Report and Recommendation of the President to the Board of Directors

Sri Lanka Project Number: 40061 February 2010

Proposed Loan and Administration of Loan and Grant Republic of Indonesia: JavaBali Electricity Distribution Performance Improvement Project

CURRENCY EQUIVALENTS (as of 13 January 2010)

Currency Unit rupiah (Rp)

Rp1.00 = $.0001090156

$1.00 = Rp9,173

ABBREVIATIONS ADB Asian Development Bank AFD Agence Franaise de Dveloppement ASEAN Association of Southeast Asian Nations CDM Clean Development Mechanism CER certified emission reduction CFL compact fluorescent lamp CMI Carbon Market Initiative CO2 carbon dioxide DGEEU Directorate General for Electricity and Energy Utilization EBITDA earnings before interest, taxes, depreciation, and amortization EIRR economic internal rate of return EURIBOR Euro interbank offered rate FIRR financial internal rate of return IEA International Energy Agency IPP independent power producer IRSDP Infrastructure Reform Sector Development Program LED light-emitting diode LIBOR London interbank offered rate PLN PT (Persero) Perusahaan Listrik Negara (State Electricity

Corporation) PSO public service obligation SAIDI system average interruption duration index SAIFI system average interruption frequency index UNFCCC United Nations Framework Convention on Climate Change WACC weighted average cost of capital

WEIGHTS AND MEASURES GWh (gigawatt-hour) 1,000 megawatt-hours kilovolt-amperes kVA kW kilowatt kWh (kilowatt-hour) 1,000 watt-hours MVA megavolt-amperes MW (megawatt) 1,000 kilowatts MWh (megawatt-hour) 1,000 kilowatt-hours tCO2eq ton of CO2 equivalent

NOTES

(i) The fiscal year (FY) of the Government and its agencies ends on 31 December. (ii) In this report, "$" refers to US dollars.

Vice-President C. Lawrence Greenwood, Jr., Operations 2 Director General K. Senga, Southeast Asia Department (SERD) Director A. Jude, Energy and Water Division, SERD Team leader S. Hasnie, Principal Energy Specialist, SERD Team members D. T. Bui, Economist, SERD R. Butler, Social Development Specialist (Resettlement), SERD R. Kausar, Infrastructure Specialist, SERD M. Sultana, Senior Social Development Specialist, SERD Y. Tsujiki, Financial Analysis Specialist, SERD S. Tumiwa, Principal Planning and Coordination Specialist, Regional

and Sustainable Development Department S. Zaidansyah, Counsel, Office of the General Counsel

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS

Page LOAN AND PROJECT SUMMARY i

I. THE PROPOSAL 1

II. RATIONALE: SECTOR PERFORMANCE, PROBLEMS, AND OPPORTUNITIES 1 A. Performance Indicators and Analysis 1 B. Analysis of Key Problems and Opportunities 2

III. THE PROPOSED PROJECT 8 A. Impact and Outcome 8 B. Outputs 9 C. Investments 10 D. Special Features 12 E. Project Investment Plan 13 F. Financing Plan 13 G. Implementation Arrangements 14

IV. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 18 A. Financial Analysis 18 B. Economic Analysis 18 C. Environmental Benefits and Social Safeguards 18 D. Sustainability 19 E. Risks 19

V. ASSURANCES 19

VI. RECOMMENDATION 21

APPENDIXES 1. Design and Monitoring Framework 22 2. Climate Change and Indonesia 24 3. Power Sector Analysis 26 4. Analysis of Tariffs, Subsidies, and Sector Road Map 30 5. Development Coordination 35 6. Detailed Cost Estimates 38 7. Implementation Schedule 39 8. Procurement Plan 40 9. Outline Terms of Reference for Consultants 46 10. Financial Performance and Projections of PLN 48 11. Financial Analysis 52 12. Economic Analysis 55 13. Summary Poverty Reduction and Social Strategy 60

SUPPLEMENTARY APPENDIXES (available on request) A. Diagnostic Study of the Indonesian Power Sector B. Strategic Road Map of the Indonesian Power Sector C. Technical Assessment of the PT Perusahaan Listrik Negara's Distribution Network D. Methodology for Benefit Assessment of Energy Efficiency in Distribution E. Indonesian Power Distribution Development Strategy F. Concept Paper for Energy Efficient Lighting Pilot G. Preliminary Clean Development Mechanism Assessment Report

LOAN AND PROJECT SUMMARY Borrower Republic of Indonesia Classification

Targeting classification: General intervention Sector (subsector): Energy (energy efficiency and conservation) Themes (subthemes): Economic growth (promoting economic efficiency and enabling business environment), environmental sustainability (eco-efficiency), capacity development Climate change: The Project contributes to climate change mitigation. Location impact: Rural (medium), urban (low), national (medium) Partnership: Agence Franaise de Dveloppement (AFD)

Environment Assessment

Category C: The environmental implications were reviewed and no adverse impacts were identified.

Project Description The Project will reduce the overall carbon dioxide (CO2) emissions

of Indonesia's power sector and contribute to the global effort of mitigating the impact of climate change. This will be achieved by saving energy, increasing capacity, deferring distribution capacity expansion by distribution network rehabilitation, and reducing peak demand from use of efficient lighting by residential customers. The efficient lighting program will pilot the use of 500,000 compact fluorescent lamps (CFLs) and light-emitting diodes (LEDs) in selected isolated and islands grids.

Rationale Indonesia ranks among the top 20 polluters in the world. The country's CO2 emissions per capita have grown significantly since the 1980s, a large part of which is from the burning of oil. Emissions will get worse in the short term, as the Government plans to rapidly expand the use of coal for power generation to reduce its reliance on imported oil. The Government's energy conservation and energy efficiency initiatives will offset part of these emissions, and these efforts need to be part of mainstream planning to have larger impact. PT (Persero) Perusahaan Listrik Negara (State Electricity Corporation [PLN]), the state-owned power utility, has invested in energy efficiency projects for its power distribution, which has reduced overall distribution losses and CO2 emissions. To maintain the momentum, PLN has an ambitious plan to invest about $1.2 billion in distribution between 2010 and 2014. A large part of this plan will be financed by internal resources, and loans from bilateral and multilateral partners.

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The Asian Development Bank (ADB) will engage with PLN in its overall energy efficiency improvement initiative, with the proposed small Project covering the entire JavaBali network with cofinancing from the Agence Franaise de Dveloppement (AFD). The proposed project components could be implemented within 2 years. If the proposed Project and the partnership in financing is successful, ADB will scale up this operation with a sector project (using a multitranche financing facility) and support part of PLN's financing needs for the energy efficiency strategy. The Projects objective is to reduce the peak load demand and system losses by implementing distribution network rehabilitation and an efficient lighting program that will also contribute towards greenhouse gas reduction. Carbon credits will be sought following the approved methodology of the Clean Development Mechanisms (CDM) executive board. This investment is in line with ADB's commitment to clean energy and energy efficiency across Asia.

About 200 megawatts (MW) equivalent in distribution system capacity will be freed and about 400 gigawatt-hours (GWh) will be saved annually through energy efficiency at a cost well below the cost of developing equivalent new capacity. This will reduce the emissions of Indonesia's power sector by about 330,000 tons (t) each year.

Impact and Outcome The impact of the proposed Project will be reduced CO2 emissions

by the power sector. The outcome of the Project is to contribute to PLN's overall power distribution efficiency and quality of power supply.

Project Investment Plan The investment cost of the Project is estimated at $120.0 million,

including physical and price contingencies, interest and other charges during implementation, and taxes and duties of $9.0 million.

Financing Plan A loan of $50,000,000 from the ordinary capital resources of ADB

will be provided to the Republic of Indonesia under ADB's London interbank offered rate (LIBOR)-based lending facility. The loan will have a 25-year term including a grace period of 5 years, an interest rate determined in accordance with ADB's LIBOR-based lending facility, a commitment charge of 0.15% per annum, and such other terms and conditions set forth in the draft loan and project agreements. AFD will cofinance the Project in the amount of $50 million. The loan will have a 15-year term, including a grace period of 5 years, and an interest rate in LIBOR equivalent to a Euro Interbank Offered Rate (EURIBOR)-flat rate and such other terms and conditions set forth in the draft loan agreement.

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A cofinancing agreement will be entered into by ADB and AFD under which the parties will jointly finance the investment costs. ADB will administer the AFD loan including procurement, recruitment of consultants, and disbursement, according to the cofinancing agreement to be signed. A grant from the Clean Energy Fund under the Clean Energy Financing Partnership Facility will be provided to PLN in the amount of $1.0 million equivalent to be administered by ADB. PLN will finance $19.0 million of the Project costs, including all local taxes and duties.

Financing Plan

($ million) Source Total % Asian Development Bank 50.0 41.67 AFD a 50.0 41.67

Multi-Donor Clean Energy Fund under the Clean Energy Financing Partnership Facilityb

1.0

0.83 PT (Persero) Perusahaan Listrik Negara

19.0

15.83

Total 120.0 100% a Agence Francaise de Dveloppement. b Established by the governments of Australia, Norway, Spain, and Sweden; and administered by ADB.

Source: Asian Development Bank estimates. Allocation and Relending Terms

Under a subsidiary loan agreement that will be on terms and conditions satisfactory to ADB and AFD, the Government will relend to PLN the proceeds of the ADB and AFD loans.

Period of Utilization November 2012 Estimated Project Completion Date

May 2012

Implementation Arrangements

PLN will be the executing agency and has overall responsibility for the implementation of the Project. PLN will appoint the deputy director for distribution and commercial for JavaBali to supervise the implementation of the Project. The deputy director for distribution and commercial for JavaBali will appoint a project director who will be supported by qualified staff. In each of the five participating regions, the existing technical staff of PLN will implement the Project. The regional manager will appoint a project manager who will be supported by several technical staff. The project managers of each region will coordinate the day-to-day activities through the project director in PLN headquarters but will report to the regional general manager.

Executing Agency PT (Persero) Perusahaan Listrik Negara (State Electricity Corporation or PLN)

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Procurement The Government requested, and ADB management approved, (i)

advance action for procurement of goods and related services, and (ii) retroactive financing for goods and related services. The advance action will cover tendering and bid evaluation up to the stage of ADBs approval of PLN's recommendation for award of contract before the effective date of the loan agreement. The retroactive financing for goods will cover the 12 months prior to the date of the loan agreement with a ceiling of $5 million, or 10% of the ADB loan amount. The Government was advised that ADB approval of advance contracting and retroactive financing does not commit ADB to approve the proposed loan and that ADB financing will be dependent upon the Government's compliance with all aspects of ADB's procedural requirements, including compliance with the relevant provisions of the loan agreement and ADB's guidelines. All procurement to be financed under the ADB and AFD loans and CEF Grant will be carried out in accordance with ADBs Procurement Guidelines (2007, as amended from time to time), and the procurement plan prepared and agreed upon between the Government and ADB. Ten contract packages will be procured under the Project through either international competitive bidding or national competitive bidding. Equipment for the pilot project for efficient lighting will be procured though limited international bidding.

Consulting Services Consultants will be selected and engaged under the Project in

accordance with ADBs Guidelines on the Use of Consultants (2007, as amended from time to time). An international consulting firm will be engaged to manage implementation of the Project. The firm will deliver 105 person-months of consulting services (15 person-months of international and 90 person-months of national consulting) following ADBs quality- and cost-based selection method and using full technical proposal. Individual consultants will deliver 18 person-months of consulting services (6 person-months of international and 12 person-months of national consulting) for implementation of the pilot project for efficient lighting.

Project Benefits and Beneficiaries

The Project will reduce the power sector's CO2 emissions by 330,000 t per year. It will also support registration of the proposed Project with the regulatory authorities to capture the value of the avoided emissions as cash flows under the CDM. The value of the avoided CO2 emissions will be around $3.5 million each year. The proposed Project will improve the efficiency of power distribution in all of its five regions on the islands of Java and Bali. PLN will save energy by reducing its distribution losses and at the same time improve power supply voltage to its feeders in west, central, and east Java.

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Overall, about 400 GWh of electricity will be saved annuallyabout 100 GWh in Jakarta, 40 GWh in central Java, 50 GWh in west Java, 180 GWh in east Java, and 30 GWh in Bali. The value of the 400 GWh of saved power (assuming a marginal cost of $0.15 per kilowatt-hour) is about $60 million each year. About 200 MW of equivalent distribution system capacity will be freed and, using the saved energy, PLN will be able to connect about 1.2 million additional customers to the JavaBali network.

Risks and Assumptions This Project involves no new technology and PLN has all the necessary skills to design and implement the project components, hence risks related to design and implementation are low. Shortage of power generation in the system is another risk, as distribution investment alone will not improve power supply reliability and quality unless there is sufficient power to distribute. However, PLN's efforts in mobilizing financing from both internal and external resources is showing results as about 2,500 MW of additional generation capacity in Java will be commissioned between 2010 and 2012. PLN has also identified a range of specific risks: (i) stronger growth in electricity demand, resulting in overuse of existing equipment (reducing its lifespan); (ii) a worsening financial situation, if revenues are lower than expected because of delays in the payment of subsidies by the Government; and (iii) insufficient investment from independent power producers (IPPs) delaying the much-needed investments in generation. PLN has developed a range of mitigation measures to address these risks, such as (i) planned investments to rehabilitate and optimize the distribution network to reduce overloading and promote demand-side management to reduce demand, (ii) arrangements to raise capital from the domestic market and through borrowings (bilateral and multilateral lenders) so that investments can be implemented in a timely manner, and (iii) introduction of higher tariffs and terms to secure primary energy requirements through long-term contracts, etc.

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on (i) a proposed loan to the Republic of Indonesia, (ii) proposed administration of a loan to be provided by Agence Franaise de Dveloppement (AFD) to the Republic of Indonesia, and (iii) proposed administration of a grant to be provided by the Clean Energy Fund under the Clean Energy Financing Partnership Facility to PT (Persero) Perusahaan Listrik Negara, for the JavaBali Electricity Distribution Performance Improvement Project. The design and monitoring framework is in Appendix 1.

II. RATIONALE: SECTOR PERFORMANCE, PROBLEMS, AND OPPORTUNITIES

2. Indonesia ranks among the top 20 polluters in the world. The country's carbon dioxide (CO2) emissions per capita have grown significantly since the 1980s, a large part of which is due to the burning of oil. As a strategy to reduce its reliance on imported oil, the Government plans to rapidly expand the use of coal for power generation, which will increase CO2 emissions from the power sector. At the same time, the Government has taken initiatives to implement energy conservation and energy efficiency policies to reduce emissions. PT (Persero) Perusahaan Listrik Negara (State Electricity Corporation [PLN]), the state-owned power utility, has invested in energy efficiency projects for power distribution, which has reduced overall distribution losses and CO2 emissions. PLN has an ambitious plan to invest about $1.2 billion in the distribution sector between 2010 and 2014 to further reduce distribution losses and CO2 emissions. A large part of this plan will be financed by loans from bilateral and multilateral partners. 3. The Asian Development Bank (ADB) will engage with PLN in its energy efficiency improvement initiative, with the proposed small Project covering the entire JavaBali network with cofinancing from AFD. If the proposed Project and the partnership in financing are successful, ADB will scale up this operation with a sector project (using a multitranche financing facility) and support PLN's financing needs for pursuing its energy efficiency strategy. This investment will supplement ADB ongoing policy work in the power sector, and will reduce energy sector emission by reducing distribution losses, promoting energy efficient lighting alternatives to customers, and making customers aware of energy efficiency measures. A. Performance Indicators and Analysis

4. Geographically Indonesia is unique with its huge number of islands and vast coastlines. About 65% of the population of Java island lives in coastal regions, and they are therefore vulnerable to the effects of sea-level rise. Indonesian islands are vulnerable to earthquakes and high waves because of their geographic locationbetween two shelves of the Asian landmass and the combined Australian and New Guinean landmass. Indonesia's forest areas are also prone to natural disasters, and events such as volcanic and tectonic earthquakes and tsunamis are fairly common. In addition, the islands are subject to extreme weather events, such as long dry seasons and floods. According to the International Disaster Database (2007), 1 the 10 biggest natural disasters in Indonesia in the last 100 years took place after 1990, and most of these disasters were weather-related: flood, drought, forest fire, and increase of endemic diseases. The Government estimates that the economic losses from the 10 biggest disasters to be about $26 billion, of which around 70% is climate related.

1 Centre for Research on the Epidemiology of Disasters (CRED). 2007. The International Disaster Database.

Available: http://www.emdat.be/

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5. As Indonesia is vulnerable to the threat of climate change, the Government plans to reduce greenhouse gas emissions from the energy sector, and from land use, land-use change, and forestry. Indonesia ratified the United Nations Framework Convention on Climate Change through Act No.6 in 1994, and ratified the Kyoto Protocol through Act No. 17 in 2004. It also plans to invest in carbon sequestration activities. The Government plans to work with its bilateral and multilateral partners to tackle the threat of climate change. 6. According to the World Resource Institute's publication2 in 2007, Indonesias emissions per capita have grown by about 150% since the 1980s, and by about 67% since the 1990s. About 56.5% of annual CO2 emission is from oil burning, 35% is from coal, and 18.5% is from gas. Estimates for annual emissions vary from 250 million tons (t) to 280 million t. The power sector is a major emitter, and this will increase further with the Government's plan to expand the use of coal for power generation. 7. According to a Government study,3 if no effort is made to reduce emissions, total CO2 emissions from the energy sector could reach 1,200 million t by 2025. The Government could significantly reduce these emissions using three simple strategies: (i) energy diversification, (ii) energy conservation; and (iii) implementation of clean technology. The immediate solutions are increased use of renewable energy, energy efficiency, and conservation. According to the National Energy Conservation Master Plan 4 , Indonesia could save about 10%30% of its energy demand through conservation and efficiency measures. A detailed analysis of climate change issues and overall emissions in Indonesia is discussed in Appendix 2. 8. Despite the Government's plan to diversify energy resources and mainstream energy efficiency, it is compelled to build more coal-fired power stations to meet immediate energy demands. These short-term decisions are prompted by the many problems faced by the power sector, some of which are discussed in section B. B. Analysis of Key Problems and Opportunities

1. Key Problems and Constraints

a. Growing Power Demand, Supply Shortage, and Lack of Investment

9. Indonesian electricity demand is growing rapidly; demand growth peaked at about 16% per annum during 19941995, with a maximum demand of about 12,800 megawatts (MW) in 1997. This demand was met by power purchase contracts with independent power producers (IPPs); most contracts were 30-year "take-or-pay"5 agreements in dollars. When demand growth slowed in 1997, these take-or-pay obligations led PLN into a severe financial crisis and, as a result, investments in the power sector fell considerably. New investments have not kept pace with the growing demand for electricity; since 2001, electricity sales have grown by about 7% and the peak demand by 6%, but during the same period PLNs power system grew by less than half of that amountthe transmission network grew by 3.2%, the distribution network grew by 1.7%, and new generation capacity grew by 1.4%. Distribution rehabilitations were delayed. The deferral of rehabilitation has no immediate impact on the distribution system but as investments are delayed (due to budget shortfall), the distribution systems were overloaded and 2 Climate Analysis Indicators Tool (CAIT). Available: http://cait.wri.org/ 3 Republic of Indonesia. 2007. National Action Plan Addressing Climate Change. Jakarta. 4 National Energy Conservation Plan/ Rencana Induk Konservasi Energi Nasional (RIKEN)- Decree No. 100.K 5 A buyer agreeing to buy a fixed quantity of electricity from a generator for an agreed price over a period of time

irrespective of the actual need of the buyer in future.

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losses increased. Because of lack of investments in the power sector, the main islands of Java and Bali are experiencing power outages. With the high demand, the system reserve margin has become smaller, causing frequent load shedding with blackouts lasting for 23 hours each day. In December 2008, the maximum system demand was 15,570 MW (compared with 16,300 MW in 2007) in the JavaBali grid and during the same month PLN had to shed between 80 MW and 860 MW every day from the peak demand. Detailed analysis of the power sector is in Appendix 3.

b. Dependency on Oil and High Cost of Power

10. Oil is one of the most expensive fuels for power generation. As more than 30% of power generation in Indonesia is based on either diesel or fuel oil, the cost of power generation is high. In 2008, PLN's average cost of production was $0.13 per kilowatt-hour (kWh), while the cost of power generation in neighboring countries was between $0.03/kWh6 and $0.11/kWh. Since PLN is fully exposed to the international market price of oil, its reliance on oil also creates large fluctuations in its power generation cost, while the tariff remains fixed.

c. Lack of Incentives and Policy Support for Renewable Energy

11. Indonesia has great potential for renewable energy, especially hydro and geothermal. Solar technologies are becoming more attractive in Indonesia as price of solar panels has come down and panel efficiencies have improved. In addition, there is scope for low-carbon emission energy sources based on coal seam methane and coal mine methane. These sources improve energy security as they are not exposed to international supply or pricing risks. The Government has to provide direct incentives for renewable energy development, so that in isolated off-grid areas and in remote islands, small-scale renewable energy generation could be established, despite its high cost, rather than the ubiquitous stand-alone diesel generation.

d. Lowest Electrification Rate in the Region

12. About 90 million people, or 38% of the Indonesian population, have no access to electricity and most of the rural population relies on biomass for their primary fuel for cooking and kerosene for their lighting needs. Because of the lack of incentives for private investment and shortage of capital for public investment, access to electricity by the Indonesian population remains one of the lowest in the region.

e. Inefficient Lighting Contributing to High Energy Intensity

13. Indonesia's energy consumption per capita is much smaller than it is in both Thailand and Malaysia, while Indonesia's energy intensity is significantly higher than that of its neighbors. Use of relatively inefficient appliances by residential consumers contributes to this. Although electricity consumption by the residential sector varies widely across different income classes in rural and urban areas, on average more than 50% of the electricity is used for lighting by residential customers. Consumers are aware of the benefits of energy efficient compact fluorescent lamps (CFLs), however they continue using incandescent bulbs which are cheaper but consume about five times more energy. Consumers are concerned about the cost and quality of CFLs, but unaware of the quality, standard, or regulated labeling for CFLs. While good quality CFLs can last for 8,00015,000 hours, poor quality ones often fail within 100 hours. When cheap ones fail after a short time, consumers are reluctant to replace them.

6 The average wholesale electricity price in the National Electricity Market of Australia.

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f. Main Cause of the Problems

14. Most problems described in paras. 9-13 stem from the following main causes: (i) low tariffs and high subsidies, (ii) policy gaps as a result of poor coordination and decision making, (iii) barriers to private sector investment and lack of regulatory clarity, (iv) PLN's overall monopoly position, and (v) the absence of a rural electrification strategy and financing. In addition, the Indonesian power tariff is one of the lowest in Asia and, because of the low tariffs, PLN only recovers part of its cost of electricity production and supply from its sales revenue. Electricity tariffs have remained the same7 since 2003, although the cost of supply has more than doubled from $0.056 to $0.132 per kWh during the same period. Since the Government has maintained these low tariffs for social reasons, it provides direct subsidies to PLN to meet the financing gap. In 2008, subsidies to PLN became a major drain on Government budget and reached the all time high of $7.6 billion, increasing from $315 million in 2004. Detailed discussion on tariffs and subsidies is in Appendix 4. The low tariffs and associated subsidies have created a range of disincentives for PLN, consumers, and other stakeholders, leading to the main problems in the sector.

2. Governments Policies and Plans 15. As Indonesia is an oil producing country, the Government has always faced the policy issue of allocating the right amount of oil for local consumption and for export, especially during periods of high prices. For example, after the oil crisis of the 1970s it progressively reduced the proportion of oil for power generation from about 70% in the 1980s to about 54% in 1993 and to 21% in 1998. However, this proportion rose back to about 36% in 2005, and the high domestic consumption made Indonesia a net importer of oil. This prompted immediate policy change, and the Government increased domestic oil prices by 49% in March 2005 and by 105% in October 2005, causing the price of high-speed diesel to triple, from $0.18 per liter in 2004 to $0.55 per liter in 2006. 16. In addition to raising prices, the Government initiated a fast-track program8 to reduce dependency on oil for power generation. Under this program, it plans to develop 10 coal-fired power plants in JavaBali (7,520 MW) and 23 coal-fired power plants outside JavaBali (1,963 MW). A second fast-track program that includes about 60% renewable energy generation will be implemented between 2009 and 2014. These initiatives will address the immediate problems of power shortage, the high cost of power (and dependency on oil), and low use of renewable energy. As a policy support to encourage these investments, in April 2009 the Government issued ministerial decree No.5/2009, which removed the previous price cap of $0.045/kWh for power purchase from IPPs, and gave PLN the exclusive authority to decide on IPP prices. PLN has increased the price for new IPPs to between $0.065/kWh and $0.085/kWh, and since then has acted as a single buyer of electricity from the IPPs. ADB's engagement in the power sector will help the Government to switch to clean coal technologies and renewable energy options for future power generation (discussed in paragraph 29). 17. The overall sector strategy is reflected in the Governments Blueprint of National Energy Management 20052025, which recognizes the high share of oil in the energy mix and dependence on oil imports, and sets the following targets for 2025: to reduce the use of oil to

7 In real terms, the tariffs have actually been reduced by about 50% since 2003, as the Indonesian consumer price

index increased to 161.73 in 2008 from 105.65 in 2003. Source: Statistics Indonesia. 8 Presidential Decree No. 71 of 2006, requiring PLN to invest in new coal steam-fired power plants under its energy

diversification strategy and add about 10,000 MW to address the power deficit.

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less than 20% and increase the use of (i) coal (from 15.7% to more than 33%), (ii) liquefied coal (to more than 2%), (iii) natural gas (from 23% to more than 30%), (iv) geothermal energy (from 1.9% to more than 5%), and (v) biofuels and other renewable energy (to more than 10%). 18. The Government is addressing the issue of lowest electrification in the region in its National Electricity Development Plan, which aims to increase the electrification ratio to 90% by 2020. PLN plans to connect around 10 million new customers between 2010 and 2014 to achieve the Governments commitment to increasing the electrification rate, and has a long list of investment plans with an estimated cost of about $14.4 billion.

3. Opportunities

19. In some respects the power sector in Indonesia has significantly improved in recent years compared to the 1990s and early 2000s. These improvements are in line with broader trends to better economic management and governance in Indonesia. For example, PLN has introduced greater transparency in reporting, established good corporate governance and independent audit, and strengthened financing to support issuance of international bonds. It is also moving from an engineering-dominated culture to one with greater emphasis on other disciplines. For example, losses have been reduced gradually since 2004. In 2007, the gigawatt-hours sold per employee increased to 3.8 GWh from 1.7 GWh in 2002, and the number of customers served per employee increased to 941 from 648 in 2002. PLN has also developed separate accounting reports for the operations of its distribution businesses in geographic regions. Sector issues are discussed in details in Supplementary Appendix A. 20. In relation to energy efficiency, the energy policy currently being developed should set out principles that guide priorities, identify specific areas for immediate attention, and consider budget implications. ADB's sector study recommends the setting up of a separate directorate general for energy efficiency and renewables to lead implementation of the energy efficiency policy. 21. As Indonesias subsidized energy sector contributes to inefficient public spending and impedes investment to modernize the sector, there is a strong economic justification for investing in projects that mitigate climate change. In addition, because the subsidies are linked to world energy (and price shocks), potential carbon payments for emission reductions will not only provide economic benefits but also reduce exposure to oil pricessufficient incentives to promote energy efficiency. 22. PLN is committed to increasing efficiency in its distribution network. During 20042008 PLN invested about $730 million in the JavaBali distribution network, averaging about $175 million each year, except in 2008 when the investment level dropped to about $33 million because of the high price of fuel. Investments were made in electrical equipment and in replacing old equipment that did not meet load specifications. Networks were optimized to meet the changing needs of growing power demand and changing load flow conditions, and to avoid overloading of equipment and bottlenecks in the network. These investments reduced distribution losses. PLN management is committed to reducing distribution losses to 6% (the international norm is 3%5%) by investing about $1.2 billion between 2010 and 2014. In 2008, the distribution system loss was about 8.4%its lowest level everas a result of PLN's network optimization investments since 2003. 23. Through the proposed Project, ADB will establish a partnership with the AFD to support PLN's energy efficiency initiative. It will also bring in expertise and processes to quantify and

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capture the benefit of the avoided CO2 emissions as a financial benefit to the project, and participate in the global efforts to mitigate the threat of climate change. If this approach and partnership is successful and progress is made on implementation of some of the policy recommendations, ADB will scale up this small investment with a sector project for energy efficiency and renewable energy to meet the growing local investment need and to generate the global public good of emission reduction to tackle the threat of climate change.

4. Clean Development Mechanism Credits 24. Under the Kyoto Protocol, the Clean Development Mechanism9 (CDM) was developed to set targets for emissions and create a market for emission reduction with economic value. The CDM allows emission reduction (or emission removal) projects in developing countries to earn certified emission reduction (CER) credits, each equivalent to 1 ton of CO2 and these CERs can be traded, sold, and used by industrialized countries to meet part of their emission reduction targets set under the Kyoto Protocol. Indonesia has large potential to reduce emissions either by energy saving or through energy efficiency. As Indonesia relies heavily on oil and coal for its power production, it is, theoretically, a country with high CDM potential in the Association of Southeast Asian Nations (ASEAN) region. An emission factor of more than 0.8 tons of CO2 per MWh implies that each megawatt-hour of avoided power generation in Indonesia produces about 60% more emission credit than it does in the Philippines, which has an emission factor of about 0.5 tons of CO2 per MWh. Despite this large incentive, according to the database of the United Nations Framework Convention on Climate Change (UNFCCC), as of October 2009 only 24 projects had been registered from Indonesia with the executive board of the CDM and about 224,000 CERs had been issued, indicating that Indonesia had only been able to capture about 2% of the global CDM market.

5. ADB Strategy

25. The developing countries of Asia are gradually developing strategies and programs for both their climate change and adaptation measures. To mitigate energy-associated emissions, energy efficiency improvements and low-carbon and zero-carbon solutions are being adopted. Already, ADB is working with new financing mechanisms and capacity building for energy efficiency improvements, renewable energy, waste to energy, sustainable transport, and other emission mitigation projects. This will be achieved through ADB's clean energy and environment programs, including the Energy Efficiency Initiative, Carbon Market Initiative (CMI), and Sustainable Transport Initiative. 26. ADB has initiated a range of energy programs including the Energy Efficiency Initiative10 to increase the number of clean energy projects in Asia and the Pacific. One of the key components of the program is the CMI, which provides technical support and up-front financing for clean energy projects with greenhouse gas mitigation benefits. The CMI is a value-added service extended to renewable energy and energy efficiency projects in Asia and the Pacific that are suitable for ADB financing. It contributes to ADBs sustainable development efforts by providing additional financial incentives to project developers and sponsors to construct and operate clean energy projects. In Indonesia, ADB provided technical assistance to develop institutional capacity to process and promote CDM projects.11

9 More information is available at http://cdm.unfccc.int/index.html 10 Launched in July 2005, with the aim of investing $1 billion per year on clean energy from 2008 to 2010 11 ADB. 2004. Technical Assistance to the Republic of Indonesia for Institutionalizing the Clean Development

Mechanism. Manila.

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27. ADB has had a long relationship with the Government of Indonesia and PLN. ADB started its lending in 1970 and has financed 30 power projects totaling about $3.4 billion and 36 technical assistance projects totaling about $14 million. The lending has focused on the generation and transmission sectors. ADB Independent Evaluation Department studies for the sector show that ADB has a comparative advantage in providing loans for energy, transport, communications, social infrastructure, and finance projects. The Independent Evaluation Department noted that in the power subsector, with few exceptions, the completed loan projects succeeded in achieving their expected outputs and immediate objectives, including the provision of additional capacity to match load growth, the removal of transmission system constraints, improvement in system efficiency and reliability, increase in the use of indigenous energy resources (hydropower and geothermal), and contribution to socioeconomic development. 28. ADBs country strategy and program for 2006200912 and country operations business plan 2009201113 support a medium-term growth rate of 6% per annum and highlight the importance of removing infrastructure bottlenecks in the power sector and establishing attractive, effective, and transparent incentives for private sector participation. 29. Clean energy and energy efficiency will be the target of ADB's future investments in Indonesia. Investment in the generation sector will be either in the form of publicprivate partnerships (to encourage private sector investments) or through the use of guarantee instruments to mobilize commercial cofinancing that will be limited to renewable energy (hydropower or geothermal power) and efficient thermal power plants14 (with supercritical or ultra-supercritical boiler combined-cycle gas-fired power plants). ADB's involvement will play a catalytic role by attracting other investors. ADB's interest will be limited to strategic transmission investments that will (i) link different islands to reduce the overall need for reserve capacity to improve system reliability, remove transmission bottlenecks, and transmit cheaper power from one area to the other; or (ii) connect two transmission grids across national boundaries where both countries will benefit from cross-border power trading with ADB playing the role of an honest broker. In addition, ADB will promote political-risk guarantees or other guarantees to reduce the risk of private investments in power transmission. ADB's focus on distribution will cover both rehabilitation for loss reduction and reliability improvement, and new investments to support new connections. 30. Recently the Government requested the International Energy Agency (IEA) to undertake an energy policy review for Indonesia, which suggested six areas for priority attention: (i) domestic energy pricing and subsidies; (ii) policy coordination, decision making, and implementation; (iii) energy sector investment; (iv) independence and authority of energy regulators; (v) harnessing of a sustainable development agenda particularly through renewable energy implementation; and (vi) mainstreaming of energy efficiency and conservation policy. As a necessary next step of the IEA study, ADB has finalized a detailed sector diagnostics and a sector strategy. These studies are in Supplementary Appendixes A and B.

6. Development Coordination

31. The World Bank's strategic focus is on strengthening the technical and operational capacities of state institutions such as PLN. Together with ADB and Japan, the World Bank is

12 ADB. 2006. Indonesia Country Strategy and Program (20062009). Manila. 13 ADB 2008. Country Operations Business Plan, Indonesia (2009-2011). Manila 14 Using less coal (less CO2 ) for the same amount of power generation by increasing plant efficiency.

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supporting effective targeting of electricity subsidies and development of a sustainable pricing policy. The policy loans of ADB and the World Bank have the objective of increasing private investments in the energy sector through publicprivate partnerships, focusing on clean and renewable energy projects (such as geothermal power investments together with Pertamina Geothermal Energy and the $500 million Upper Cisokan pumped storage project), and power transmission and distribution projects including gas distribution. 32. Japan's lending to Indonesia has been similar. About 26% of its total portfolio in Indonesia is for the energy sector; 377 billion of development assistance was lent to the sector during 19962006. Japan has also prepared a geothermal sector master plan, which was completed in December 2007, and an energy efficiency study, finalized in 2008. Project lending by Japan has mainly focused on generation, including both small-scale geothermal and gas-fired power plants. In 2009, Japan International Cooperation Agency signed an agreement with PLN to finance the $1.8 billion high-voltage direct current link connecting Sumatra with Java to meet the growing demand for power in the JavaBali grid. Cooperation and harmonization of development partners in the power sectors has been generally fluid with regular invitations from each of the key players to participate in meetings or missions and exchange of information and documents. Policy dialogue was undertaken jointly on several occasions and this is well received by the Government in light of the Paris Declaration. Key activities and strategies of major development partners are described in Appendix 5.

7. Lessons Learned

33. During and after the Asian financial crisis, many components of the then ongoing projects had to be cancelled due to inadequate counterpart financing. ADB's last energy sector project loan 15 had sufficient allocation for counterpart financing. However, difficulties in complying with ADBs social and environmental safeguards policies and slow processing of contract awards delayed the implementation of these projects. Although both the projects were designed to be completed by March 2008, less than 30% of the combined loan amount had been disbursed as at February 2010. Land acquisition and resettlement has been the main cause of implementation delay of these two projects. The proposed Project will not face these delays as it involves no new civil works. 34. The risk of procurement delays has been addressed through advance procurement action for consultant selection and for preparation of bidding documents. ADB's procurement specialists have been involved in designing the procurement plan and its contract packages to minimize the risk of future delays. Because the project components involve rehabilitation, they will not trigger any of the social and environmental policy safeguards of ADB.

III. THE PROPOSED PROJECT

A. Impact and Outcome

35. The impact of the proposed Project will be reduced CO2 emissions by the power sector. The reduction will be about 330,000 tons each year for about 15 years a small amount compared with the total annual emission by the Indonesian power sector. Despite its small impact, nationally the Project will demonstrate the ability to (i) defer large investments in 15 ADB. 2002. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the

Republic of Indonesia for Renewable Energy Development Project. Manila (Loan 1982-INO); and ADB. 2002. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Indonesia for Power Transmission Improvement Project. Manila (Loan 1983-INO).

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generation and distribution system capacity through energy efficiency, and (ii) earn revenues from the CDM mechanism. Once successful, a larger operation of a similar type will reduce large emissions by the power sector. 36. The outcome of the Project will be to contribute to PLN's corporate effort to improve overall distribution efficiency and improve quality of power supply. Overall loss will be reduced to 7.0% from 8.4% by 2013. Customers' power supply voltage will improve in all regions, especially in rural areas. In 2008, on average, each customers power supply was interrupted about 6.8 times. The project will contribute to reducing the average number of power interruptions per year to three interruptions by 2013. Reliable and higher quality power in the house will have a positive impact on household income and social activities, especially in the evening. The increased longevity of appliances (in households, schools, or hospitals) will increase service delivery and economic activities. B. Outputs

37. The proposed Project has five outputs: (i) reduced losses in the JavaBali power distribution system, (ii) incremental sales resulting from increased distribution capacity, (iii) increased access to power by new customer connections, (iv) reduced peak demand and increased awareness of efficient lighting options in isolated grids and selected islands, and (v) efficient project implementation. 1. Part 1: Reduction of Distribution Losses 38. Output 1. The Project will reduce distribution losses by (i) reconfiguring electrical equipment through optimization of its location and size, (ii) reconductoring or replacing old low- and medium-voltage overhead distribution lines, (iii) replacing overloaded low- and medium-voltage transformers with new transformers of appropriate specifications, (iv) inserting additional transformers (splitting feeders into two) in long low-voltage overloaded distribution lines, (v) installing cubicles that will operate within design parameters, and (vi) new switching stations and capacitors. By 2012, the total savings from loss reduction will be about 400 GWh each yearcomprising about 100 GWh in Jakarta, 40 GWh in central Java, 50 GWh in west Java, 180 GWh in east Java, and 30 GWh in Bali. The value of the 400 GWh of saved power (assuming a marginal cost of $0.15/kwh) is about $60 million each year. 39. Output 2. Incremental sales are the additional energy the distribution network will be able to distribute to customers because of the optimization of its distribution system. As some of the bottlenecks will be removed, the network's overall capacity will increase because of the Project. Incremental sales will be the result of (i) reconfiguring the equipment, (ii) reconductoring both low- and medium-voltage overhead lines, (iii) additional transformer capacity, and (iv) capacitors that will reduce reactive power. The overall incremental sales will be about 635 GWh per year, with about 175 GWh in Jakarta where, for each square kilometer (km), PLN's load density is about 2.2 MW serving about (6,800 people), and about 85 GWh in central Java, where the load density is 68 kilowatts (kW), serving about 980 people. 40. Output 3. Increased access to power is an indirect output of this Project. The energy saved in output 1 will be enough to connect about 1.2 million new customers to the grid in Jakarta (275,000), central Java (110,000), west Java (110,000), east Java (620,000), and Bali (85,000). As a result, the waiting time for new connection will be reduced. The waiting list for new connection has grown from 414,000 in 2004 to about 800,000 in 2008. At the end of 2008, while PLN connected about 800,000 new customers, another 819,000 were on the waiting list

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225,000 in west Java, 200,000 in Jakarta, 210,000 in central Java, 160,000 in east Java, and 24,000 in Bali. Larger numbers of customers will be connected through incremental sales. 2. Part 2: Efficiency Lighting Pilot 41. Output 4. Reduced peak demand in pilot areas will be achieved by promoting energy efficient lighting solutions to residential customers. Compact fluorescent lamps (CFLs) are a well-established alternative to incandescent light bulbs. According to recent IEA studies,16 about 25% of the energy consumed by CFLs is converted to visible light compared with just 5% for a conventional incandescent lamp. Hence a typical CFL consumes about 20%25% of the energy used by an incandescent light bulb for the same level of light. Put simply, if 1 million incandescent bulbs are replaced with CFLs at a cost of about $1.0 million, the electricity demand will be reduced by 50 MW. The impact on the power system will be the same as building a new 50 MW power station, which may cost at least $50 million, another $2 million$3 million each year to operate, and take 34 years to construct. 42. Electricity consumption by Indonesias residential sector varies widely across different income classes in rural and urban areas. However, more than 50% of the electricity is used for lighting by residential customers, making efficient lighting the main focus for immediate energy efficiency gains. Under this Project about 500,000 CFLs and LEDs will be distributed in selected isolated and island grids covering the entire country. Multiple sites (either island grid or isolated systems within the main islands) will be part of the pilot. This will include the distribution of about 30,000 CFLs on the island of Nusa Penida, which will have a large visible and quantifiable output. Nusa Penida has an installed capacity of about 3,400 kW, of which about 900 kW is generated by wind and solar and the remainder by diesel that is shipped to the island. Preliminary estimates suggest that the maximum demand of 1,900 kW of the island could be reduced by 300 kW if efficient lighting is used by its 7,000 users. The marginal cost of generation on Nusa Penida is about $0.30/kWh that involves burning about 7,000 liters of diesel fuel each day at a cost of $7,000, including transport cost. This could be reduced by 30%a potential saving of $800,000 each yearif each family on the island replaced their incandescent bulbs with low-wattage CFLs or equivalent LEDs. A detailed description of this in Supplementary Appendix F. 3. Part 3: Project Implementation 43. Output 5. The Project will also provide consultants to support Project implementation, preparation and evaluation of bidding documents, and construction supervision. Although PLN has the technical competency to design and implement similar projects, implementation consultants will support PLN to implement the project within the tight 2-year time frame. In addition, the consultant will assist PLN in all aspects of procurement and will also ensure that the design is the least-cost solution for the individual region. C. Investments

44. Under the Project, the following investments will be made in the five regions of JavaBali. The investment in equipment will be supported by implementation consultants to ensure timely delivery of the outputs.

16 International Energy Agency. 2006. Barriers to Technology Diffusion: The Case of Compact Fluorescent Lamps.

Available: http://www.iea.org/Textbase/Papers/2008/cd_energy_efficiency_policy/4-Lighting/4-fluorescent.pdf

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1. Jakarta Region 45. The distribution network in the Jakarta region has been progressively overloaded over the years and needs urgent rehabilitation. The medium-voltage feeders are short and the main part of the network is underground. The sustained heavy feeder loads have damaged parts of the distribution network. Hence, system reconfiguration, including reinforcement by new, efficiently located urban substations, is required to reverse this situation. In Jakarta and the Tangerang region the Project will (i) install around 226 additional distribution transformers with 315 kilovolt-amperes (kVA), 400 kVA, 630 kVA, and 1,000 kVA ratings; (ii) upgrade 77 existing distribution transformers and connecting low-voltage lines; (iii) lay about 180 km of medium-voltage underground cables and about 25 km of overhead distribution lines; and (iv) connect 21 additional distribution transformers on the medium-voltage overhead line in the industrial areas of Tangerang and Kebayoram.

2. West Java 46. In west Java and Banten, most feeder lines are long, resulting in high losses and a network that operates on a poor power factor of less than 0.85.17 The city of Bandung faces a large number of outages each year as feeder lines are overloaded. The Project will procure new efficient transformers, and shorten the length of feeder lines to reduce losses to improve the quality of supply, especially in the main industrial areas. The Project will cover Bandung (the capital city of west Java), Banten (the capital of Banten province), Bekasi, Depok and Karawang (industrial areas near Jakarta), and Bogor. 47. The Project will (i) add 15 new switching stations on land already owned by PLN; (ii) install new medium-voltage feeder lines (about 249 km of underground cables and 45 km of medium-voltage overhead distribution lines); (iii) reconductor around 160 km of medium-voltage distribution lines; (iv) install or replace 62 medium-voltage cubicles in switching stations; (v) motorize 110 remote-controlled reclosers, load break switches,18 and cubicles; (vi) install around 350 new pole-mounted distribution transformers, and 6 transformers (400 kVA and 630 kVA) connected by 150 km of low-voltage distribution lines equipped with twisted cable; (vii) upgrade 108 distribution transformers; (viii) replace around 50 km of low-voltage-line conductors, changing from 35 square millimeter bare conductors to low-voltage twisted cable; and (ix) replace 915 low-voltage panels in the distribution transformers.

3. Central Java 48. The central Java distribution system supplies large rural areas and some big cities. In rural areas, the single-phase system is unable to cope with load density and growth. The long feeder length, which in some cases exceeds 60 km, causes large voltage drops and high losses. The power factor (about 0.8) is also seen as a problem in this region. In central Java (central Java and Jogyakarta), the Project will (i) transform about 85 km of single-phase medium-voltage lines to three-phase lines; (ii) upgrade about 61 km of three-phase medium-voltage lines; (iii) upgrade 2,888 pole-mounted distribution transformers according to the above upgrading; and (iv) install 13 capacitors banks along 13 medium-voltage feeder lines.

17 Power factor is the ratio of the real power to the apparent power, and is a number between 0 and 1 expressed as a

percentage. 18 An electric switch designed to operate (open or close) a circuit with several hundred thousand volts.

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4. East Java 49. The distribution system in east Java is characterized by two different types of networks: one supplying large industrial customers and the other supplying residential consumers through long feeders. The network is old and overloaded. The Project will upgrade urgently needed overloaded feeders and (i) reconfigure around 445 km of medium-voltage lines so that they can supply the main feeder loads to two different switching stations; (ii) upgrade about 510 km of medium-voltage distribution lines; (iii) upgrade about 970 km of low-voltage distribution lines; and (iv) upgrade about 1,055 distribution transformers and reconfigure the corresponding low-voltage systems.

5. Bali 50. The island of Bali has many commercial (large hotels and resorts) and high-revenue residential customers, mostly in south Bali; the population in east and north Bali is more rural. Two challenges are faced in Bali: (i) rehabilitating the aged network in the southern part to meet quality of supply expectations of the tourism industry, and (ii) improving the reliability of the underground system. The Project will (i) replace about 100 km of low-voltage distribution line conductors and 4 km of underground cables, (ii) install 296 pole-mounted distribution transformers and equip the corresponding new connecting low-voltage lines, and (iii) reconfigure the feeders from New Kuta and Payangan switching stations to optimize the spindle system. This will need about 18 km of new medium-voltage lines. D. Special Features

51. PLN is operating in an environment where the cost of power generation is high and, depending on international oil price variations, the generation cost may even increase further. Therefore, there is a strong argument for improving energy efficiency to reduce the volume of high-cost (and subsidized) energy and greenhouse gas emissions. Indonesia has large numbers of incandescent bulbs in operation and consumersespecially poor oneshave not shifted to energy efficient CFLs to reduce energy consumption. While some consumers have switched to CFLs, others have opted for inexpensive CFLs (three for $1), which are often of poor quality and last only about 1,000 hours. On an overall life cycle cost basis these are more expensive than ordinary incandescent bulbs. Hence there is a need to demonstrate and quantify the benefits of CFLs to policy makers and end consumers. 52. This project will demonstrate that (i) good quality CFLs can last 10,00015,000 hours and can reduce lighting energy demand by 80%, (ii) through competitive bulk procurement the cost of high-quality CFLs can be reduced to $1.00$1.50, and (iii) CDM credit may bring more revenue than the cost of a CFL and its free distribution to end consumers. The planned 500,000 CFLs under the proposed pilot in isolated and island grids will save about 20,000 tons of CO2 emissions each year, and the overall value of CDM credit could be close to $200,000 each year for the next 57 years, almost offsetting the total cost of the CFLs. Once these benefits are demonstrated and a methodology for receiving CDM credit is secured, PLN may scale up CFL distribution to customers across the nation. 53. In 2007, a PLN plan to distribute about 50 million CFLs would have achieved demand reduction of at least 1,200 MW of peak system capacity plus associated transmission, avoiding investment of $1.3 billion of power generation capacity and saving $450 million a year in fuel costs.19

19 Saving 500,000 tons of oil at about $900 per ton.

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E. Project Investment Plan

54. The project investment cost is estimated at $120.0 million, including taxes and duties of $9.0 million. The total cost includes physical and price contingencies, and interest and other charges during implementation. Table 1 has the overall investment plan. Detailed cost estimates by expenditure category and detailed cost estimates by financier are in Appendix 6.

Table 1: Project Investment Plan ($ million)

Item Total A. Base Costa 1. Distribution Loss Reduction 1. Jakarta Region 23.1 2. West Java 31.5 3. Central Java 13.5 4. East Java 27.8 5. Bali 6.2 2. Implementation Consultant 1.0 3. Pilot for Efficient Lighting 0.9 Subtotal (A) 104.0

B. Contingencies

1. Physicalb 4.2

2. Pricec 7.8 Subtotal (B) 12.0

C. Financial Charges During Implementationd 4.0 Totale 120.0

a in March 2009 prices. b Computed at 4% for equipment and installation costs. c Computed at 1.9% (2009), 1.0% (2010), and 0.0% (2011) on

foreign exchange costs and 5.5% (2009) and 5.6% (2010 and 2011) on local currency costs and includes provision for potential exchange rate fluctuation.

d Includes interest during construction and commitment charges. Interest during construction has been computed at the 5 year forward London interbank offered rate plus a spread of 0.2%. e Includes taxes and duties of $9.0 million.

Source: Asian Development Bank estimates. F. Financing Plan

55. The Government has requested a loan of $50.0 million from ADBs ordinary capital resources to help finance the Project. The loan will have a 25-year term, including a grace period of 5 years, an interest rate determined in accordance with ADBs London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.15% per annum, and such other terms and conditions set forth in the draft loan and project agreements. The Government has provided ADB with (i) the reasons for its decision to borrow under ADBs LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any communication or advice from ADB.

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56. The Government has also sought a loan from the AFD of $50.0 million. The loan will have a 15-year term, including a grace period of 5 years, and an interest rate in LIBOR equivalent to a EURIBOR-flat rate and such other terms and conditions set forth in the draft loan agreement. ADB will administer the AFD loan in regard to procurement, recruitment of consultants, and disbursement, according to the cofinancing agreement to be signed. 57. The Government and PLN will enter into a subsidiary loan agreement that will be on terms and conditions satisfactory to ADB and AFD, whereby the Government will relend the $100 million to PLN. The Multi-Donor Clean Energy Fund under the Clean Energy Financing Partnership Facility20 will provide grant cofinancing equivalent to $1.0 million to PLN to finance Part 2, which is on the distribution of CFLs and LEDs. PLN will finance $19.0 million of the project costs including all local taxes and duties.

Table 2: Tentative Financing Plan ($ million)

Source Total % Asian Development Bank 50.0 41.67 AFD a 50.0 41.67

Multi-Donor Clean Energy Fund under the Clean Energy Financing Partnership Facilityb

1.0

0.83 PT (Persero) Perusahaan Listrik Negara

19.0

15.83

Total 120.0 100% a Agence Francaise de Dveloppement. b Established by the governments of Australia, Norway, Spain, and Sweden;

and administered by ADB. Source: Asian Development Bank estimates.

G. Implementation Arrangements

1. Project Management

58. PLN will be the executing agency and has overall responsibility for the implementation of the Project. PLN will appoint the deputy director for distribution and commercial for JavaBali to supervise the implementation of the Project. The deputy director for distribution and commercial for JavaBali will appoint a project director who will be supported by qualified staff. The project director and staff will: (i) monitor the progress of the Project; (ii) supervise the consultants and contractors under the Project; (iii) submit the necessary documentation to ADB for the withdrawal of Loan and Grant proceeds; (iv) prepare periodic reports to ADB, including the Project completion report and annual audited project accounts report; (v) manage the Project accounts and financial records for auditing; and (vi) monitor the socioeconomic impact of the Project. 59. In each of the five participating regions, the existing technical staff of PLN will implement the Project. The regional manager will appoint a project manager who will be supported by several technical staff and will be responsible for (i) managing the implementation of the Project at the regional level, (ii) carrying out the procurement activities in the region, (iii) supervising the contractors working in the region, (iv) providing support to the consultants recruited under the Project, and (v) preparing the necessary documentation for the withdrawal of loan proceeds. The project managers of each region will coordinate the day-to-day activities through the project 20 Established by the governments of Australia, Norway, Spain, and Sweden; it is administered by ADB.

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director in PLN headquarters but will report on their overall activities to their respective regional manager.

2. Implementation Period

60. The Project will be implemented over a period of 2 years and will be completed by May 2012. The detailed implementation schedule is in Appendix 7.

3. Procurement

61. All procurement to be financed under the ADB and AFD loans and CEF Grant will be carried out in accordance with ADBs Procurement Guidelines (2007, as amended from time to time), and the procurement plan prepared and agreed upon between the Government and ADB. Ten contract packages will be procured under the Project through either international competitive bidding or national competitive bidding. Equipment for the pilot project for efficient lighting will be procured though limited international bidding. All procurement contracts will contain anticorruption provisions as specified by ADB and will address environmental and social issues in compliance with ADB and AFD rules. Procurement details are provided in the procurement plan (Appendix 8).

4. Advance Procurement Action and Retroactive Financing

62. The Government requested, and ADB management approved, (i) advance action for procurement of goods and related services, and (ii) retroactive financing for goods and related services. The advance action will cover tendering and bid evaluation up to the stage of ADBs approval of PLNs recommendation for award of contract before the effective date of the loan agreement. The retroactive financing for goods will cover the 12 months prior to the date of the loan agreement, with a ceiling of $5 million or 10% of the ADB loan amount. The Government was advised that ADB approval of advance contracting and retroactive financing does not commit ADB to approve the proposed loan and that ADB financing will be dependent upon the Government's compliance with all aspects of ADB's procedural requirements, including compliance with the relevant provisions of the loan agreement and ADB guidelines.

5. Consulting Services

63. Consultants will be selected and engaged under the Project in accordance with ADBs Guidelines on the Use of Consultants (2007, as amended from time to time). An international consulting firm will be engaged to manage implementation of the Project. The firm will deliver 105 person-months of consulting services (15 person-months of international and 90 person-months of national consulting) following ADBs quality- and cost-based selection method and using full technical proposal. The outline terms of reference for the consultants are in Appendix 9. Individual consultants will deliver 18 person-months of consulting services (6 person-months of international and 12 person-months of national consulting) for implementation of the pilot project for efficient lighting.

6. Anticorruption Policy

64. ADBs Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Government and PLN. Consistent with its commitment to good governance, accountability, and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to the Project.

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The Government and PLN will also (i) undertake necessary measures to create and sustain a corruption-free environment for activities under the Project; (ii) institute, maintain and ensure compliance with internal procedures and controls for activities under the Project, following international best practice standards for the purpose of preventing corruption, money laundering activities, and the financing of terrorists, and shall require all relevant ministries and agencies to refrain from engaging in any such activities; (iii) comply with ADBs Anticorruption Policy (1998, as amended to date); and (iv) where appropriate, ensure that relevant provisions of ADBs Anticorruption Policy are included in all bidding documents for the Project. The Government and PLN (i) acknowledge ADBs right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive and coercive practices relating to the Project, and (ii) agree to cooperate fully with any such investigation and to extend all necessary assistance, including providing access to all relevant books and records, as may be necessary for the satisfactory completion of any such investigation. All external costs related to such investigations will be met by the Project resources. 65. To ensure transparency and good governance, PLN will publicly disclose on its website information on how loan proceeds are being used. For each procurement contract, PLN will disclose (i) the list of participating bidders, (ii) the name of the winning bidder, (iii) basic details on bidding procedures adopted, (iv) the amount of the contract awarded, (v) a list of goods and services purchased, and (vi) the intended and actual utilization of loan proceeds under each contract being awarded. PLN will ensure that all project staff are fully aware of ADB procedures, including procedures for implementation, procurement, use of consultants, disbursement, reporting, monitoring, and prevention of fraud and corruption. ADB will organize special training for PLN staff covering all aspects of project implementation and ADB procedures, including procedures for implementation, procurement, use of consultants, disbursement, reporting, monitoring, and prevention of fraud and corruption.

7. Disbursement Arrangements

66. Withdrawal of ADB and AFD loan and CEF Grant proceeds will be in accordance with ADB's Loan Disbursement Handbook (2007, as amended from time to time) and with arrangements between the Government and ADB. All payments including payments for consultants, contractors, and suppliers of the main procurement packages will be paid by direct payment.

8. Accounting, Auditing, and Reporting

67. The Government and PLN will maintain records and accounts to identify all goods and services financed by loan proceeds. PLN will maintain separate accounts by funding source (ADB and AFD and CEF Grant). Each of the regional offices will maintain similar records and submit annual accounts and financial statements to PLN headquarters for further submission to ADB. The Government and PLN will ensure that accounts and financial statements are audited annually, in accordance with sound accounting principles. The annual Project account will contain detailed descriptions of the sources of receipts and expenditures. The annual financial statements will consist of income statement, balance sheet, statement of cash flows and related notes to the financial statements. The annual financial statements shall be consolidated for all PLN's operations. The audits will be conducted by independent auditors that will be selected in accordance with competitive selection procedures acceptable to ADB. PLN will furnish to ADB and AFD, not later than 6 months after the close of each fiscal year, certified copies of audited project accounts and audited financial statements, and ensure that the auditors provide an

17

opinion on PLN's compliance with the agreed financial covenants and indicate the details of the actual calculation for all ratios. 68. PLN will prepare quarterly progress reports and submit them to ADB and AFD within 20 days of the end of the quarter. The reports will be prepared in a format acceptable to ADB and will include, among other things, (i) project progress in each project area, (ii) the status of institutional development activities, (iii) delays and problems encountered and actions taken to resolve them, (iv) compliance with loan covenants, and (v) expected progress during the next 6 months. Within 6 months of the Project's physical completion, the Government and PLN will prepare and submit to ADB and AFD a project completion report in ADB's standard format, including costs and status of compliance with loan covenants.

9. Project Performance Monitoring and Evaluation

69. Within 3 months of the loan effectiveness date the project management unit will develop a project performance management system on the basis of the project design and monitoring framework to examine the Projects technical performance; evaluate delivery of project facilities; assess achievement of project objectives; and measure the Projects social, economic, financial, environmental, and institutional impacts.

10. Stakeholder Participation and Consultation during Implementation

70. As part of its own requirements, PLN will meet stakeholders in each of the five regions during implementation with support from implementation consultants. During the feasibility study, focus group interviews were conducted with customers to identify the potential impact of the Project in terms of access to reliable electricity and its impact on daily life, social services, and business. ADB and AFD missions will meet stakeholders during project inception and review missions.

11. Project Review

71. In addition to regular monitoring, ADB, AFD, and the Government will jointly review project performance at least twice a year. The review will assess implementation performance and achievement of project outcomes and objectives, review financial progress, identify issues and constraints affecting the Project, and work out a time-bound action plan for their resolution and monitoring of compliance. In 2010, ADB, AFD and the Government will undertake a midterm review to assess implementation status; review project parameters; and take appropriate measures including modifying the scope and implementation arrangements, and reallocating loan and grant proceeds, as appropriate given implementation experience, to achieve the project objectives.

12. Financial Performance of PLN and Financial Management

72. PLNs operational and financial performance over the past 5 years has strengthened considerably. Its net sales (revenue from customers and subsidies) increased by about 170%, from Rp62 trillion in 2004 to Rp169 trillion ($17 billion) in 2008. PLNs earnings before interest, taxes, depreciation, and amortization (EBITDA) were Rp15.85 trillion in 2008 with an EBITDA margin of 9.6% in 2008. However, overall net incomenet of taxes, interests, and payments related to exchange rateshas been negative for all years during 20042008. Government subsidies, under the public service obligations (PSOs), contributed a significant part of the

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revenue.21 If tariffs are increased to achieve full cost recovery, PLN will be able to continue its operations, as it has the overall human resources, systems, and financial, accounting, and technical infrastructure to run the power sector in Indonesia. Each PLN distribution branch has finance, budget, accounting, and revenue control divisions with experienced staff. Each branch has a computerized enterprise resource planning system to control financial management, budget planning, and human resource management. Each branch produces individual annual financial statements and budget reports. The financial reports include the balance sheet, profit and loss reports, and cash-flow reports. All the reports and activities are regularly audited by PLN branch or headquarters internal auditors, external auditors, and state auditors. The financial management system and PLN distribution office staff are considered adequate for accounting purposes. Detail assessment of PLN's financial performance is in Appendix 10.

IV. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS

A. Financial Analysis 73. The financial analysis of the Project was carried out in real terms using 2009 prices. The costs include capital investment, physical contingency, and operation and maintenance. Financial benefits in the financial analysis were based on (i) the value of the energy saved using the average fuel cost of $0.035 per kWh, and (ii) the value of the incremental sales from the increased capacity of the distribution system. Incremental sales are multiplied by a projected PSO margin of 4.5%. The average financial internal rate of return (FIRR) is 19.1%, which exceeds the weighted average cost of capital (WACC) of 2.0%. The robustness of the investment was evaluated by carrying out a sensitivity analysis for changes in major assumptions. The Project is thus considered financially viable and sustainable. Details are in Appendix 11. Detailed explanation of the valuation of the benefits and the methodology for calculation is in Supplementary Appendix D. B. Economic Analysis 74. The estimation of the project net present value and economic internal rate of return (EIRR) is carried out in two cases: (i) a conservative case, using only the loss-reduction benefits; and (ii) using both incremental sales and loss reduction. For case (i), the Project's EIRR is estimated at 35.9%. The net economic present value at a 12% discount rate is $202 million. When the benefits of increased, sales are added to the benefits of loss reduction and the economics of the project become even stronger. With the proxy value of increased sales at almost Rp1,000/kWh (the difference between the captive power price and supply cost) the EIRR is more than 100% and the project's net present value is about $1.4 billion. The detailed economic analysis is in Appendix 12. C. Environmental Benefits and Social Safeguards

1. Environmental Aspects

75. ADB has discussed with PLN the types of distribution lines and devices that will be installed, the types of waste that could be generated during the implementation of the project, and PLN's corporate management strategy for handling such waste materials. Most capacitors and transformers will be newly installed and some will be reinforced, new distribution lines will be installed, mostly pole-mounted transformers will be added, and no new substations will be built. Waste generated will be minimized and contain no hazardous materials. PLN also

21 Subsidy as percentage of total revenue: 5.6% in 2004 and 49.6% in 2008.

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confirmed that no circuit breakers and capacitors will be decommissioned under the Project. Such activities do not require UKL/UPL (environmental management certificate) according to the Government's AMDAL or environmental impact assessment process law. The Project is assessed environment category C, and as such, according to ADB's Environment Policy (2002) and Operations Manual Section F1/OP (2006), an Environmental Impact Assessment (EIA) or Initial Environmental Examination (IEE) is not required.

2. Resettlement

76. The Project will not involve any land acquisition and resettlement. All rehabilitation activities will be undertaken on land already owned or leased by PLN or within premises of existing facilities. Idle land owned by the Government is often occupied by squatters, but PLN has confirmed that no such cases are involved in this project. PLN also confirmed that the project activities in central and east Java will not involve any involuntary resettlement. 77. ADB's Project Appraisal Mission visited both of these sites and confirmed this claim. On the basis that no resettlement impacts are envisaged, the resettlement impact of the Project will be category C and therefore no resettlement plan is required. If the Project changes and needs to be recategorized, a resettlement plan will be prepared at that time.

3. Social Aspects 78. The Project will not have any negative impact on ethnic minority groups; overall the effects will be significantly positive because customers from all ethnic groups will benefit from the Project. Therefore, ADB's indigenous peoples policy will not be triggered. Appendix 13 provides a summary poverty reduction and social strategy. D. Sustainability 79. The Project covers investments and activities that are part of the core business activities of a power distribution business. PLN has the technical ability to maintain its network and has plans for it. Financing is also not constrained as the Government has been providing subsidies which consistently cover the shortfall in revenue. The only remaining risk is high oil prices in future if the reliance on oil continues. E. Risks

80. This Project involves no new technology and PLN has all the necessary skills to design and implement the project components, making it a less risky project in terms of design and implementation. 81. Lack of power generation in the system is a risk. Distribution investment alone will not improve power supply reliability and quality unless there is sufficient power to distribute. However, PLN's efforts to mobilize financing from both internal and external resources is showing results, as about 2,500 MW of additional generation capacity in Java will be commissioned between 2010 and 2012. PLN has also identified the following specific risks: (i) a stronger growth of electricity demand would result in an overuse of existing equipment (reducing its lifespan), (ii) a worsening financial situation would exist if revenues are lower than expected because of delay in the payment of subsidies by the Government, and (iii) insufficient investment from IPPs would delay the much-needed investments in generation. PLN has established the following mitigation measures: (i) investments to rehabilitate and optimize the

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distribution network to reduce overloading and promote demand management to reduce demand; (ii) arrangements to raise capital from the market and through borrowing so that investments can be implemented in a timely manner; and (iii) the introduction of higher tariffs and terms to secure primary energy requirements through long-term contracts, etc.

V. ASSURANCES 82. In addition to standard assurance, the Government and PLN have given the following project-specific assurances, which will be incorporated in the legal documents:

(i) The Government and PLN will ensure that throughout the implementation of the Project, adequate budgetary allocation of the required counterpart funds are approved and released in a timely manner to ensure proper implementation of the Project.

(ii) The Government and PLN will ensure that the implementation of the Project will

(a) be conducted in a manner that will not cause any adverse environmental impact, and (b) comply with the Governments environmental laws and regulations, and ADBs Environment Policy (2002).

(iii) The Government and PLN will ensure that the implementation of the Project will

not require any land acquisition and involuntary resettlement. Nevertheless, in the event that any project-related activity will cause land acquisition and/or involuntary resettlement, the Government and PLN will promptly prepare a resettlement plan and other requirements set out in ADB's Involuntary Resettlement Policy (1995).

(iv) PLN will perform all actions necessary to ensure that, beginning 1 January 2012,

it will achieve a self-financing ratio of at least 15% (fifteen percent) and produce, for each of its fiscal years after fiscal year ending on 31 December 2011, cash from internal sources equivalent to not less than 15% (fifteen percent) of the annual average of PLN's capital expenditures incurred, or expected to be incurred, for that year and the succeeding fiscal years.

(v) PLN will perform all actions necessary to ensure that, (a) it will not incur any

debt, unless its net revenues for the twelve (12) months prior to the date of such incurrence will be at least 1.2 times for the period beginning 1 January 2011 and at least 1.5 times for the period beginning 1 January 2012, of its estimated maximum debt service requirements for any succeeding fiscal year on all its debt, including the debt to be incurred

(vi) PLN will maintain, for its fiscal year ending on (a) 31 December 2011, a ratio of

total operating expenses to total operating revenue not higher than 87% (eighty seven percent), and (b) 31 December 2012, a ratio of total operating expenses to total operating revenue not higher than 80% (eighty percent).

(vii) By July 2010, PLN will publicly disclose on its website the breakdown, by

customer class, of its cost of its electricity supply for fiscal year 2009 into three (3) components, namely generation, transmission, and distribution and make similar disclosure in July of the succeeding years for the relevant fiscal year.

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(viii) The Government and PLN will continue their cost reduction initiatives by changing the generation mix and improvement of energy efficiency. In addition PLN will have (a) a gradual increase in the amount of its cost of operation that can be recovered from its customers, and (b) a gradual decrease in its reliance on government subsidies.

83. Prior to the effectiveness of the Loan Agreement, the following will have occurred:

(i) the Loan Agreement between AFD and the Government will have been duly executed and delivered, and all conditions precedent to its effectiveness (other than a condition requiring effectiveness of the Loan Agreement) fulfilled or arrangements satisfactory to ADB have been made for the fulfillment thereof within a period of time satisfactory to ADB;

(ii) the Subsidiary Loan Agreement between the Government and PLN, in form and

substance satisfactory to ADB and AFD, have been duly executed and delivered and become fully effective and binding upon the Government and PLN in accordance with its terms; and

(iii) the Grant Agreement between