KOSOVO: URGENT DECISIONS NEEDED IN NKPP PROCESS

UNCLAS SECTION 01 OF 04 PRISTINA 000404 SENSITIVE SIPDIS STATE FOR EUR/SCE, EUR/ACE, DRL, INL, S/WCI; NSC FOR HOVENIER, USUN FOR SGEE, USOSCE FOR AHYDE E.O. 12958: N/A TAGS: ENRG EAID ECON EFIN ETRD ETTC PREL KV SUBJECT: KOSOVO: URGENT DECISIONS NEEDED IN NKPP PROCESS SENSITIVE BUT UNCLASSIFIED - PLEASE PROTECT ACCORDINGLY ¶1. (SBU) SUMMARY: In July 2009, the Government of Kosovo (GOK) publicly announced its decision to move forward with the World Bank-funded New Kosovo Power Project (NKPP). The announcement, made in close consultation with key international donors, was long-awaited. After years of delay, it appeared that the GOK would finally realize new power generation in the near future. Almost immediately after the announcement, one of four pre-qualified consortia withdrew from the NKPP process; by mid-August, a second consortium withdrew. With only half of the qualified bidders remaining, the NKPP tender can continue as envisioned this summer but serious questions have been raised about the viability of the project in its current form. ¶2. (SBU) SUMMARY CONTD: Three years have passed since the start of the NKPP process and the current situation is unsustainable. The Kosovo Consolidated Budget (KCB) risks being consumed by continuing subsidies to the existing power plants - Kosovo A and B - and costs of energy imports. The Kosovo Energy Corporation's (KEK) equipment is facing catastrophic failure, outages are a daily occurrence, and existing mines will run out of coal by 2011. At this critical juncture, it is vital that the GOK take decisions to ensure a tender that will result in investment in the energy sector by the end of ¶2010. While the USG would like to honor the announcement that was made earlier this summer with the World Bank (WB),the current deal is unraveling. It is time for a fresh look at the most feasible options available to secure a reliable source of energy and investment for Kosovo as soon as possible. END SUMMARY. SLOW START FOR NKPP -------------- ¶3. (SBU) In early 2006, the WB bank began discussions with the GOK on the NKPP project, initially called "Kosovo C". WB technical assistance to this project was approved shortly thereafter, and a call for expressions of interest (EOI) in NKPP was launched the same year. After the initial EOI period concluded at the end of 2006, resulting in four consortia pre-qualified to bid on the NKPP project, decisions on how the eventual tender would be structured moved slowly. This, in turn, increased the urgency of opening a new mine to feed the existing generation (Kosovo A and Kosovo B),and to alleviate the growing drain on the KCB from subsidizing the aging power plants and covering electricity imports. Coal from the existing mine will run out at the end of 2011, and capital expenditures on failing equipment and power imports range from 10-12% of the budget. This summer's announcement by the GOK to move forward with a coordinated and integrated approach to Kosovo's energy sector reform was welcomed by all. With the full support of the USG, the European Commission (EC) and the WB, Prime Minister Thaci outlined a NKPP structure focusing on new mine development and a staged approach to new generation. The USG agreed to support coordinated privatization of Kosovo B, and the EC agreed to review options for the early closure of Kosovo A. ¶4. (SBU) Almost immediately after the GOK announced the new NKPP approach, one of the four pre-qualified consortia, led by German company RWE AG, withdrew from the process. By mid-August a second group, led by German utility EnBW partnering with the American Washington Group International, also withdrew. There is speculation that a third consortium will also pull out. While the NKPP tender process can continue with only two bidders, or even one, confidence in the project has been shaken. Regardless of whether another group pulls out, the GOK must make a serious decision about how to ensure the substantial investment needed to open and operate the new mine and to operate the existing generation facilities to ensure power for Kosovo until new generation can be brought online. This decision cannot be postponed any longer. Further delays increase the already high risk of catastrophic failure of the existing generation equipment, the risk of running out of coal before a new mine can be opened, and further burdens the KCB. Current Situation -------------- ¶5. (SBU) In the next week, the NKPP transaction advisor is anticipated to complete discussions with the two remaining PRISTINA 00000404 002 OF 004 pre-qualified consortia to determine their interest in continuing with the project as currently outlined. If both consortia remain interested, the structure announced this summer will remain the guiding plan. The USG will continue to support the NKPP and to coordinate Kosovo B privatization, collaborating closely with the WB and EC to ensure our combined efforts lead to a successful outcome. ¶6. (SBU) If only one NKPP bidder remains interested, the GOK can either declare the NKPP process as currently constituted over, or proceed into direct negotiation with the remaining bidder. There is no legal impediment to direct negotiations with a single bidder. Although it can be argued it will be difficult for Kosovo to secure value in such a situation, significant negotiation is part of any successful contract, no matter what the structure. Given that movement on developing essential NKPP contract documents and other decision making has been extremely slow to date, all of this could proceed much faster through direct negotiation. This would also allow the GOK to explore the possibility of the bidder operating Kosovo A and B, in order to ensure Kosovo's power supply while waiting for new generation to come online. Given the urgency of the situation, if only one bidder remains, we would recommend that the GOK proceed to negotiate directly. ¶7. (SBU) If both remaining consortia withdraw, the GOK has a number of options to consider. The sector assets, including the new mine, existing generation (Kosovo A and B) and new generation development, could all be bundled together or offered in various combinations. Any and all alternatives must be evaluated in terms of what will be the most timely and effective in ensuring Kosovo's power supply needs and minimizing the budget impacts. In this situation, the GOK could choose to re-visit all four original pre-qualified consortia to gauge interest in the revised package - whatever the composition - or to open a new EOI to pre-qualify potential bidders. No matter how many bidders ultimately remain, if a well-defined transaction structure were taken back to all of the consortia, including the two that have withdrawn, significant interest in the project might be regenerated. Opening a new EOI would add considerable time to the process. Recommendation for a Way Forward -------------- ¶8. (SBU) The NKPP transaction advisor has identified nine options, from among the many possible, that the GOK could explore if one or no bidders remain. The most viable option is a structure that will seek one investor to develop the new mine to supply all generation (Kosovo A, Kosovo B, and new generation),while rehabilitating and expanding Kosovo B. This option, among other things, improves the reliability of Kosovo B and its environmental performance, ensures adequate investment in the new mine, allows the investor to coordinate both mining and power plant operations to serve Kosovo's domestic energy needs, and will generate export earnings. Both the financial risks to the investor and the project's complexity are reduced, allowing for one partial-risk guarantee. ¶9. (SBU) This option assumes that the GOK will continue to own and retain ultimate financial responsibility for Kosovo A, raising the possibility that some donor assistance will be needed in the event of equipment breakdowns. Including Kosovo A as an asset for sale in the package is possible, but the facility is substantially older and less efficient than Kosovo B and has other associated environmental liabilities, so its inclusion is likely to complicate matters for the investor. However, although selling Kosovo A is likely not a viable option, proper oversight of Kosovo A operations is needed until the plant is eventually retired, both to ensure demand for lignite and more reliable power for Kosovo. ¶10. (SBU) In order to provide the greatest amount of flexibility to the investor, an optional and well-structured Operation and Maintenance agreement for Kosovo A should be included in the offer. This would allow the investor to reduce their direct operational risks through increased control of all generation assets and limit their financial risks by reducing the number of transactional relationships required. Inclusion of a properly-constructed Operation and Maintenance Agreement would also minimize the impact on the KCB until the plant is closed. By making the proposed Operation and Maintenance agreement optional, if the bidder PRISTINA 00000404 003 OF 004 perceives inclusion of responsibility for Kosovo A as too complicated and risky, they could choose to decline this portion of the offer without damaging the overall project framework. Potential Hurdles -------------- ¶11. (SBU) A likely objection to the proposed integrated structure is that it would create a private monopoly situation. Numerous countries have a dominant generator, and the small size of Kosovo's national market means that effective regulation can substitute for public ownership. A more likely issue will be the GOK's frequent inability to make and implement the timely and firm decisions needed to allow any structure for this transaction to proceed. While it appears Prime Minster Thaci has acknowledged that failure to ensure a successful outcome to this transaction in 2010 is politically unacceptable, whether or not the GOK maintains enough political capital to achieve this feat remains to be seen. ¶12. (SBU) It is possible, even likely, the WB will insist on remaining engaged with both the sector and the NKPP transaction, while not agreeing to the recommended course of action. Although the suggested guidance to the GOK is not risk-free, Kosovo cannot afford further delays to energy sector reform. Key issues in the failure of NKPP to reach a conclusion to date include not only the slow preparation of main project documents by the NKPP transaction advisor and the global financial crisis, but also the risk-increasing complexity of the current structure. Further complications, such as re-opening the process to new expressions of interest and including a large requirement for new generation size, will certainly limit the chances of near-term success. In the event the WB does not agree to pursue the transaction in a timely manner that will fulfill Kosovo's energy needs, the USG must consider whether the WB's interests still coincide with its equities in Kosovo and our on-going assistance to the energy sector. ¶13. (SBU) The GOK must now make some serious decisions to ensure that a new energy sector transaction structure will succeed in attracting investors by the end of 2010. The transaction must meet Kosovo's need for reliable power supply and at the same time minimize the potentially catastrophic exposure of the KCB to the sector's insatiable demands for current and capital expenses. If no transaction were to happen by the end of 2010, equipment costs and energy imports could balloon to 40% of Kosovo's entire budget. Resources demanded by the energy sector come at the expense of Kosovo's vast social and economic development needs. Comment and Recommendation -------------- ¶14. (SBU) The USG is making all good faith efforts to work with the WB to find a way forward on NKPP, however facts on the ground are rapidly changing the circumstances under which the USG agreed to move forward this summer. Action now needs to be focused on a path that will attract private investors to develop the new mine, while ensuring generation investment that will meet Kosovo's energy needs in both the short and long term. Further delay jeopardizes this process. An approach that is narrowly focused on development of the new mine and overly-prescriptive on the size of new generation, will work against the USG's assistance to Kosovo's energy sector. In that case, it may prove increasingly difficult to remain partnered with the WB. ¶15. (SBU) Given the USG's commitment to Kosovo's energy sector reform, the GOK will inevitably ask us for guidance on the current situation. Our recommendation is to urge the GOK to instruct the NKPP transaction advisor to prepare a tender to open the new mine in conjunction with Kosovo B. The tender should include either a requirement or the option for expanded generation within Kosovo B at an economically justifiable size. It should also include the possibility of a well-structured Operation and Maintenance Agreement for Kosovo A until its closure. Kosovo A's closure should not be delayed any further as a result of this approach, but this bloc will continue to be part of the power generation equation until new capacity comes on-line. The transaction advisor should re-visit all pre-qualified consortia with this package to obtain a market test of their interest. If only one consortium were to remain interested, PRISTINA 00000404 004 OF 004 the GOK should direct the transaction advisor to proceed to direct negotiation. Both Kosovo's budget and future development depend on swift action and strong commitment by the GOK to see this process through. END COMMENT. DELL