Document of

The World Bank

FOR OmCAL USE ONLY

3~~~~/AJ 3o.0/5A /C-

urt No.P-5024-HU

.~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~eo No P 24,

MEMORADUM AND RqWOMMENDATIOW

- t--OF1 IE

PRESIDENT 0THE

INTEPI!ATIONAI BADK FOR RECONTUCTON AMD DEVELOPMENT

TO TE

EXECUTI DIRECTORS

ON

PROPOSED WANS

IN AMOUNTS EQUlIVALENT TO US$100 MILLION AND US$10 MILLION

TO THE

HUNGARIAN NATIONAL OIL AND GAS TRUST

AND THE

£NATION~L BANK OF HUNGARY

WITH THE GUARANTEE OF THE

HUNGARIAN PEOPLE'S REPUBLIC

FOR AN

ENERGY DEVELOPMENT AND CONSERVATION PROJECT ,

APRIL 3, 1989

This docment bas a restieted distribution and may be used by recpits only In te performance oftheir offical duties. Its contents may o.t otherwise he disclosed wthout World nk autorization.

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-~~~~~~~~~~~~~ U

CURR5NCY EQUIVALENTS

Currency Unit - Forint (Ft)

AVERAGE EXCHAN(E RATES(Forints per US$).

1983 1984 1985 1986 1987 1988 l989 (Feb.)

US$1.00 2 Ft 42.7 48.0 50.1 45.8 47.0 50.0

WEIGHtl AND MEASURES

Meqfric System

ABBREVIATIONS AND ACRONYMS

.NBH - National Bank of HungaryERR, - Economic Rate of ReturnOKGT - Hungarian National Oil and Gas Trust

FISCAL YEAR

'January 1 - December.31

FOP,OMCIJAL USE ONLY

RUNGAiY-

EN8RGY DEVELOPMENT AND CONSERVATION PROJECT

LOAN AND PROJECT SUMMARY

(A) LOAN FOR OIL AND GAS DEVELOPMENT

Borrower: Hungarian National Oil and Gas Trust (OKGT).

Guarantor: Hungarian People's Republic -

Amount: US$100 million equivalent.

Terms: 15 years, including a five-year grace period, at the Bank'sstandard varilable interest rate. OKGT would pay to theGuarantor a premium of l90 per annum over the Bank rate onthe outstanding amount of the Bank loan.

(B) LOAN FOR ENERGY CONSERVATION

Borrower: National Bank of Hungary (NBH).

Guarantor: Hungarian People's Republic.

Beneficiaries: Industrial and other enterprises.

Amount: US$10 million equivalent.

Terms: 15 years, including a five-year grace period, at the Bank'sstandard variable interest rate.

Onlending Terms: Subloans will be denominated in Forints with NBH taking theexchange risk. The loan will be onlent to the participatingbanks for a maximum period of 12 years, including a graceperiod not exceeding three years, at NBH's prevailingrefinancing rate or at the prevailing Bank rate plus a 202mark up, whichever is higher. This amount will be onlent to

- commercial sub-borrowers for eligible subprojects at ratesdetermined pursuant to each bank's lending policy statementagreed with the Bank under energy conservation or industrialrestructuring loans. The subloans would thus carry anadequate interest spread, interest rates that are positive inreal terms and do not include a subsidy, and be for a maximumperiod of 12 years, including a grace period not exceedingthree years.

This document has a resuicted disrbution and may be used by recipient only in the pefonance }I of their offcial duties. Its contents may not otherwise be disclosed without World Bank authrzatio.

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Financina Plan, IBkD , - 'Domestic Loans-OKGT * I )45O uillionDomestic Loans.- Energy.Conegi i.4 ;U 4.0 milIlon' ;OKGT US$ A75.0 millionSub-borrowers' contribution US$ 16.0 millionTotal- . i

Economic Rate of Return: -The preappraised OKGT subprojects show an -ERR ofbetween 172 and several hundred percent. A minimumof 18% will be required for the energy conservationsubprojects, well above the estimated opportunitycost of-capital, and in line with ongoing energyconservation projects in Hungary.

Staff Avpraisal Report: Report No. 7674-HU Dated Agril 3. 1989.

Ma:s IBRD 21399

MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT', OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT/, TO THE EXECUTIVE DIRECTORS

ON PROPOSED LOANSTO THE HUNGARIAN NATIONAL OIL AND GAS TRUST

AND THE FATIONAL BANK OF HUNGARYWITH THE GUARANTEE OF THE HUNGARIAN PEOPLE'S REPUBLICFOR AN ENERGY DEVELOPMENT AND CONSERVATION PROJECT

1. The following memorandum and recommendation on proposed loans to theHungarian National Oil and Gas Trust (OKGT) for US$100 million equivalent andto the National Bank of Hungary (NBH) for US$10 million equivalent is -submitted fior approval. The proposed loans would be at the standard IBRDvariable interest rate with 15 years' maturity and would help finance anenergy development and conservation project. OKGT would pay to the Guarantora premium of 10% per annum over the Bank rate on the outstanding amount of theBank loan.

2. Background. The energy sector is central to Hungary's developmentprocess and accounts for an important share of Government investment. Overthe past 15 years energy investments have accounted for up to 15% of totalnational investment and about two thirds of the volume of investments financedby the central Government budget. Even with this high level of investment,Hungary has had to rely on imports for a large share of its energy needs,accounting in 1987 for 48% of total primary energy consumption. Hungary is amature oil and gas producer, resulting in a declining trend in discoveries.Continuing exploration efforts are justified but will increasingly have toinvolve the most modern techniques and a more integrated explorationapproach. Through the 1970s, Hungary's energy policy was directed to meetingthe needs of a capital and energy intensive industrial investment program,while energy prices below economic cost encouraged overall energy consumptiongrowth. In the present decade there has been a gradual shift towards greateremphasis on demand management, supported by substantial improvements in energypolicies. Further improvements are needed, in particular concerning energypricing and the loss-making coal subsector. Hungary's energy consumption perunit of GNP is still well above that of most developed countries with marketeconomies. The income elasticity of demand, which has declined considerablyin this decade, needs to be reduced further and thus limit the need for newinvestments in the sector, thereby permitting more substantial investments inthe directly productive sectors of the economy, in line with the Government'sstrategy. This would require active demand management including an improvedpricing structure, and a carefully optimized investment program including inthe oil and gas sector. The Bank has supported the Government's energypolicies in the past decade through four energy sector projects (two energyconservation projects, a petroleum project and a power project), all of whichare being effectively implemented.

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3. Rationale for'Bank Involvement. Since lending to Hungary began in1983, the Bank's country assistance strategy has focused on supportingHungary's program of reform and structural adjustment to make the economy moreefficient, flexible, market-oriented and competitive, especially inconvertible currency markets. In recent years, this strategy has beenimplemented mainly through a series of hybrid loans for industrialrestructuring, combining quick disbursing funds to support institutional andpolicy reform, and investment funds to support restructuring at the enterpriseand subsector levels. Investment loans in other sectors have also supportedimplementation of the reform, as well as improvement in enterpriseefficiency. Following the adoption by the Government in 1987 of medium-termprogram of stabilization and adjustment to correct imbalances created byeconomic deterioration, the Bank stepped up its aup:ort to the reform throughan industrial sector adjustment loan. This loan, combined with an IMF Standbyin 1988, pLovided crucial external support to strengthen the Government'sincreased reform and adjustim-et efforts. The Bank's assistance strategy willcontinue to support the Goverrment in carrying out its adjustment efforts. Itwill address medium to long term constraints to sustainable growth, assist indeveloping institutional capacity in line with systemic reforms, and helpensure Hungary's continued access to axternal financing. In the energysector, the Bank's policy dialogue has resulted in significant improvements inpolicies and support for the strengthening of sector institutions, in linewith the development objectives. Continued Bank support is important for thepolicy framework to develop in line with overall Government objectives,removing the significant remaining distortions in energy pricing, making thepriciqg system more responsive to border price movements, and strengtheningthe capabilities and autonomy of the leading enterprises in the energysector. This is particularly important at the present stage of energy policyreform due to the sensitive social implications of pending policy changes. Atthe same time, the sector enterprises, particularly within oil and gas, needoutside stimulus and support to modify significantly their traditionalorganization and mode of operations. Within the energy sector, the petroleumsubsector is expected to suffer a sharp decline in economic production unlessmeasures are taken to broaden participation in the industry and to modify theexisting exploration practices, while the coal mining companies need to havemore autonomy and responsibility for their investment decisions and e:onomicresults, without counting on Government subsidies.

4. Prolect Obiectives. The main Project objectives are to support: (i)significant improvements in the policy and institutional framework of theenergy sector including appropriate pricing coupled with subsidy elimination,restructuring of the coal mining sector and improved investment planning inthe power subsector; (ii) development of the oil and gas sector througngradual restructuring of the national oil and gas company (OKGT), opening upthe sector to foreign investment, an improved petroleum taxation andregulatory framework, and financing of priority investments; and (iii)preparation of an updated energy conservation program and financing of relatedinvestments. These measures will strengthen demand management, improveresource utilization and reduce the energy sector's demand for investmentfunds.

5. Project Description. The Project, of which the Bank loan to OKGTwould finance the convertible currency component, would include high-priorityinvestment subprojects in oil and gas field development, upgrading andenhanced recovery, underground gas storage and pipeline network improvements,

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in addition to exploration and production equipment and studies, technicalassistance and training. The investment subprojects have all been evaluatedby the Bank, and found to meet minimum technical, economic and environmentalcriteria. (In one,case, the detailed project design is being reviewed inorder to increase further its viability.) The Bank's evaluation of thesubprojects proposed for financing has already been instrumental insignificant improvements in their design and costing.

6. The OKGT loan will also support the opening of Hungary's petroleumindustry to international investment as well as OKGT's institutionaldevelopment, building on the technical in'provements achieved under the first* etroleum project. Consultants have been recruited to help prepare acontractual framework for international oil companies to undertake explorationand production in Hungary. OKGT will strengthen the emphasis on its coreactivities (oil and gas exploration, production, transport and refining) andimplement selectively an improved management information system. itsexploration activities will be reoriented towards a more integrated approachin order to explore for reserves in geologically complex locations; theexploration decision process will be more clearly based on economic criteria;and the service activities will be organized in separate units. OKGT willprepare a strategy for developing gradually an export market for some of itspetroleum services.

7. The loan to NBH will provide foreign exchange iinancing for theenergy conservation program financed through NBH and the participatingcommercial banks to support conservation subprojects initiated by theenterprises themselves. Onlending for an individual subproject will belimited to US$1.5 million equivalent and would be for a maturity not exceeding12 years including three years of grace. The funds will be onlent throughcommercial banks on a first-come first-served basis in continuation of ongoingBank loans, and will finance the direct foreign exchange costs of (a)industrial and other enterprises for eligible enexgy saving and backgroundindustry subprojects, and (b) energy monitoring equipment required byenterprises and institutes to strengthen their ability to monitor energy useeffectively and carry out energy audits.

8. Procurement will be based on Bank guidelines. Revolving funds ofUS$7.0 million and US$2.0 million for OKGT and NBH, respectively (equal toabout four months of disbursements), and retroactive financing for OKGT of upto uTS$10 million equivalent (10% of the US$100 million loan to OKGT) areproposed. A breakdown of costs and the financing plan are shown in ScheduleA. The procurement method and disbursement schedules are shown in ScheduleB. A timetable of key project processing events and the status of Bank Gr9upoperations in Hungary are given in Schedules C and D, respectively. The StaffAppraisal Report No. 7674-HU dated April 3, 1989 and a map are also attached.

9. Agreed Actions. At negotiations, agreements were obtained from theGovernment, OKGT and NBH on: (i) The Government's energy policies and actionsincluding confirmation of the basic energy pricing program and bringing theprices of all energy carriers up to the level of their economic costs, and theelimination of all preferential energy consumer prices by 1991 (for naturalgas, night electricity in the whole country, and day electricity in the ruralareas and smaller urban areas) and 1993 (for coal, district heating, and daytime electricity in Budapest and the other large cities) in approximatelyequal annual increments. As a first step, the Government intends to put into

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effect before October 1989 consumer price increases with a weighted average ofmore than 20%, including adjustments of more than 30% for coal and more than352 for day time electricity in Budapest. These price increases willrepresent a significant first step in the price adjustment process; (ii)OKGT's institutional development policies aiming at reorienting it towardsmore efficient institutional organization and practices; (iii) OKGT'stechnical assistance program under the project, including for managementinformation system, export market strategy, field development practices,drilling and well-stimulation practices, exploration methodology and petroleumcontracts; (iv) OKGT's use of qualified consultants in exploration management;(v) OKGT continuing to meet miinimum financial ratios for pre-tax profits(minimum 8% of resources used), long term debt/service coverage ratio (atleast 1.5), current ratio (at least '.5), and long term debt to equity ratio(maximum 60:40), and continuing to prepare satisfactory financial statementsand to have these audited by an acceptable external auditor; (vi) themodernization of the framework for the Government's oil and gas regulationswith the aim of expanding OKGT's operational autonomy; and (vii) NBH onlendingthe proceeds of the energy conservation loan to participating commercial banksfor relending to enterprises for eligible energy conservation investment.Eligible banks will be those classified as eligible participating banks underindustrial restructuring projects.

10. OKGT has sent to the Bank a Letter on its Institutional Strategy thatplaces heavy emphasis on the need to base operational and investment decisionson profitability criteria, in the context of increasing operational autonomyand increased concentration on the core oil and gas activities. It isintended to transform'OKGT into a joint stock company, when this is permittedunder the evolving lego'l framework, and there will be an institutionaldevelopment program aimeJ at improved efficiency and integration of technicaldisciplines and the separation of service activities into separate units. Theoil and gas exploration methodology will be modified, including through thehelp of integrated sub basin geological studies. Foreign investment inexploration and production will be welcomed based on a contractual frameworknow under preparation.

11. Benefits. Significant improvements in the energy pricing structure,supported by the Project, will: bring consumer prices gradually in line withproducer prices and thus eliminate energy-related subsidies, remove thepricing preferences for certain industries, and abolish power pricinganomalies for certain regions and in peak-off peak pricing. Together withsteps to strengthen power investment planning these measures will provide animproved policy framework, restrain the growth in energy demand and encouragerational inter-fuel substitution. The coal restructuring program supportedunder the Project will eliminate subsidies from the Government's budget,establish criteria for the support of new investments and promote the closingof uneconomic mines together with a rationalization of the surface activitiesof the mining companies. The Project will result in the opening of thepetroleum sector to international investment and in a significantstrengthening of OKGT, which will continue to play an important role in theHungarian petroleum sector. Together, these measures should make it possibleto reduce the rate of decline in domestic oil and gas production.

12. The OKGT subloan will finance high priority development investmentsubprojects with ERRs of from 17 to several hundred percent. In addition, theProject will also finance high priority OKGT investments in pipeline

debottlenecking and upgrading and expansion of Hungary's underground gasstorage capacity, permitt1ng the delivery of gas in the high demand winterseason. The energy conservation subprojects will assist Hungary in achievingenergy savings. The subprojects will meet high minimum rate of returncriteria (182 in line with minimum rate of return criteria for ongoing energyconservation projects in Hungary), and on the basis of the subproject pipelineand past experience, should show ERRs of 25%-35% and more, which are wellabove the estimated opportunity cos- of capital. The energy conservationsubprojects are expected to have a positive environmental impact by reducingenergy waste.

13. Risks. The Project has set ambitious objectives which could turn outto be difficult to achieve in full if the policy and institutional changesshould take longer to implement or yield results than now expected, e.g., forsocial or political reasons. These risks are considered to be withinacceptable limits in light of the analysis and dialogue that has preceded theGovernment and OKGT undertakings and the overall commitment to sustainedpolicy reform. Further, the Project provides for carefully designedconsulting support and consistent Bank follow-up. The OKGT subprojects havebeen well prepared and carefully examined and thus present low technicalrisks. All subprojects have also been reviewed for their environmentalimpact. Special risks were found in only two subprojects, where sour gas andCOz create corrosion and embrittlement problems. These risks are beingaddressed satisfactorily in project design.

14. Recommendation. I am satisfied that the proposed loans would complywith tte Articles of Agreement of the Bank and recommend that the ExecutiveD4 ectors approve the proposed loans.

Barber B. ConablePresident

Attachments

Washington, DCApril 3, 1989

-6

- Schedule A

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Estimated Costs and Financing Plan

Proiect Cost:Local Foreian Totl--- (Us$ mi11ion)---

OKGT

Field development et.c. 364.1 79.6 443.7Underground gas storage 50.5 17.8 68.3Pipeline improvements 63.3 6.9 70.2Exploration equipment - 10.0 10.0Technical assistanceand training 1.5 4.0 5.5Price contitgencies 43.6 8.7 52.3

Subtotal 523.0 127.0 650.0

BNI

Energy conservation 20.0 10.0 30.0

Total 5430

Financing Plan:

IBRD - 110.0 110.0Domestic Loans - OKGT 25.0 - 25.0Domestic Loans - Energy

conservation 4.0 .- 4.0OKGT 498.0 27.0 525.0Sub-borrowers 16.0 - 16.0

Total l37^O

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Schedule B

HLNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Procurement H1ethod and Disbursements

Category a/ Amount Procurement - Finanecna(US$ Million) 'tethod

IC$ Other

A. OKGT Loan 100.0 80.0 20.0 1001 of foreign expendituresand 100X of local expenflitures

- Technical assistance (ex-factory) for goods:fandand training 3.5 3.5 1002 of foreign expenditures

- Equipment 10.0 7.0 3.0 for consultants' services and- Subprojects for field training

development, upgradingand external recovery 63.0 i4.0 9.0

- Subprojects for under-ground gas storage 12.0 10.0 2.0

- Subprojects for pipe-line improvements 5.0 4.0 1.0

- Unallocated 6.5 5.0 1.5

B. NBH Loan 100% of foreign expendituresand 1002 of local expenditures

- Energy conservation (ex-factory) for goods; andsubprojects 10.0 8.5 1.5 1002 of foreign expenditures

for services

Total 11. £LII;

a/ Allocations for OKGT loans are somewhat arbitrary since foreipn exchangecosts for these components are larger than the loan amount.

Estimated IBRD Disbursements

IBRD Fiscal Year

1990 1991 1992 1993 1994 1995_- - __ - - _ --_(U S million)

A. OKGT

Annual 7.0 18.0 27.0 26.0 17.0 5.0Cumulative 7.0 25.0 52.0 78.0 95.0 100.0

B. NBH

Annual 0.3 0.9 1.6 3.2 3.0 1.0Cumulative 0.3 1.2 2.8 6.0 9.0 10.0

Schedule C

HUNGARY

ENERGY DEVELOPMENT AND CONSERVATION PROJECT

Timetable of Key Proiect Processing Events

(a) Time taken to prepare 18 months

(b) Prepared by: OKGT and Government with BankAssistance

(c) First Bank Mission November 1987

(d) Appraisal Mission Departure: June 1988

(e) Negotiations: March 1989

(f) Planned Date of Effectiveness: June 1989

(g) List of Relevant PCRs and PPARs: None

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Schedule DPage 1 of 2

THE STATUS OF BANK GROUP OPERATIONS IN HUNGARY

A. -STATEMENT OF BANK LOANS &'(As of December 31, 1988)

US$ MillionLoan Fiscal (Less Cancellations)No. Year Borrower Purpose Loan Undisbursed

One loan and six B loans fully disbursed 266.5 -

2317 1983 HPR ' Industrial Energy Conservation 109.0 11.62397 1984 NBH ' Ind. Exports and Restructuring 110.0 6.52398 1984 OKGT ' Petroleum 90.0 4.92510 1985 NBH Integrated Livestock 80.0 53.92511 1985 NBH Fine Chemicals 73.0 13.02557 1985 HPR Transport (Rail/Road) 75.0 21.02697 1986 NBH Power 64.0 57.12700 1986 NBH Industrial Restructuring 100.0 41.72709 1986 NBH Industrial Energy Cons. II 25.0 16.82738 1987 NBH Crop Production Improvement 100.0 42.02834 1987 NBH Industrial Restructuring II 150.0 85.92847 1987 NBH Telecommunications 70.0 57.52936 1988 NBH Agroprocessing Modernization 70.0 65.02966 1988 NBH Technology Development 50.0 50.02965 1988 NBH Industrial Sector Adjustment 200.0 124.0

Total: Q' 1,632.5Of which repaid 56.6

Total now held by Bank 1,575.9

Total undisbursed 650.9

_/ The status of these projects is described in a separate report on allBank/IDA-financed projects in execution, which is updated twice yearly andcirculated to the Executive Directors on April 30 and October 31.

_I Hungarian People's Republiccl National Bank of Hungaryd/ National Oil and Gas Trust_1 In addition, in the third quarter of FY89, the Third Industrial

Restructuring Project (US$140 million) has been signed and the SecondTransport Project (US$95 million) has been approved by the Board.

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Schedule DPage 2 of 2

B. STATEMENT OF IFC LOANS(As of December 31, 1988)

Fiscal Type of US$ MillionYear Obligor Business Loan Equity Total

1988 Dunament Polistirolgyart Chemical 29.78 4.13 33.91

1988 Salgotarjan Glass Wool Glasswool 3.44 1.39 4.83

1987 UNIC Bank Banking - 3.21 3.21

1987 Huni Fermentation Ltd. Lysine Mfr. 8.55 2.70 11.25

Total Gross Commitments 41.77 11.43 53.20

Less cancellations, terminations,repayments and sales - - -

Total Commitments now held by IFC 41.77 11.43 53.20

Total undisbursed 11.29 0.33 11.62

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