. In the aggregate, electricity prices have been set at a level to fully finance operatingcosts and 100% of new investments. However, rates charged to households (where demand isrelatively inelastic) have been kept artificially low at about 25% of the cost of supply, whileprices to industry (where demand is elastic) have been set high in order to cross-subsidizehousehold consumption. This structure of prices is economically inefficient: the weightedaverage tariff for industrial users is too high given the low cost of fuel, low labor costs and anearly zero cost of capital (as much of the asset base was originally funded as a budgettransfer). Moreover, while this price structure is intended to achieve equity and reducepoverty, these objectives would be better met through targeted direct transfers as part of theauthorities' overall social programs or, where adequate targeting of transfers is impossible toimplement under present conditions, through instruments such as life-line pricing.

8. The Government has assigned a high priority to addressing the problems of the powersector. The goal of the program is to increase the efficiency of the sector's operation byestablishing a pattern of prices reflecting economic costs and relative scarcities (demand andsupply over time), improving regulatory oversight, improving the quality of service, andoperational restructuring. The Bank is providing technical assistance to the Government tohelp define and implement a comprehensive reform agenda along these lines. The reformsinclude the establishment of a competitive market for electricity, where feasible, comple-mented by enhancing the effectiveness of the regulatory regime for the segments of the powermarket where the competitive provision of service is suboptimal. Structural, financial,institutional capacity building and ownership issues will all be addressed under these reforms.

9. Price Reform. The Government's priority objective in natural monopoly reform is tointroduce pricing practices for electricity, gas, and rail services that will encourage efficientproduction and usage. A fundamental issue the Government must face in this regard is thatpricing in natural monopolies is based on Soviet-style accounting, which fails to appropriately

- 21 -Appendix 1

Page 3

treat key cost components such as depreciation and prevents providers from recovering theactual cost of service. In response to this, the Government will attempt to move towardmodem pricing principles used in market economies.

10. The Government committed to price reform in the natural monopoly industries in itsMedium-Term Program. By June 30, 1997, the Government will establish principles andprocedures for the pricing of electricity, natural gas, and railways services. With a view toencouraging efficient production and usage of these services, these pricing principles will: (i)allow suppliers to recover prudently incurred fixed and variable costs; (ii) reflect differences incost between customer classes and geographic regions; and (iii) over time adjust to reflect theevolution of costs and demand conditions. To facilitate effective regulation, detailed pricereform studies have been initiated for each subsector, and the Government will prepare a listof information and reporting requirements for the regulated entities (including details onproposed investment and the structure and cost of financing).

11. Cross-subsidies are currently the most acute pricing issue. They impose artificiallyhigh costs on industrial production while inefficiently subsidizing households. Under itsnatural monopoly reform program supported by the SAL, the Government approved in earlyApril 1997 an ambitious action plan for the phased elimination of cross-subsidies amongconsumer groups for all natural monopoly services (GoR Resolution No. 389). In addition,the FEC submitted to the Government a detailed proposal to decrease cross-subsidies forelectricity consumption. By the end of July 1997, the Government will introduce a two-blocktariff for household electricity consumption.

12. Elimination of cross-subsidization will lead to further increases in energy prices andrailway tariffs paid by households. This may have a substantial poverty impact. To mitigatethis the Government has mandated municipal authorities to set housing allowances programswhich aire to provide targeted mean-tested income transfers to families with housing expendi-tures exceeding 15% of their gross money income. Most municipalities have been runningsuch programs since 1995. In addition, to improve local capacity for delivering socialassistance, the Government has decided recently to pilot a few alternative schemes foradministering universal mean-tested poverty benefits. These pilots will be supported throughthe Bank's proposed Social Protection Assistance Adjustment Loan.

13. Reducing Payment Arrears. The Government's second objective is to reduce paymentarrears on electricity and natural gas utility bills and improve the flow of payments in the fueland energy sector. Energy providers are faced with the problem of being unable to cut offsupply to so-called "strategic customers;" such customers can still obtain services even if theyare in arrears. This has created a chain of payment arrears which have multiplied through theeconomy and has also led to increased tax arrears to the budget. The arrears have also inmany cases seriously affected the financial viability of local utility companies. The originallist of "strategic customers" was long and included defense-related as well as many othercompanies. In January 1997 the Government substantially reduced the list of "strategiccustomers"; entities taken off the list account for the large bulk of all energy deliveries to

Appendix 1 - 22 -Page 4

"strategic customers" as previously defined. Virtually all remaining "strategic customers" areentities responsible for Russia's external and internal security. Earlier legal provisions thatprohibited suppliers form cutting off service to classes of customers have also been revoked,including most recently provisions under Government Resolution No. 307 of April 7, 1994.

14. Additionally, the Government will use the regulatory process and corporate governancemechanisms to encourage strict enforcement of payment discipline. To improve the flow ofpayments and reduce arrears in the energy sector, the Government has made adequateprovisions in the 1997 budget to pay for the fuel and energy consumption of the remaining"strategic customers" who may not be disconnected for nonpayment, as listed in GovernmentDecree 74, issued January 28, 1997. The Government will ensure that there are no arrears toenergy suppliers on account of the remaining strategic customers.

15. Introducing Competition Where Monopoly is Not "Natural. " The Government's thirdobjective is to promote more competitive market structures for the energy and infrastructureindustries. To be sure, throughout the world many of these industries were once thought to benaturally monopolistically structured. But due to changes in technology and expansion ofmarkets, today many of these industries increasingly possess competitive attributes. As aresult, services can be provided more efficiently when there are multiple suppliers rather thana single supplier. In Russia, the electricity, gas, and rail sectors are dominated by verticallyintegrated monopoly providers who are in a position to inflate costs, overprice services, andrestrict network access. To help rectify this, the Government will begin a step-by-steprestructuring of these industries with a view to demonopolization and eventual privatization ofcompetitive segments. An Interministerial Commission under the former Minister ofEconomy completed a reporta in early 1997 with specific recommendations for restructuringthe electricity, natural gas, and railways sectors. On April 28, 1997, Presidential Decree No.426 was issued adopting the structural reform principles for the electricity, natural gas, andrailways sectors for 1997 as outlined in that report. The decree instructs the Government toelaborate a detailed medium-term restructuring program to be adopted by a governmentresolution by June 30, 1997.

16. In the power sector, the formation of a joint stock company to develop a new generat-ing plant, with equity participation by several enterprises, including non-power sector entities(mostly completed) is a first step in the establishment of a competitive power market. TheMoscow regional power company (MosEnergo), and recently an increasing number of otherregional power utilities, issued ADRs and to this end have begun complying with stricter andmore transparent reporting (particularly financial) requirements. In April, 1997, the Govern-ment took steps to change the management of RAO EES Rossii and to ensure that therepresentative group of interministerial officials on the Board of RAO have clear instructionsto implement governmental policies in the electric power sector (Government Resolutions No.

' "On Developing Plans for Structural Reforms of Natural Monopolies" submitted to the Government indraft on January 28, 1997 and in final on March 26, 1997.

23 - Appendix I

Page 5

401 of April 1, 1997 and No. 439 of April 22, 1997). The Government has outlined thefollowing program for the remainder of the year:

a. By September 30, 1997, the Government will issue a resolution to create anindependent non-profit Wholesale Market Operator to operate the wholesale electricitymarket, including the dispatch of electricity from generators and the settlement andclearance of payments, and the Government will establish a Supervisory Council forthe Wholesale Market composed of representatives of market participants (with no par-ticipant having a dominant position). By September 30, 1997, the FEC will also makepublic a Wholesale Market Agreement which specifies the duties and responsibilities ofthe participants in the wholesale market.

b. By June 30, 1997, the Government will outline general principles (based on areport by the FEC) for the commercial licensing of enterprises participating in thewholesale market. By August 30, 1997, the Government will issue a resolution givingthe FEC exclusive authority to issue such licenses. By September 30, 1997, the Gov-ernment will solicit public comments on drafts of each type of license and by December31, 1997, it will make final versions public.

c. By December 31, 1997, the Government will publish a plan to create a suffi-cient number of generation companies independent of RAO EES Rossii to establish acompetitive wholesale market.

17. Strengthening Regulation. The Government's fourth objective is to develop theinstitutional capacity for effective independent regulatory oversight of natural monopolysectors. This process will take time. Regulatory Commissions have been establishedthroughout the energy, transport, and telecommunications sectors. But the clout of theseagencies remains weak. The Government has plans to further strengthen and ensure theindependence of these commissions, beginning with those in the energy sector; a proposedBank TA loan in the power sector is under preparation to assist with this task. The ground-work has been laid in the Government's budget to enable the FEC to raise staffing levelscloser to mandated levels.

- 25 - Appendix 2

Page 1

SUMMARY SCOPE OF WORK

IMPLEMENTATION POLICY ADVICE

Objective:

To support the Electricity Reform Implementation Unit (ERIU) in analyzing policyissues necessary to refine the Government's concept for restructuring the sector, develop aplan for realizing the concept, and modify the concept and plan as new issues arise duringimplementation.

Tasks:

Assist the ERIU to further refine and modify if necessary the Government's concept forrestructuring as specified in Decree 426 of April 28, 1997. Issues to be analyzed include:

O an assessment of which regional generation markets are, or can be made competi-tive, based on an analysis of system technical and market characteristics, includingtechnical features of the transmission grid and system dispatch system that limitcompetition on the wholesale market,

O macroeconomic and microeconomic conditions which need to be in place to allowfor the effective functioning of competitive markets,

O procedures for generation companies to submit bids and determining market clearingprices in those generation markets likely to be competitive,

O requirements with respect to participation in the market, including an evaluation ofregulations that would encourage or require combined heat and power plants ownedby the Energos to participate in the wholesale market,

O methodology for regulating wholesale market prices in those regional generationmarkets that will not be competitive,

O the feasibility of separating the generation, marketing, and distribution activities ofthe Energos or other proposals designed to introduce competition in local powermarkets,

O pricing for transmission services that are consistent with regional differences in thewholesale market price and provide the proper incentives to generation companies,

O the appropriate role of nuclear and large hydro plants in the wholesale market, in-cluding whether the ownership of hydro plants should remain with the transmissiongrid to assure system reliability,

O the number and structure of generation companies necessary to create competitivemarkets, and

O the appropriate legal form and ownership of the Wholesale Market Operator and theSupervisory Council.

Appendix 2 26 -Page 2

* Assist in preparing an implementation plan for realizing the concept including the estab-lishment of priorities, a schedule of activities and milestones, and preconditions that mustbe achieved before moving on to the next stage of implementation.

* Assist in carrying out a detailed risk analysis of the proposed action plan and prepare a riskmitigation plan which adequately addresses those risks which can be managed.

* Assist the ERIU to intervene in proceedings before the Federal Energy Commission inwhich the FEC will specify regulatory methodologies for setting tariffs and prices at thewholesale and local levels.

-27 -

Appendix3Page 3


RAO EES ROSSII - COMMERCIALIZATION

Objective:

To support the commercialization and corporatization of RAO EES Rossii, both byaddressing immediate management and operating deficiencies and by assisting the company tostrenglhen and develop systems and procedures which will allow it to operate efficiently, as acommercial entity, within the proposed new sector structure.

Tasks:

Accounting and Financial Management Systems:

* Establish systems to provide critical financial operating data needed by management and bythe regulatory agencies.

* Propose improvements in the system of financial controls, internal audits, inventorymanagement, and procurement.

- Improve the management and control over subsidiary companies.

Econoimics and Investment Planning

- Develop procedures for undertaking feasibility studies of investment projects.• Undertake feasibility studies for major current and planned projects including implementa-

tion and financing plans.- Analyze the tariff and pricing system for RAO services so as to ensure adequate cost

recovery consistent with FEC regulation.

Corporate Finance

* Develop a financing strategy for the company taking into account the company's investmentplan and the cost of capital for each source of financing.

* Establish relationships with several commercial and investment banks to obtain theirassistance in developing a financing strategy and supply financial and operating informationto the investment public.

Recruitment and Personnel

* Assess the skills, training, and capabilities of existing staff and develop a staffing plan thatprovides the required skills and capabilities.

* In cooperation with the training advisor, develop a training and recruiting plan that willensure that staff with required skills and capabilities are employed.

Forensic Accounting

* Evaluate the systems in place to control fraud and corruption, and propose new systems toreduce the potential for such conduct.

Appendix 3 - 28 -

Page 4


TRANSMISSION NETWORK COMMERCIALIZATION AND RESTRUCTURING

Objective:

To support the creation of a separate network business within RAO and its commer-cialization and corporatization so that it can operate effectively within the proposed sectorstructure.

Tasks:

* In cooperation with the training advisor, provide information and organize study tours bysenior management to learn how independent network organizations operate in other coun-tries.

* Develop and assist in the implementation of a plan for the organization, management, andstructure of a separate network business unit within RAO.

* Advise and provide training on the latest transmission technologies.* Coordinate closely with the RAO commercialization advisor to assure that the network

business receives necessary advice and assistance in commercialization.* Cooperate with the policy advisor in analyzing policy issues concerning transmission.* Develop a High Voltage Transmission Agreement between RAO and the Wholesale Market

Operator and obtain approval of the Federal Energy Commission including levels of serviceand tariffs for transmission services.

* Assist RAO in negotiating a transmission license with the Federal Energy Commission.

- 29 - Appendix 3

Page 5


GENERATION COMMERCIALIZATION AND RESTRUCTURING

Objective:

To ensure that independent generation companies are established within the RAOcompany structure and support their commercialization and corporatization so that they canoperatLe effectively within the proposed sector structure.

Tasks,:

* Cooperate with the policy advisor to establish technical and economic criteria for creatinggerneration companies from existing RAO assets that will be both commercially viable andintroduce competition to the extent feasible.

3 Develop and assist in the implementation of a plan for the organization, management, andstructure of these generation companies.

3 Coordinate closely with the RAO commercialization advisor to assure that the generationcompanies receive necessary advice and assistance in commercialization.

3 Cooperate with the policy advisor in analyzing policy issues concerning the generationcompanies.

3 Develop a plan for spinning off the generation companies so that they are independent ofRAO.

3 Assist the companies in negotiating generation licenses with the Federal Energy Commis-sion.

3 Assist the companies in negotiating generation agreements with the Wholesale MarketOperator.

Appendix 3 30 -

Page 6


NUCLEAR POWER COMMERCIALIZATION AND RESTRUCTURING

Objective:

To support the commercialization and corporatization of the nuclear power plantsmanaged by Rosenergoatom so that they can operate effectively within the proposed sectorstructure.

Tasks:

* Develop and assist in the implementation of a plan for the organization, management, andstructure of this nuclear generation enterprise.

* Coordinate closely with the RAO commercialization advisor to assure that the nuclearplants receive necessary advice and assistance in commercialization.

* Cooperate with the policy advisor in analyzing policy issues concerning nuclear generation.• Assist the company in negotiating a generation license with the Federal Energy Commis-

sion.• Assist the company in negotiating a generation agreement with the Wholesale Market

Operator.

Appendix 3Page 7


FEDERAL ENERGY COMMISSION INSTITUTIONAL DEVELOPMENT

Objective:

To ensure that the Federal Energy Commission (FEC) is capable of carrying out itsresponsibilities to oversee the development of competitive markets where feasible and improvethe regulation of those that remain monopolies.

Tasks:

Institutional Development

* Developing a business plan for the organization that includes organizational structure,staffing, training, premises and equipment.

* In cooperation with the training advisors, provide information and organize study tours forFEC' staff to learn about the organization of similar agencies in other countries.

* Develop a policy analysis team in the Commission that can analyze the key issues faced bythe Commission.

. Develop Rules of Procedures that specify how the Commission and its staff will deal withregulated entities, license holders, and the general public and ensure an open and fairprocess.

* Establish an international team of regulatory experts that can provide advice.* Develop a communications plan including necessary equipment so that the FEC can swiftly

inform the RECs and local Energos about its decisions and receive responses.* Evaluate how the FEC can better guide the Regional Energy Commission (REC) to improve

their regulation at the oblast level including legislation if necessary.

Regulaitory Methodology

* For those markets that are unlikely to be competitive (for example, transmission and localdistribution), develop a regulatory methodology in cooperation with the policy advisor forsetting tariffs that allow regulated companies to recover prudently incurred costs, provideproper incentives to users of electricity, and eliminate cross subsidies.

* As a means of establishing regulatory authority over sector companies, assist the FEC toprepare and issue licenses to all companies in the sector.

* Assiist the FEC to prepare and negotiate a market members agreement and create aSupervisory Council to oversee the operation of the Wholesale Market Operator.

* Assiist the FEC in cooperation with the policy advisor to develop a methodology todetermine whether a generation market is competitive and how to regulate those marketsthat are not.

Appendix 3 - 32Page 8


WHOLESALE MARKET OPERATOR SUPPORT

Objective:

To support the creation of an independent Wholesale Market Operator which is able toorganize and manage the price setting process on the wholesale market, ensure efficientdispatch, and implement a fair transparent process for payments and settlements.

Tasks:

* In cooperation with the policy advisor, analyze the appropriate legal structure for the neworganization (e.g. joint stock company, state-owned enterprise, foundation, or trust) and forthe Supervisory Council that will oversee its operations on behalf of the participants in themarket.

* Assist in establishing the Wholesale Market Operator including the separation of functionsnow carried out by RAO and their transfer to the Market Operator.

* Create a structure for the new organization including subsidiaries such as a market pricingadministrator and funds administrator.

* In cooperation with the policy advisor, assist the Market Operator to create a methodologyand procedures for establishing prices on the wholesale market (including software) basedon competitive bidding to the extent possible and obtain approval from the FEC.

* Create a system for billing buyers, paying suppliers, and settling transactions includingperiodic publication of all payments and prices that is fair and transparent to all partici-pants.

* Review the technical adequacy of the system dispatch system for implementing a wholesalemarket and recommend improvements.

* In cooperation with the transmission advisor, review the technical adequacy of thetransmission network for implementing a competitive wholesale market.

* In cooperation with the policy advisor, assist in the creation of a Supervisory Councilincluding its membership, functions, and meeting schedule.

* If markets in some regions can not be integrated into the national market due to transmis-sion constraints, assist the national Market Operator to create regional market operators.

33 - Appendix 3

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REGIONAL ENERGY COMMISSION INSTITUTIONAL DEVELOPMENT

Objective:

To ensure that the Regional Energy Commissions (RECs) are capable of carrying outtheir responsibilities to regulate local generation and distribution of heat and power.

First P'hase

* Advise the ERIU on selecting up to five RECs that will receive assistance in the first phaseof the effort.

* For these RECs, assist in developing a business plan that includes organizational structure,staffing, training, premises and equipment.

* In cooperation with the training advisor, provide information and organize study tours forsenior officials to learn about the organization of similar regulatory agencies in othercountries.

* Help these RECs to develop a policy analysis team.* In cooperation with the legal advisor, develop Rules of Procedures that specify how each

REC and its staff will deal with regulated entities, license holders, and the general public toensure an open and fair process.2 Establish an international team of regulatory experts that can provide advice when requestedby any REC.

* In cooperation with the policy advisor and the FEC, assist these RECs to develop amethodology for regulating prices for power and heat that allow regulated companies torecover prudently incurred costs, provide proper incentives to users of electricity and heat,and eliminate cross subsidies.

* Assist the regional administrations to establish RECs and provide adequate funding andindependence.

Second Phase

* Create a plan for the "roll out" of the lessons learned and information gained from the firstphase so that all of the RECs receive assistance in the second phase.

* Create teams of Russian consultants who can visit each of the RECs in the second phase,provide written descriptions of the first phase experience, provide training in cooperatingwith the training advisor, and organize study tours for officials to visit the first phaseRECs.

Appendix 3 34 -

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REGIONAL ENERGO COMMERCIALIZATION

Objective:

To support the commercialization and corporatization of the local generation anddistribution companies (Energos) both by addressing immediate management and operatingdeficiencies, and by assisting the companies to strengthen and develop systems and procedureswhich will allow them to operate efficiently, as commercial entities, within the proposed sectorstructure.

Tasks:

First Phase

- Advise the ERIU on selecting up to five Energos that will receive assistance in the firstphase of the effort (these Energos should be in the same oblasts selected in the previousScope of Work).

_ For the first phase Energos, improve the systems for financial controls, internal audits, andprocurement.

- Develop a system for evaluating investment projects.- In cooperation with the policy advisor and the FEC advisor, assist the Energos to develop

systems and methodologies for pricing and tariffs consistent with the regulations of the RECand FEC.

_ Develop a corporate finance plan for these Energos that will allow them to financenecessary investment projects.

_ Analyze and propose technical and engineering improvements in the operation of theEnergos that will reduce costs.

* Develop a recruitment and staffing plan for these Energos.* In cooperation with the ethics advisor, investigate corruption and fraud with the intent of

establishing controls to stop such conduct in the future.

Second Phase

* Create a plan for the "roll out" of the lessons learned and information gained from the firstphase Energos so that all Energos receive assistance in the second phase.

* Create teams of Russian consultants that can visit each of the Energos in the second phase,provide written descriptions of the first phase experience, provide training, and organizestudy tours for officials to visit the first phase RECs.

- 35 - Appendix 3

Page 1 1


ETHICS

Objective:

To ensure that the staff of both government agencies and sector companies follow highstandards of ethics and thus increase the efficiency and effectiveness of their organizations.

Tasks:

* Assist the FEC, local RECs, and sector companies to prepare codes of conduct that specifystandards of behavior for the staff of regulatory agencies and sector companies.

* Prepaire financial disclosure requirements that would require staff in regulatory agencies todisclose their financial dealings and investments in regulated companies and that wouldrequire staff of sector companies to disclose their financial dealings with competitors,suppliers, or customers.

* Provide advice on the appropriate penalties or sanctions if the codes of conduct anddisclosure requirements are violated.

a Develop proposals for legislation, if necessary, that would codify these standards for staffof regulatory agencies.

* Advise the FEC on how these standards may be enforced through its powers of regulation.* In cooperation with the training advisor, develop training programs that would ensure that

all staff are aware of the ethics requirements.

Appendix 3 - 36 -

Page 12


COMPENSATION

Objective:

To improve industry productivity by helping to rectify existing compensation inequitiesthat prevent the industry from optimizing the quality of its employment choices.

Tasks:

* Survey the major companies of the Russian electricity industry to establish the qualificationsrequired for management positions in the future.

* Survey the labor markets accessible to the Russian electricity companies to determine thecompensation levels and conditions of employment necessary to attract the required manag-ers and staff to the industry.

* Produce a report and recommendations for use by industry companies and regulators onoptimal compensation packages for all industry players.

Appendix 3

Page 13


TRAINING

Objective:

T'o enhance the quality of human capital within the power sector to help create a systembetter prepared for commercial operation.

Tasks:

* Advise and assist the different entities within the sector in conducting training needsanalyses and designing training strategy and implementation plans.

* Stay abreast of and advise and assist entities within the sector on relevant local andinternLational training opportunities.

* If ide]ntified needs are not met by existing training programs, manage the development oftailored training within the limits of available resources.

* Monitor the training activities of each of the teams to assure training is well-designed,targeted and that there is no duplication of effort.

* Identify, develop and either deliver or coordinate delivery of any useful cross-team trainingprograms.

* When cross-team training is necessary, assist in the formulation of terms of reference andmanage the implementation of such programs within the limits of available resources.

* Periodically review the training programs planned by each team and disseminate theprinciples and results to all interested parties.


SUJMMARY SCOPE OF WORK

DOWNSIZING AND SOCIAL ASSISTANCE

Objective:

To ease the economic and social strain placed on some workers and consumers byindustry downsizing and tariff adjustments and to ensure that the reform program is notderailed by political and public resistance to labor retrenchment and/or electricity priceincreases.

Tasks:

Industry Downsizing

* Conduct a survey of industry staff and managers to determine the likely scale of redundan-cies in each of the next three years and determine the demand for retrenchment servicesbeyond those already available.

3 Conduct a worldwide literature survey on downsizing and retraining programs, and providesummaries and advice to the Government and industry managers as to optimal options.

* Develop a catalogue of retraining and downsizing services and financing sources availableto electricity sector companies.

* Explore the need for and potential benefit of an industry-specific retraining programincluding proposed financing.

* Coordinate information dissemination efforts with reform program communications team.D Prepare recommendations for any required industry-wide retraining programs, including

potential sources of finance, precedents, timing, and implementation processes.

Social Protection

First Phase

* Thoroughly review international experience in social protection schemes with respect toutility costs and use this analysis in making recommendations.

* Work with local administrations of the initially targeted oblasts to identify what socialprotection services exist.

* Deternine if the portion of the population that will not be able to afford electricity isproperly targeted. If not, devise targeting systems.

* Calculate the estimated cost of providing adequate social protection including the number ofhouseholds affected and the level of income support required to offset higher electricityprices.

* Examine current methods of funding targeted assistance and, if inadequate, explore possiblealternatives.

* Coordinate efforts with communications advisors to assure affected parties are informed ofsocial protection efforts.

39 - Appendix 3Page 15

Second Phase

* Create a plan for the "roll out" of the lessons learned from the first phase so that all of theoblasts receive assistance in the second phase.

Appendix 3 40 -Page 16


LEGAL

Objective:

To help maximize the effectiveness and efficiency of the reform and ultimate operationsof the sector by providing relevant legal support during the reform process and establishing alegal framework suitable for a more commercially-oriented electricity sector.

Tasks:

General Reform

* With the FEC advisors, review international legal and regulatory experience in theelectricity sector and prepare relevant briefings for the Electricity Reform SupervisoryBoard and the Government.

* Provide advice and support to the Electricity Reform Supervisory Board and the Govern-ment on necessary legal actions and legislation.

* Stay abreast of the legal and regulatory work done within each of the sector entities andensure there is no duplication of efforts.

* If legal and regulatory initiatives are more advanced in the phase one targeted oblasts,create a plan for the "roll out" of the lessons learned and information gained from theseexperiences so that all of the sector entities in the remaining oblasts receive full informa-tion.

Specific Entities

. Provide or coordinate the provision of legal advice:* to RAO headquarters in areas including decentralization, corporate governance, and

any other matters requiring legal advice.* for the establishment and operations of commercial network and generation business

operations.* to the FEC including the establishment of a Wholesale Market Operator, regulation,

licensing and any other relevant legal matters.* to the Wholesale Market Operator including appropriate legal structure for this or-

ganization and its Supervisory Council, contracting and any other relevant legalmatters.

* to the nuclear power companies including licensing, regulation, and any other rele-vant legal matters.

* to the RECs in the targeted oblasts including regulation, licensing, and any otherrelevant legal matters.

* Ensure lessons learned from RECs in targeted oblasts are disseminated.

- 41 - Appendix3

Page 1RUSSIAN FEDERATION


DRAFT TERMS OF REFERENCEIMPLEMENTATION MANAGEMENT AND COORDINATION

BACKGROUND

In 1992, the Russian Government carried out a partial restructuring of the powersector, establishing RAO EES Rossii (RAO) as a nation wide holding company for governmentstakeholdings in generation, transmission and distribution assets. At the same time, localdistribution companies (Energos) were established in each region, retaining ownership of thesmaller generating plants, and supplying both electricity and heat, on a monopoly basis, tofinal consumers. While the industry structure has successfully maintained reliable powersupply during a difficult economic period, a number of deficiencies have come to light withrespect to the manner in which the sector now operates. These include high operating costs,inadequate cash generation, and inadequate investment to meet current and expected needs. Inorder to address these shortcomings, the Government has adopted a concept for the reform andrestructuring of the power sector and has requested a loan from the World Bank to financetechnical assistance in support of further developing and implementing a restructuringimplementation plan. A Supervisory Board on Electricity Reform has been established underthe First D)eputy Prime Minister in charge of Natural Monopolies, to provide oversight andpolicy guidance to the process. In addition, an Electricity Reform Implementation Unit(ERIU) is being established to manage the review and implementation process, and at the sametime to manage the technical assistance which will be provided.

The overall scale of the technical assistance is substantial. Total cost is estimated atapproximately US$70 million. Direct and indirect loans from the World Bank would financeapproximately US$45 million; bilateral and multilateral agencies would provide grantfinancing for approximately US$13 million; and the Russian Government and sector agencieswould coiltribute the remaining US$12 million. Sixteen separate areas of support have beenidentified., including support for the corporatization and commercialization of sector operatingcompanies, for institutional strengthening of the regulatory agencies, for development ofpower market institutions, and for advice on a range of cross-cutting issues such as training,public participation, and social impact analysis and mitigation. Management, coordination,and execution of this program will require substantial effort. For this reason, provision hasbeen made to finance assistance to the ERIU in these efforts.

OBJECTIVE

ThLe objective of the assignment is to assist the ERIU in managing the components ofthe technical assistance project which are being financed by the World Bank loan, andcoordinating the efforts of both Bank-financed and donor-financed advisory teams to ensurethat all issues are covered in a consistent and cost-effective manner.

Appendix 3 - 42 -

Page 2

SCOPE OF WORK

The selected advisors would work with the ERIU to provide support in all aspects ofcoordinating and managing the technical assistance program. Particular areas where assistancewould be required include, but are not limited to, the following:

Refinement of Reform Concept:

* assist the ERIU in outlining a program of research which will satisfactorily addressoutstanding issues which need to be resolved before a reform plan and implementation plancan be developed;

* help to develop or refine detailed terms of reference (TORs) for carrying out this additionalresearch;

Planning and Scheduling of Technical Assistance Program:

* assist the ERIU in preparing a detailed plan for the execution of the various components ofthe technical assistance program, including a clear identification of all tasks to be carriedout, and of interdependencies among tasks;

* review draft TORs and/or scopes of work and indicative budgets for other activities relatedto institution building and corporatization of the operating and regulatory entities andcross-cutting issues and suggest improvements or modificationis as appropriate;

* assist in developing TORs for the remaining advisory teams, based on the draft scopes ofwork, together with agreed modifications .

* carry out a critical path assessment and develop a detailed schedule for the program,showing starting and completion dates for each step, and critical milestones;

* assist the ERIU staff in monitoring and revising the schedule as necessary.

Review and Monitoring of Progress and Outputs:

* assist with the review and monitoring of progress of the TA program with respect tosatisfactory accomplishment of terms of reference, and adherence to schedules;

* inform other advisors and the ERIU of any deviations from the schedule which mightaffect the successful completion of tasks;

* periodically review the program to ensure that overall objectives are being met and identifyareas where additional research or assistance might be required;

* advise the ERIU on the appropriate scope and terms of reference for additional workrequirements.

- 43~ - Appendix 3

Page 3

Study Coordination:

* establish links and maintain regular contact with donor agencies and with the advisoryteams which are being financed on a grant basis to ensure that their efforts are fully coor-dinated with work being carried out by other advisory teams;

* closely monitor the progress and review the results of this work; if necessary, work withadvisory teams and their sponsors to ensure that commitments with respect to accomplish-ments are met.

* maintain a document and reference library of all major consultant reports and relevantdoctunents;

* organize regular coordination meetings with all advisors and ERIU staff.

Contracting and Procurement:

* consider appropriate packaging of the technical assistance components of the work programthat will facilitate efficient procurement without compromising the quality of the output;

- assist the ERIU in carrying out required advance notification and advertising of consultingservice requirements, in developing a consultant short-list, and in preparing bidding docu-ments for consultant services, including finalization of TORs,

3 assist as required with the evaluation of bids;

* partiicipate in contract negotiations;

* assist the ERIU to procure necessary office and communications equipment, using NationalShopping procedures.

Accounting Systems and Procedures:

* the advisor would assist the ERIU in setting up appropriate procedures for the maintenanceof project accounts and supporting documentation;

* the advisor would advise ERIU staff on any special requirements associated with account-ing ifor projects financed by the various lending and donor agencies and assist them inmeeting these requirements;

* the advisor would assist with the selection of auditors to carry out required annual reviewsof ERIU accounts, including those relating to the project.

Training:

* in consultation with the training coordinator, the advisor would ensure that ERIU staffreceived in-depth training in the various aspects of project management in general andWorld Bank procedures for procurement, disbursement, and project accounting in particu-lar.

Appendix 3 44 -

Page 4

TIMING

The advisor would be expected to begin work within four weeks of the signing of thecontract. The overall duration of the technical assistance program is approximately two years.The advisor would be expected to maintain a continuous presence in Moscow throughout theproject; with additional staff mobilized as appropriate during periods of peak activity.

STAFFING

The advisor should be prepared to nominate a full-time Project Manager, to work withthe Director of the ERIU on an ongoing basis throughout the duration of the assignment. TheProject Manager would be responsible for mobilizing other staff as required, in an efficientand cost-effective manner and ensuring that necessary specialized skills are available asneeded. The Project Manager should have an in-depth understanding of the power sector andof power sector reform and restructuring efforts in other countries. The advisory team shouldinclude individuals or groups with experience in various aspects of power sector restructuring(markets and competition, regulation, institutional strengthening) as well as skills in projectmanagement and execution (procurement, scheduling, accounting).

REPORTING

The advisor team would be accountable to the Director of the ERIU. The advisorwould be expected to submit monthly reports detailing the status of procurement and dis-bursements, and progress relative to budgets and schedules. The team would also providewritten comments and reviews on the periodic reports submitted by other consulting teams,highlighting in particular any findings or results which might affect work in other study areas.

4- Appendix 3Page 5


DRAFT TERMS OF REFERENCEACCOUNTING AND FINANCIAL MANAGEMENT SYSTEMS - RAO EES ROSSII

BACKGROUND

RAO EES Rossii (RAO) was established in 1992, as part of the Government's partialrestructutring of the power sector, to serve as a nation wide holding company for governmentstakeholdings in generation, transmission and distribution assets. RAO was given ownershipof the high voltage transmission grid, large thermal and hydropower plants, dispatch centers,and rese,arch and design institutes. Regional Energos retained ownership of the smallercombined heat and power and hydro plants (which constitute approximately 40 percent ofsystem capacity), and became local distribution/generation companies, supplying bothelectricity and heat, on a monopoly basis, to final consumers. The nuclear plants remained inthe ownership of the Government, and were placed under the management of Rosenergoatom..In addition, the Energos were instructed to transfer 49 percent of their equity to RAOG. Totalvalue of RAO's assets (including its interests in the Energos) is estimated to be approximatelyUS$2 billion. The Government has since sold a part of their shareholdings in RAO, andcurrentl) holds approximately 52 percent.

In the period since the initial restructuring, a number of deficiencies have come to lightwith respect to the manner in which the sector is operating. These include high operatingcosts, inadequate cash generation, and inadequate investment to meet current and expectedneeds. In order to address these shortcomings, the Government has adopted a concept for thereform and restructuring of the power sector and has requested a loan from the World Bank tofinance technical assistance that will, among other things, support the corporatization andcommercialization of power sector entities to enable them to operate more efficiently both inthe current environment and as commercial entities within the proposed new sector structure.A part of the proceeds of this loan would be used to finance the present assignment. Anoutline of the general organization and structure of the reform support program is attached.

OBJECTIVE

Despite its broad ranging responsibilities and interests, RAO's systems of financialreporting and controls are not up to modern standards. This hinders management's ability toproperly plan and manage cash flows, to understand where and how monies are beingexpended, and to control losses and inefficiencies within its various operating divisions. Theobjective of this study is to assist RAO in designing and implementing financial informationsystems and controls which will meet modern international standards. The initial focus of the

b Five Energos failed to comply fully with the decree - two remained fully independent and three transferred lessthan 49 percent of their shareholdings. RAO has since increased its ownership stake in most of the other Energos,and now holds more than 49 percent of 53 Energos (including 100 percent of 9 Energos).

Appendix 3 - 46 -

Page 6

work will be at the corporate level. However, it is expected that these systems and procedureswill be established such that they can be transferred, with moderate modifications, to thecompany's operating subsidiaries. Specifically, the advisor will be expected to: (a) immedi-ately begin providing critical financial operations data as requested by RAO senior manage-ment; (b) evaluate the current system of financial controls and assist in transforming them toworld standard level, including the introduction of a competitive, transparent procurementsystems for major purchases; (c) assist in the development of a full and sound internal auditoperation; and, (d) assist in the development of a system of financial reporting for managementand external audit.

SCOPE OF WORK

Task 1: Corporate Structure and Authorities: The advisor will identify all companieswhich are directly or indirectly controlled by RAO EES and/or its managers (the "Group"),and obtain the charter and recent protocols of the governing body of each. The findings willbe summarized in a regularly updated report for use by management. The advisor will alsoidentify all persons in the Group who have the authority to enter into contracts on behalf ofany Group entity or, by virtue of their association with the Group, to instruct others to enterinto major contracts.

Task 2: Critical financial activity (CFA) reporting: The advisor will immediatelysurvey available financial data and the needs of senior management and develop a weekly CFAreporting system. CFA shall include:

* a summary of the balances and activity in all bank accounts controlled by RAO EES andthe subsidiaries under its control (the Group);

* a summnary of all major Group noncash receipts and deliveries;

* a tabulation of all major contracts executed during the period;

* other critical information as the management of RAO may request.

The advisor will also prepare a report on the status of intercompany billing andaccounting within the Group, together with recommendations for correcting any deficiencies.

Task 3: Internal Audit: The advisor will develop and assist in the implementation of asuitable internal audit function within RAO EES. To this end, the advisor will:

* determine existing practices with respect to internal audit and prepare a report to manage-ment identifying any shortcomings in the current procedures;

* prioritize deficiencies in terms of their potential to lead to losses and implement interimnreview procedures to immediately address the most critical areas;

* develop a detailed plan for implementing an internal audit function within the company,including staffmg, organization, budget, and a schedule for implementation;

47 - Appendix 3

Page 7

* assist RAO in the development of the internal audit department.

Task 4: Financial Controls: The advisor will assist in the development of a system ofinternal financial controls, including appropriate procedures for the control of cash, invento-ries, and other corporate assets, and a system for the control of contractual commitments andother obligations made on behalf of the company. To this end, the advisor will:

* review existing systems of financial control and prepare a report to management identify-ing any shortcomings in the current procedures;

* prioritize deficiencies in terms of their potential to lead to losses, and implement interimreview procedures to inmmediately address the most critical areas;

* develop a detailed plan for implementing a suitable system of financial controls within thecomrpany and -its subsidiaries, including procedures and monitoring systems;

* draft detailed operational procedures related to the proposed system of financial controlsand assist in introducing the new procedures throughout the company;

* assist RAO in acquiring or developing computer software necessary to adequately monitorthe financial control systems.

Task 5: Financial Management Information System: The advisor will assist RAO todevelop a modem system for the timely collection, analysis and reporting of financialinformaLtion. The system should be adequate to meet the company's financial informationneeds in terms of: (a) internal and external audits, including the expected need for auditswhich comply with IAS; (b) preparation of information for submission to regulatory agencies;(c) analysis and management of operating costs within the various divisions of the company;(d) corporate budgeting and cash flow planning; and, (e) management of investments,including capital work in progress. The advisor will ensure that the systems are compatiblewith the introduction of Generally Accepted Accounting Practices, including accrual-basedaccounting. The advisor is expected to:

* iderntify general management needs with respect to financial information and classify theseneeds with respect to source, type, frequency and timing;

* survey existing data and reports which are prepared for internal and external use andprepare a detailed record, including reports which are currently required under Russianlaw and accounting convention;

* examnine ways in which the existing reporting systems could be expanded and/or modifiedto better meet the financial information requirements of management;

* iderntify gaps in the current reporting system and develop a plan to correct these deficien-cies, including priorities, schedule, and estimated cost for each level of implementation;

* assist in report design;

* assist RAO in acquiring and/or developing necessary computer software;

Appendix 3 - 48 -Page 8

* work with RAO subsidiaries and their advisors to ensure that the reporting system isimplemented throughout the company;

* assist in the development and execution of necessary training programs both for accountingstaff in terms of the preparation of required reports and for management in terms of the useof the reports to better manage the financial performance of the company.

TIMING

The advisor would be expected to begin work within four weeks of the signing of thecontract. Both Tasks 1 and 2 should be substantively completed within one month ofcommencing work. The initial reports to management on the status of internal audit proce-dures and financial controls should be completed within three months of project inception.The full assignment is expected to be completed within a two year period, with the first sixmonths devoted primarily to emergency actions, and normal system development activities tobegin during months four to eight.

STAFFING

The advisor is expected to fully utilize the resources available within the RAOorganization, both to assist in designing and to execute the implementation plans for the newsystems and procedures.

REPORTING

The advisor would be accountable to the Chairman of the Board of Directors of RAO,or to any individual(s) within the company whom the Chairman designates as his representa-tive for purposes of particular Tasks. The advisor should also be aware of the parallel effortsthat will be under way as part of the overall program of support for the reform and restructur-ing process, and should ensure that he both coordinates with other teams and makes use of theresources available for such tasks as the development of training programs and the corporati-zation of other power sector operating entities.

Appendix 3Page 9


DRAFT TERMS OF REFERENCEECONOMICS AND INVESTMENT PLANNING - RAO EES ROSSII

BACKGROUND

RAO EES Rossii (RAO) was established in 1992, as part of the Government's partialrestructuring of the power sector, to serve as a nation-wide holding company for governmentstakeholdings in generation, transmission and distribution assets. RAO was given ownershipof the high voltage transmission grid, large thermal and hydropower plants, dispatch centers,and research and design institutes. Regional Energos retained ownership of the smallercombined heat and power and hydro plants (which constitute approximately 40 percent ofsystem capacity) and became local distribution/generation companies, supplying bothelectricity and heat on a monopoly basis to final consumers. The nuclear plants remained inthe owniership of the Government, and were placed under the management of Rosenergoatom..In addition, the Energos were instructed to transfer 49 percent of their equity to RAOC.

In the period since the initial restructuring, a number of deficiencies have come to lightwith respect to the manner in which the sector is operating. These include high operatingcosts, inadequate cash generation, and inadequate investment to meet current and expectedneeds. In order to address these shortcomings, the Government has adopted a concept for thereform and restructuring of the power sector and has requested a loan from the World Bank tofinance technical assistance which will, among other things, support the corporatization andcommercialization of power sector entities to enable them to operate more efficiently both inthe current environment and as commercial entities within the proposed new sector structure.A part of the proceeds of this loan would be used to finance the present assignment. Anoutline of the general organization and structure of the reform support program is attached.

OBJECTIVE

Prior to the initial restructuring of the sector, planning for capital investments wascarried out by the Government, and resources were allocated from the budget to financeapproved projects. Since the formation of RAO, resources have continued to be spent, asavailable, on ongoing projects. However, little has been done in the way of a comprehensivereview of these or other planned investments to ensure that available funds are being allocatedin an appropriate fashion and that planned new investments are optimal given the changes inmarket conditions. The objectives of the proposed study are: (a) to develop a coherent pictureof current investments, both under way and planned; (b) to assist in updating the investment

c Five Energos failed to comply fully with the decree - two remained fully independent and three transferred lessthan 49 percent of their shareholdings. RAO has since increased its ownership stake in most of the other Energos,and now holds more than 49 percent of 53 Energos (including 100 percent of 9 Energos).

Appendix 3 . 50 -

Page 10

plan, including the assignment of priorities; (c) to assist in developing a financing plan for theproposed investment program to ensure that adequate funding is available; and, (d) to assistRAO in developing the capabilities necessary to ensure that future investments are financiallyand economically viable.

SCOPE OF WORK

Task 1: Review of Current Investments: The advisor will carry out a comprehensivereview of all major capital investment projects now under way which are either beingimplemented or supported by RAO. A database and status report on each project will beprepared covering progress to date, financing, and estimated time and resources required tocompletion. For the most active and substantial projects, the advisor will ensure thatconsistent data on estimated project costs, revenues and cash flows are available and arepresented in an accessible form for management review. The advisor will also develop andimplement a mechanism for the regular updating of the project database and the verification ofall data.

Task 2: Development of an Updated Investment Program: The advisor will assist RAOto develop an updated investment program, including both the completion of ongoing projectsand the initiation.of new projects currently in the investment program. The advisor will:

- review work which has been done to date on analyzing the costs and benefits of projects inthe investment pipeline;

* report to management on projects where more detailed analysis is needed or desirable inorder to establish the project's feasibility;

- within the context of the current Russian economic framework and outlook, review theoverall investment program to assess whether other projects not currently planned or pro-posed should be considered as priority candidates and carry out a screening-level analysisto determine whether they warrant immediate consideration;

* prepare a ranking of projects (or groups of projects) in their order of priority based onboth economic returns and on financial returns to the implementing agencies;

In addition, because the partially completed Bureya hydro power station is of particularconcern to the Government and to RAO, the advisor will develop detailed terms of referencefor further work which is needed in order to provide a bankable feasibility study of the projectand will, through a competitive process, contract with a suitable group of qualified consultantsto carry out the work necessary to complete the feasibility analysis of the project. Thisfeasibility analysis would also be financed under the World Bank loan.

Task 3: Development of a Project Financing Plan:

* examine possible sources of financing for key projects now in the development program, asidentified by management, including but not limited to internal cash generation, commer-

- - Appendix 3

Page 1 1

cial or development bank financing, and private equity participation (domestic and/orforeign);

* identify possible barriers to accessing sufficient capital to carry out the proposed projects,and suggest ways in which these barriers might be overcome;

* consider the implications of the proposed new sector structure on both the ranking ofinvestment projects and on the potential sources of financing.

As part of this task, the advisor will also be expected to assist RAO in developingprinciples for pricing of generation and transmission services, which will form the basis fordiscussions with the regulatory agencies.

Task 4: Investment Planning Procedures: Assist in developing a comprehensive andsystematic set of procedures for the preparation and evaluation of 'bankable' investmentprojects, and ensure that the staff of RAO's investment division fully understand theseprocedures and can implement them in the future. Preparation and evaluation proceduresshould include:

* preparation of market forecasts, including analysis of price elasticity;

* least-cost evaluation of alternative resources available to meet demands (including bothdemand-side and supply-side options);

- enviromnental impact assessment and development of mitigation plans;

- detai]Led planning, scheduling and cost estimating;

- project risk analysis and risk mitigation planning;

3 evaluation of project financial viability;

• development of financing plans;

* cash flow and rate-of-return analysis;

* development of implementation plans.

In addition, as RAO management is decentralized, the advisor shall assist the headquar-ters staff to develop, train and monitor the Economics and Investment staff within each majorRAO business unit.

TIMINGr

The advisor would be expected to begin work within four weeks of the signing of thecontract. Task 1 should be substantively completed within one month of commencing work.The preliminary ranking of investment projects and the financing plan should be completedwithin a nine-moiith period from project inception. Overall, the expected duration of theassignment is expected to be one year.

Appendix 3 - 52 -

Page 12

STAFFING

The advisor is expected to fully utilize the resources available within the RAOorganization to assist both in data collection and analysis of the investment program.

REPORTING

The advisor would be accountable to the Chairman of the Board of Directors of RAO,or to any individual(s) within the company whom the Chairman designates as his representa-tive for purposes of particular Tasks. The advisor should also be aware of the parallel effortsthat will be under way as part of the overall program of support for the reform and restructur-ing process, and should ensure that he both coordinates with other teams and makes use of theresources available for such tasks as the development of training programs, and the corporati-zation of other power sector operating entities.

- Appendix 3Page 13


DRAFT TERMS OF REFERENCEPUBLIC PARTICIPATION AND COMMUNICATIONS

BACKGROUND

In 1992, the Russian Government carried out a partial restructuring of the powersector, establishing RAO EES Rossii (RAO) as a nation wide holding company for governmentstakeholdings in generation, transmission and distribution assets. At the same time, localdistribution companies (Energos) were established in each region, retaining ownership of thesmaller generating plants, and supplying both electricity and heat, on a monopoly basis, tofinal consumers. While the industry structure has successfully maintained reliable powersupply during a difficult economic period, a number of deficiencies have come to light withrespect to the manner in which the sector now operates. These include high operating costs,inadequate cash generation, and inadequate investment to meet current and expected needs. Inorder to address these shortcomings, the Government has adopted a concept for the reform andrestructuring of the power sector and has requested a loan from the World Bank to financetechnical assistance in support of further developing and implementing a restructuringimplementation plan. A Supervisory Board on Electricity Reform has been established underthe First Deputy Prime Minister in charge of Natural Monopolies, to provide oversight andpolicy guidance to the process. In addition, an Electricity Reform Implementation Unit(ERIU) is being established to manage the review and implementation process, and at the sametime to manage the technical assistance which will be provided.

I'he scope of the reform and restructuring concept is extensive, involving substantivechanges in the way in which the sector operates and sector participants interrelate with eachother, customers, and the general public. Considerable effort will be required to ensure thatinformation regarding the process is disseminated in a timely and accurate manner, that allinterested parties have an opportunity to put forward their concerns and viewpoints, and aresatisfied that their viewpoints have been taken into account. To provide support to thisprocess, the services of an advisor on public participation and communications are required.

OBJECTIVE

The objective of this assignment is to assist the ERIU in the design and execution of acomprehensive communications and public participation process, aimed at ensuring thatinterested parties are adequately informed about the reform and restructuring process and havean opportunity to participate in a timely and effective manner.


SCOPE OF WORK

The selected Advisor would work with the ERIU, and with other agencies as required,to provide support in all aspect relating to communications and public participation. Specificduties would include, but are not limited to, the following:

Support to the ERIU:

* Develop a communications strategy for each stage in the development and implementationof the reform plan;

* In consultation with the ERIU Director, develop an overall budget for the communicationsprogram;

* Develop a mechanism for regular media briefings and consistent response to all mediainquiries and assist in the preparation of briefing materials;

* Target and organize specific campaigns aimed at opinion makers;

* Manage a crisis team that deals with high-visibility events which require fast, definitiveand credible responses;

* Conduct regular public opinion surveys and adjust the communications strategy appropri-ately.

Coordination Among Parties:

* Stay abreast of the work of each of the other agencies involved in the reform process andwith their advisors, in order to provide accurate information to the public;

* Create an interactive internet web-site to disseminate news, documents, data, and reports toall interested parties, including consumers, employees, government agencies, creditors,investors, and the mass media;

* Assist in the dissemination of lessons learned and information gained from early stages ofthe restructuring process (for example, with the initial groups of local regulators, sectorcompanies, and administrations) to other regions.

Participatory Process:

* Assist the Federal and Regional Energy Commissions in designing and establishinghearings processes which adequately provide for public input;

* Assist the local administrations in their communications efforts and ensure they are keptabreast of the reform processes.

TIMING

The advisor would be expected to begin work within four weeks of the signing of thecontract. The overall duration of the technical assistance program is approximately two years.

-~ 55 -Appendix 3

Page 15

The advisor would be expected to maintain a continuous presence in Moscow throughout theproject wiith additional staff mobilized as appropriate during periods of peak activity.

STAFFING

The advisor should be prepared to nominate a full-time Communications Coordinator towork with the Director of the ERIU on an ongoing basis throughout the duration of theassignment. The Coordinator would be responsible for mobilizing other staff as required in anefficient and cost-effective manner and ensuring that necessary specialized skills are availableas needed. The Coordinator should be experienced in managing broadly targeted publicinformatiion programs, and also in organizing and executing programs for public participation.The advisory team should include individuals or groups with experience in media relations,public relations, survey design and execution, and the design and execution of participatoryprograms. Experience in managing public participation with respect to regulatory processeswould be desirable.

REPORTING

The advisor team would be accountable to the Director of the ERIU. The advisorwould be expected to provide monthly reports on activities carried out during the previousperiod, and on the proposed work program for the coming period, including a status report onexpenditures to date, on proposed expenditures during the coming period, and on expendituresand activities relative to the budget for the program.

Project ImplementatIon ScheduleInception through June 1998

Activity May-97 Jun-97 Jul-97 Aug-97 Sep-97 Oct-97 Nov-97 Dec-97 Jan-98 Feb-98 Mar-98 Apr-98 May-98 Jun-98

Project Development Activities (PDL)Estiblish ERIUPriority Forensic Accounting, FEC supportScoping of detailed work programs in focal areas(accounting, investments, legal, communications,wholesale market operator. FEC support)

TOR/Bidding for Implementation AdvisorPolicy Review (with Expert Panel)

Loan Approval v

Loan Effectivenes *

Project Implmentation - Phase IRAO Corporatization Support (accounting,

investments, personnel) -

Ongoing bilateral support for FEC, Energos, RECs, -

RAO corporate finance, wholesale market operatorEvaluation/Refinement of Reform Comcept(assisted by Policy Advisor. Expert Panel)

Finalize Market Structure, Refonm Plan

Project Implementation - Phase 11Refine scopes of work for sector enterprises based

on final Reform Plan/Market StructureContract enterprise advisors, advisors on cross-

cutting issuesCorporatization/restructuring supportBegin dissemination of lessons learned from pilot

regions to other Energos and RECs

Project Implementtiaon - Phane IIReogranization of generating companiesIntroduction of competitive markets where feasibleDevelopment and execution of privatization plansContinued institutional support for sector entities

Appendix 5Procurement Schedule (first year of project)

Category Estimated ProcurementCost (USD) Method _ Major Activities

Issue of Bids Contract DeliveryDocuments Submission Signature Complete

Establishing ERItConsulting Services - year one 790,000 SL 6/97 7/97 8/97 6/98Office Equipment 150,000 NS 8/97 9/97 9/97 1/98

Expert Panel * SS 7/97 8/97 9/97 ongoing

Priority AdvisorsManagement & Coordination

General Coordination and Management 1,400,000 SL 6/97 7/97 8/97 12/99Advisor

Special Services Consultants 800,000 SL 8/97 10/97 11/97 12/99

RAO - Financial and AccountingSystem Analysis and Design Advisor 1,920,000 SL 6/97 8/97 9/97 12/99System Implementation 760,000 SL 8/97 10/97 11/97 6/00

RIAO -Economics and InvestmentGeneral Advisor 2,800,000 SL 6/97 8/97 9/97 12/99

Public Participation & CommunicationGeneral Advisor 550,000 SL 8/97 10/97 11/97 6/99 >

Policy AdvisorsGeneral Advisors 1,710,000 SL 8/97 9/97 10/97 12/99Policy Analysis 300,000 SL 8/97 9/97 10/97 12/98

Category Estimated Procurement Cost (USD) Method Major Activities CD

Issue of Bids Contract Delivery °Documents Submission Signature Complete S (

Other Lead AdvisorsRAO Recruitment and Personnel 800,000 SL Commencing 10/97Compensation 'Advisor 540,000 SL Commencing 10/97Training Advisor 660,000 SL Commencing 10/97Legal Advisors 740,000 SL Commencing 10/97Wholesale Market Operator Advisors 250,000 SL Commencing 12/97Regional Energy Commission Advisors 1,150,000 SL Commencing 12/97Federal Energy Commission Support 400,000 SL Commencing 12/97Regional Energo Advisors 1,350,000 SL Commencing 2/98Ethics Advisors 750,000 SL Commencing 2/98Downsizing and Social Assistance Advisor 675,000 SL Commencing 2/98Transmission Network Advisor 1,300,000 SL Commencing 2/98Generation Company Advisor 2,150,000 SL Commencing 2/98

EquipmentRAO Accounting - Computers, Software, 825,000 NS Commencing 12/97Communications oWholesale Market Operator - Computers, 250,000 NS Commencing 1/98Software, CommunicationsRAO Economics - Computers. Software 325,000 NS Commencing 3/98REC - Computers, Software, 350,000 NS Commencing 3/98CommunicationsRegional Eenrgos - Computers. Software 500,000 NS Commencing 3/98

* Monthly cost will depend on individual's rates and on frequency of meetings/review sessions. Estimated to average $15,000 per panelist per month, including expenses.SL - ShortlistSS - Sole SourceNS - National Shopping

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Report No.: T 7126 RUType: TAN