Azerbaijan Energy Assistance Program

1. Azerbaijan Energy Assistance Program Heating Strategy for the Republic Of Azerbaijan PA Consulting Group. Presenter: Natalia Kulichenko Institutional Reform in the Heating Sector in Eastern Europe and the Former Soviet Union International Conference, Baku, Azerbaijan October 21, 2005

2. Presentation Outline • Heating Strategy Objective and Methodology • Current State of Heating Infrastructure • Current and Projected Heat Demand in Azerbaijan • Employed Tariff Methodology • Heat Sector Related Energy Legislature • Heating Sector Organizational Structure • Financial Performance of Heating Enterprises

3. Presentation Outline (continued) Strategy Recommendations: • Cost of Different Heating Options • Heating Sector Organizational Structure • Commercialisation Plans • Condominium Development • Tariff Regulation and Tariff Calculation Methodology • Action Plan

4. Heating Strategy Objective and Methodology • Strategy objectives are to provide recommendations: • To improve heating system operation and maintenance through institutional strengthening • To improve quality of heat supply and reliability of heat delivery services through involvement of private sector • To encourage implementation of energy conservation measures through financial and regulatory incentives

5. Heating Strategy Objective and Methodology • Methodology: • Assessment of current state of heating infrastructure in major urban dwellings and typical rural areas. • Development and calculations of current and projected heat demand in Azerbaijan including fuel types • Financial and economic analyses of two major heat supply companies in Azerbaijan • Analysis and recommendation on enhancement of existing heating sector related legislature, and institutional structure • Analysis and revision of currently applied heat tariff methodology • Cost assessment of different heating options

6. Current State of Heating Infrastructure • Baku City: • Current supply to consumers connected to central heating systems: 53.6% of residential buildings, 75.3% of schools, 49.3% of kindergartens, 84% of medical institutions. • 80% of residential buildings can not be supplied with heat due to unrestorable deterioration of internal distribution pipeline networks • Heating systems are not served with sufficient gas pressure and water supply so that the systems can not operate at design capacity

7. City Education Health Kindergartens Building Others Design Supplied Design Supplied Design Supplied Design Supplied Design Supplied Ganja 36 1 10 3 8 285 25 Sumqayıt 54 3 43 9 65 3 1276 44 Mingechevir 18 20 2 19 324 46 Total 108 4 73 14 92 3 1885 114 Current State of Heating Infrastructure Other Cities of Azerbaijan

8. Breakdown of Heat Demand in Urban Areas Breakdown of Heat Demand by Regions Nakhchivan 1,069.3 Baku 20000,0 6,1% 3,751.3 21,3% 15000,0 thsd. Gkal 10000,0 Sumgait 572.2 5000,0 3,2% 0,0 RS IS RS +IS 13941,0 3676,5 17617,5 Gandja Total 549.9 2801,6 949,7 3751,3 Baku 3,1% Other 1,1511.6 Mingechevir 868,9 200,4 1069,3 Nakhichevan 65,3% 163.2 10270,5 2526,4 12796,9 0,9% Others DEMAND FOR RESIDENTIAL AND INSTITUTIONAL BUILDINGS • Objective • To identify the existing heat demand of residential and institutional buildings • To select and investigate factors affecting heat demand, and design heat demand projections

9. HEAT DEMAND PROJECTIONS FOR RESIDENTIAL AND INSTITUTIONAL BUILDINGS • Projected: • Population growth - • GDP according to MED - • Residential areas - I

10. RESIDENTIAL AND INSTITUTIONAL HEAT DEMAND IN THE NAKHCHIVAN AR

11. Heating Modes Used in 1990 Gas 25.4% Heating Modes Usedin 2002 Electricity 5.5% Wood 2.8% Electricity 35,0% Diesel Other Kerosene 10,2% 0,4% 7.7% Coal Other Wood 3,1% 4.9% 2,6% Biomassa Gas Centralized Heat 0,1% 30,6% 21,1% Centralized Heat 61.4% BREAKDOWN OF FUEL TYPE USED FOR HEAT SUPPLY IN THE RESIDENTIAL AND NON-RESIDENTIAL SECTORSIN 1990 and 2002

12. PRIMARY FUEL TYPES USED IN THE HEATING SECTOR

13. Primary Fuel Types in 1990 Primary Fuel Types in 2002 Wood Kerosene Coal Diesel Fuel Furnace Oil 2,78% Wood 4,90% 0,35% 10,22% 3,94% 2,65% Furnace Oil Biomasse 0,62% Mazut 0,07% 9,61% Mazut 14,14% Gas 78,76% Gas 71,96% PRIMARY FUEL TYPES USED IN THE HEATING SECTOR

14. AZERBAIJAN’S HEAT SUPPLY SCHEME BAKU CITY’S HEAT SUPPLY SCHEME SCCA Nakhichevan SCCA Nakhchivan Heating Utility Department Executive Power of Baku City Azerenergy SC Various ministries and agencies Heating Utility Department HEATING DEP Garadakh HC HC #1 HC #2 CHPP-1 CHPP-2 Regions and towns 1,2,..., 63 Regions and towns 1,2,3,4,5 Subordinate boilerhouses Private boiler houses Boiler houses for residential blocks and distributions networks DBH, Boiler housefor residential blocks and distri-butions networks Private consumers C o n s u m e r s EXISTING INSTITUTIONAL STRUCTURE OF AZERBAIJAN’S HEAT SUPPLY SYSTEM

15. Heating Sector Related Energy Legislature Three different laws generally govern the construction or operation of facilities used for the generation, transmission, distribution, or sale of thermal energy: • Law on Power Engineering (adopted April 1998) • Law on Energy (November 1998) • Law on Electric and Thermal Power Plants (March 2000)

16. Heating Sector Related Energy Legislature (continued) Law on Power Engineering requires license applications to include: • A description of the proposed activity (Article 5). • Documents reflecting the applicant’s qualifications (Article 5). • Documents from the Ministry of Labor and Social Protection attesting to the license applicant’s compliance with laws and rules relating to the health and safety of employees (Article 5). • An analysis of how the proposed activity will effectively meet demand for heat (Article 7). • A statement of how the applicant will limit adverse effects on the environment and on historical and cultural values (Article 7). • Relevant technical and financial information, although the law does not define the details of such information (Article 7). It is not clear whether the Law requires a license for the restoration to service of existing heating facilities. The government interprets the Law on Power Engineering (and related laws) not to require a license for state-owned facilities because the law should not require the government to issue a license to itself. Under this interpretation, no license would be required for rehabilitation of facilities by the government.

17. Heating Sector Related Energy Legislature (continued) Law on Energy: • The Law on Energy duplicates the licensing requirements of the Law on Power Engineering • It imposes some different standards on the licensing process • The Law on Energy, read together with the Law on Power Engineering, creates at least one issue: which should come first, the Energy Contract or the license?

18. Heating Sector Related Energy Legislature (continued) The Law on Electric and Thermal Power Plants: Article 5.1 of the law also provides that the MFE may only issue a license for a new power plant if: • The plant will meet customer demand with due regard for quality, quantity, reliability, and timeliness of service; and • The price for energy will be lower than the prices established by other suppliers. The first of these criteria would require any prospective licensee to show a market for heat energy and that it will supply an appropriate amount of heat reliably. The second criterion apparently requires the prospective licensee to offer heat at a price lower than the prices of existing suppliers for heat energy, perhaps including electricity.

19. Financial Performance of Baku Heating Company 1 Key financial indicators: 2003 net losses 9,143.8 mln manat Accumulated deficit at Dec 31, 04 47,420.5 mln manat Total Assets 54,311.7 mln manat Receivables 24,431 mln manat (45% of total assets) Total Liabilities 61,371 mln manat Payables 54,432.1 mln manat (89%) Operating income (Ths AZM/Gcal sold) negative 30.69 Net Income (Ths AZM/Gcal sold) negative 34.24

20. Financial Performance of Baku Heating Company 1 (continued)

21. Financial Performance of Baku Heating Company 2 Key financial indicators: 2003 net losses 8,530.5 mln manat Accumulated deficit at Dec 31, 04 51,184.4 mln manat Total Assets 59,302.3 mln manat Receivables 13,849.3 mln manat (23% of total assets) Total Liabilities 45,859.7 mln manat Payables 43,451.3 mln manat (95%) Operating income (Ths AZM/Gcal sold) negative 31.47 Net Income (Ths AZM/Gcal sold) negative 35.73

22. Financial Performance of Baku Heating Company 2 (continued)

23. Analyzed Heating Options Centralized Heating (inc. rehabilitation): • Average Large HOB (ROK) • Average Medium HOB (district HOB or ROKs) • Average Small HOB (quarter or block) Solar panels (calculated separately for Nakhichevan and Baku-Absheron regions): • Solar with additional gas heater • Solar with additional electric heater • Solar with additional diesel heater

24. Analyzed Heating Options (continued) Boiler for 1 apartment building Boiler for 2 apartment buildings Individual gas boiler (for one apartment) Individual gas heater Individual electric heater Coal heater Kerosene heater Diesel heater Biomass heater Wood heater Liquefied petroleum gas heater

25. Cost of Heating Options (manats, per one m2 in 2003, ascending order)

26. Cost of Heating Options (manats, per one m2 in 2009, ascending order)

27. Heating Sector Restructuring • Heating Companies should be converted to municipal holding companies with ownership rights on assets • Some of bad debts, more than 3 years old, should be written off • Accounts receivable should be inherited by new municipal enterprises • A plan for management/lease of smaller parts of the system to be made by September 2004 • The parts that can not be taken over by management/lease contractors will continue to be municipal operation companies • The municipal companies must supply heat to a reduced consumer base • VAT should be charged at the point of actual sale

28. AZERBAIJAN’S HEAT SUPPLY SCHEME Government MFE BAKU CITY’S HEAT SUPPLY SCHEME Municipality JSC HC #1 JSC HC #2 JSC Gandjaheat JSC Sumgaitheat JSC Mingechevir heat Regions or towns 1 Regions and towns n Private boiler houses C o n s u m e r s Private consumers PROPOSED INSTITUTIONAL STRUCTURE OF AZERBAIJAN’S HEAT SUPPLY SYSTEM

29. Criteria for Selecting Smaller Parts of Heating Systems for Private Operation/Management • Completely autonomous operation of boiler houses • Satisfactory technical condition • Collection rates are above the average statistical level, consumer’s ability to pay is satisfactory • Attractiveness for future investors • Technical opportunities to connect new consumers • Availability of water and gas supply

30. Heat Sector Restructuring (continued) Municipally owned companies have to be managed according to the following rules: • Sign new contracts with all future customers -- contracts must specify performance from the supplier side (quantity and quality of heat supply) and from the customer side (maintenance of internal piping, timely payment etc.), sanctions due to non-compliance and their enforcements mechanisms • All contracts must be drawn up with legal entities in a way that makes it feasible to cut supply if people do not pay (e.g. with condominiums for the supply to a whole building) • Partial pre-payment are required from all customers in order to supply buildings • All heat supply must be metered and heat sold on Gcal basis (meters shall be paid for by customers but to introduce a subsidy scheme) • Fixed tariff to cover at least 25% of total costs/variable tariff to reflect marginal cost of supply • Heating amount must be flexible --- people only have to buy what they need (if valves not installed then agreements could be made on lower supply temperature, shorter supply season and cutting out a number of radiator strings).

31. Liberalization of Heating Market • Autonomous systems (block-level boilers that are only connected to one or a few buildings) should be promoted throughout the urban areas • Individual natural gas should be promoted to the extent that it is economical and safe • In Nakhichevan – focus on building autonomous boilers while promoting solar alternatives; installation of electric boilers until gas supply is restored

32. Role Condominiums Heat Supply • A collective organization of consumers is necessary for collective heat supply because of the inflexibility of current system design • Condominiums can offer a long-term solution to the problem of housing maintenance (not only heating) • Proper support mechanisms (legal and others) condominiums are to be an effective solution for managing buildings and communal services • Adopt condominium legislation to address the following points: • ·        Condominium charter to provide clear rules and guidelines for collective heat supply • ·        Legal access to apartments in cases of non-payment • Transfer of ownership of all common areas from municipalities to condominiums

33. Support Programs for Condominiums and Private Boiler Owners/Operators • Condominiums • Financial support (condominium lending schemes working through credit lines in local banks) • Support for poor families • Legal support (standard contracts, streamlined procedures etc.) • Information campaigns • Training of condominiums (contract issues, building energy efficiency measures) • Implement pilot projects • Private Boiler Owners/Operators • Boiler lending schemes to be established targeted at small private entrepreneurs who want to operate/own boiler houses and sell heat to condominiums.

34. Customer group Space Heating Monthly Tariffs (AZM) Hot Tap Water Monthly Tariff (AZM) m2 m3 Per person 1Gcal Residents 250 -- 700 Organizations financed from central and local budgets 600 96,000 Commercial enterprises including state owned enterprises 1,100 96,000 Industrial enterprises 1000 n/a Heat Energy Tariffs

35. Heat Energy Tariffs (continued) • The Tariff Calculation Methodology adopted by the Tariff Council in October 2002 is a variation of a unified system of setting tariffs for utilities and communal services employed back in the Soviet times. • The Methodology defines the tariff as the amount of a standard cost of a predefined structure at standard profitability per service unit. • The following formula was used to calculate a so-called average selling tariff: T = Cn x F, where:Cn - Standard cost of calculated unit of service F - Standard profitability factor. • The standard cost of service is based on actual costs for the preceding year. • The standard profitability is set by a respective decision-making body (so it does not matter as to relative to what this figure is set - relative to the cost of service or the value of fixed assets • The tariff calculated under such methodology does not encourage economical use of resources, track demand and supply fluctuations or take into account inflation processes • It varies among customer groups.

36. Heat Energy Tariffs (continued) Economic tariffs are based on the following: • Service cost is calculated by components defined in the Guidelines for Calculating Tariffs for Public Utilities (October 2002) prepared by MED, but based on substantiated technical standards • Profit is calculated through determining enterprise's financial needs for functioning and developing its production and social sphere. • The amount of profit is planned -- required investments and defined shares of investments that will be financed out of enterprises own funds, other payments that are covered out of profit The value of tariff (Т) is calculated by formula: T = C + P , where:C - Planned cost of a unit of service according to standards;P - Planned profit, per unit of service sold. Economic tariffs reflect the realistic level of a balanced price of supply and demand: • Demand is defined by needs of quantity and quality of heat services with the consideration for customers' paying ability • Supply characterizes the level of a tariff that ensure recovery of heating company’s expenses including capital investment.

37. Technical Improvements • Short term – government and donor support to repair building internal pipeline networks and install meters. Each municipal joint stock company should prepare an investment priority plan to start restoration of heating system elements • Medium term – install individual control, e.g. bypasses, valves and cost allocators, and implement simple demand side management measures (apartment and building insulations). Cost can be shared with condominiums

38. Regulatory Requirements • Large systems (presumably municipally owned) need to be regulated (monopolies) • Smaller systems need to comply only with technical standards (safety, fire, etc.) • Cost of heat supply (tariff setting) for small systems is a matter between supplier and consumers • Regulated systems use a combination of fixed/variable tariffs (two-part tariff) • Technical certification of equipment should be required

39. Social Protection Scheme • Targeted social support schemes to enable the poorest to take part in collective heat supply contracts • The schemes are to replace indirect across-the-board subsidies to district heating prevalent to date • The targeted subsidy for poor families should cover at least the fixed part of the two-part tariff

40. Implementation (continued) On the local authority level: • Develop local energy master plans and define best locally suitable heating options • Develop approval procedures for tariffs and new connections • Create favourable investment and business environment • Promote creation of condominiums On the central government level: • Preparation of legislative drafts for creation of JSCs; asset ownership transfer to local authorities; development of condominiums • Budgetary allocations to maintain heating infrastructure for the next heating season • Allocate/seek funding for pilot projects

41. Implementation Cost of implementation is locally driven On the company level: • Initiate asset inventory with issuing technical passports • Review management structure with separation of core businesses from non-core • Development business plans to maximize effectiveness of core business and outsourcing of auxiliary activities • Review and record accounting and cost allocation practices

42. Household Survey • Objectives: • Determine potential demand for district heating services in major cities of Azerbaijan • Estimate tariff levels affordable for the population and economically viable for utilities • Develop a methodology to be used in similar studies

43. Findings • Increases in district heating tariffs make the service less attractive up to the point when it is comparable with electricity tariffs • Poor urban households are more sensitive to the tariff change than non-poor urban households in Azerbaijan • Tariff rises are linearly related to utility revenue increases

44. Household Responses

45. Household Responses(continued)

46. Findings Based on survey data an econometric model developed to: Estimate demand for district heating service Simulate revenues for district heating utilities at different tariff levels • Simulation of revenues showed that utility can increase its sales revenues through raising tariffs only up to a certain critical level. At this critical level sales revenues are maximized, and any further tariff increases eventually decrease potential revenues Find the tariff levels that would maximize the revenues of the utilities

47. Findings (continued)

48. Findings (continued)

49. Further Studies

50. Further Studies(continued)