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Report and Recommendation of the President to the Board of Directors Project Number: 48386-004 November 2017 Proposed Loans, Technical Assistance Grant, and Administration of Loan Republic of Azerbaijan: Railway Sector Development Program Distribution of this document is restricted until it has been approved by the Board of Directors. Following such approval, ADB will disclose the document to the public in accordance with ADB’s Public Communications Policy 2011 after excluding information that is subject to exceptions to disclosure set forth in the policy.

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Report and Recommendation of the President to the Board of Directors

Project Number: 48386-004 November 2017

Proposed Loans, Technical Assistance Grant, and Administration of Loan Republic of Azerbaijan: Railway Sector Development Program Distribution of this document is restricted until it has been approved by the Board of Directors. Following such approval, ADB will disclose the document to the public in accordance with ADB’s Public Communications Policy 2011 after excluding information that is subject to exceptions to disclosure set forth in the policy.

CURRENCY EQUIVALENTS (as of 6 October 2017)

Currency unit – Azerbaijan manat/s (AZN)

AZN1.00 = $0.5921

$1.00 = AZN1.6890

ABBREVIATIONS

ADB – Asian Development Bank ADY – Azerbaijan Railways Closed Joint Stock Company AFD – Agence Française de Développement COM – Cabinet of Ministers km – kilometer KPI – key performance indicator LARP – land acquisition and resettlement plan LIBOR – London interbank offered rate MOF – Ministry of Finance PAM – project administration manual PBL – policy-based loan PMO – program management office TA – technical assistance

NOTE

In this report, “$” refers to United States dollars.

Vice-President Wencai Zhang, Operations 1 Director General Sean O’Sullivan, Central and West Asia Department (CWRD) Director Dong-Soo Pyo, Transport and Communications Division, CWRD Team leader Zheng Wu, Senior Transport Specialist, CWRD Team members Ana Paula Araujo, Environment Specialist, CWRD

Minhong Fan, Procurement Specialist, Operations Services and Financial Management Department (OSFMD)

Joao Pedro Farinha Fernandes, Senior Financial Sector Economist, CWRD

Faraj Huseynbeyov, Senior Project Officer, Azerbaijan Resident Mission, CWRD

Carmina Luna, Senior Project Officer, CWRD Lyailya Nazarbekova, Principal Counsel, Office of the General

Counsel Saad Paracha, Financing Partnerships Specialist, Office of

Cofinancing Operations Mary Alice Rosero, Social Development Specialist (Gender), CWRD

Ko Sakamoto, Transport Specialist, CWRD Yukihiro Shibuya, Social Development Specialist (Safeguards),

CWRD Thi Thanh Phuong Tran, Senior Environment Specialist, CWRD

Krisanta Carissa Vila, Senior Operations Assistant, CWRD Peer reviewers Anouj Mehta, Principal Financial Management Specialist, OSFMD

Ravi Venkat Peri, Principal Transport Specialist, South Asia Department

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

PROGRAM AT A GLANCE

MAP

I. THE PROPOSAL 1

II. THE SECTOR DEVELOPMENT PROGRAM 1

A. Rationale 1 B. Impact and Outcome 4 C. Outputs 4 D. Development Financing Needs and Investment and Financing Plans 6 E. Implementation Arrangements 8

III. TECHNICAL ASSISTANCE 9

IV. DUE DILIGENCE 9

A. Technical 9 B. Economic and Financial 9 C. Governance 10 D. Poverty and Social 10 E. Safeguards 11 F. Risks and Mitigating Measures 11

V. ASSURANCES AND CONDITIONS 12

VI. RECOMMENDATION 12

APPENDIXES

1. Design and Monitoring Framework 13

2. List of Linked Documents 16

3. Development Policy Letter 17

4. Policy Matrix 26

Project Classification Information Status: Complete

PROGRAM AT A GLANCE

Source: Asian Development BankThis document must only be generated in eOps. 25112016110255420138 Generated Date: 04-Oct-2017 11:22:19 AM

1. Basic Data Project Number: 48386-004Project Name Railway Sector Development Program Department

/DivisionCWRD/CWTC

Country Azerbaijan Executing Agency Azerbaijan Railways Closed Joint Stock Company, Ministryof Finance

Borrower Azerbaijan

2. Sector Subsector(s) ADB Financing ($ million)Transport Rail transport (non-urban) 400.00

Total 400.00

3. Strategic Agenda Subcomponents Climate Change Information Inclusive economic growth(IEG)

Pillar 1: Economic opportunities, including jobs, created and expanded

Environmentally sustainablegrowth (ESG)

Global and regional transboundary environmental concerns

Regional integration (RCI) Pillar 1: Cross-border infrastructure

Adaptation ($ million) 3.90Mitigation ($ million) 146.10CO2 reduction (tons per annum) 56,000Climate Change impact on the Project

Medium

4. Drivers of Change Components Gender Equity and MainstreamingGovernance and capacitydevelopment (GCD)

Institutional developmentOrganizational developmentPublic financial governance

Partnerships (PAR) Bilateral institutions (not client government)Official cofinancing

Some gender elements (SGE)

5. Poverty and SDG Targeting Location ImpactGeographic TargetingHousehold TargetingSDG Targeting

NoNoYes

Regional High

SDG Goals SDG8, SDG9

6. Risk Categorization: Complex .

7. Safeguard Categorization Environment: B Involuntary Resettlement: B Indigenous Peoples: C.

8. Financing

Modality and Sources Amount ($ million)

ADB 400.00 Sovereign SDP - Program (Regular Loan): Ordinary capital resources 250.00 Sovereign SDP - Project (Regular Loan): Ordinary capital resources 150.00

Cofinancing 175.00

Agence Francaise de Developpement - Loan (Not ADB Administered) 75.00

Counterpart 75.00 Government 75.00

Total 650.00

Note: An attached technical assistance will be financed on a grant basis by the Technical Assistance Special Fund

(TASF-OTHERS) in the amount of $1,000,000.

Agence Francaise de Developpement - Loan (Partial ADB Administration) 100.00

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on (i) a proposed policy-based loan (PBL), and (ii) a proposed project loan to the Republic of Azerbaijan for the Railway Sector Development Program. The report also describes (i) proposed technical assistance (TA) for Capacity Development and Reform Support for Railway Sector Development, and (ii) proposed administration of a project loan to be provided by Agence Française de Développement (AFD), and if the Board approves the proposed loans, I, acting under the authority delegated to me by the Board, approve the TA and the administration of the project loan.1 2. The program will provide project financing for the rehabilitation of the track and structure of the Sumgayit–Yalama rail line—a key link in the North–South Railway Corridor within the Central Asia Regional Economic Cooperation network. It will improve rail network serviceability (the project loan); and support the railway sector development reforms in management autonomy and governance, financial restructuring, reporting and control, operational efficiency, and corporate restructuring (the PBL).2

II. THE SECTOR DEVELOPMENT PROGRAM

A. Rationale

3. Sector development context. There has been a steady decline of railway market share in Azerbaijan, as also observed in other countries in the region. Road network expansion and pipeline network improvements brought competitive pressures onto railways that compounded the difficulties imposed on its infrastructure by the dearth of investment over the years.3 During the 2000s, following major investments in the oil and gas industry and a related boom in non-tradable sectors (construction and real estate), railway sector benefited from growing resource-related exports and imports of construction materials and consumer goods. But the market share of rail transport continued to decline. In 2006, at the peak of the economic cycle that Azerbaijan experienced, over 26.5 million tons of goods were transported by railways.4 This volume dropped to 22.4 million tons in 2010 and 15.5 million tons in 2016 with the current economic downturn. 4. Macroeconomic context. With low hydrocarbon prices since mid-2014 and limited new opportunities for extracting hydrocarbons, the economy of Azerbaijan—whose foreign trade is dominated by oil—is facing macroeconomic difficulties. Two waves of currency devaluation in 2015 affected consumers’ purchasing power (especially of imported goods) and the stability of the finance sector (as well as its credit origination capacity).5 Lower hydrocarbon revenues also led to a contraction in public investments, tightening domestic demand growth. Gross domestic product growth fell from 2.8% in 2014 to 1.1% in 2015 and –3.8% in 2016. To cope with these shocks, the authorities are deploying short-term measures to coordinate monetary, fiscal, and financial stability

1 The design and monitoring framework is in Appendix 1. 2 The Asian Development Bank (ADB) provided project preparatory technical assistance for Railway Sector

Development Program (TA 9154). 3 Policy issues were also a deep root contributor to the current situation. For example, the railways sector faces a

particular cost-disadvantage vis–à–vis the road sector, as no road tolls are paid by users in Azerbaijan. Road construction and maintenance is 100% paid directly by the Government.

4 Of these, 54% were oil-related products (exports and transit almost equally split) and 32% were construction materials (mostly imports from the north or the south). This is only about one-third of peak rail traffic handled in the past.

5 Credit to the economy declined sharply by 24% in 2016. Devaluation of the local currency in 2015—with a depreciation of over 100%—triggered higher dollarization, with 75.2% of deposits in foreign currency at the end of 2016. This created a severe shortage of credit.

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policies; 6 and devising finance sector stability solutions to avoid further deterioration of macroeconomic conditions. 5. Core development problem. Decades of deteriorating infrastructure and rolling stock, as well as lack of commercial orientation in management and planning decisions, have affected railway service competitiveness and financial viability. Lack of supporting policy and institutional mechanisms—the deep root causes of the current problems—aggravated the financial performance of Azerbaijan Railways Closed Joint Stock Company (ADY) over time, and only rising indebtedness allowed company operations to continue. 7 The recent steep reduction in freight demand and the level of losses in passenger services have made the heavy legacy (institutional and financial) problems at ADY increasingly difficult to manage. With the economic growth decline in Azerbaijan, gross expenditure on railway services decreased substantially, exposing the current railway problems. Crucially, while the East–West rail corridor has been under modernization since 2009,8 railway sector prospects need to be further enhanced on the North–South rail corridor.9 The latter has great potential once the network from Yalama (on Azerbaijan's Russian border) to Astara (on the Iranian border) is upgraded, and the planned Rasht–Astara link in Iran is completed.10 These service improvements will enable ADY to capitalize on the country's crossroads location and provide safer, more energy-efficient, cheaper, and less road-intensive transport. Nevertheless, deep reforms are crucial for all this to be fiscally sustainable. 6. ADY management11 and the Ministry of Finance (MOF) face the following challenges:

(i) maintaining deteriorated infrastructure and rolling stock to industry standards to avoid immediate reductions in service competitiveness, while financing key infrastructure rehabilitation and replacement investments to improve future service competitiveness;

(ii) servicing legacy debt against stagnating free cash flow, while incurring the short-term costs of reducing and rationalizing an oversized workforce, to implement productivity-enhancing changes and afford better compensation levels; and

(iii) changing ineffective management information and financial control systems, and establishing proper accounting systems to provide key financial information to support effective service level and pricing decisions.

7. Government’s reform agenda. Presidential Decree No. 1138 issued on 6 December 2016 established a strategic road map on the development of logistics and trade in Azerbaijan. Key

6 In 2016, counter-cyclical fiscal measures were deployed to maintain social expenditure levels to address the short-

term impact of the economic recession on vulnerable groups. Asian Development Bank (ADB). 2016. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Azerbaijan Countercyclical Support Facility. Manila.

7 ADY, transformed from a government railway department into a government-owned self-accounting closed joint stock company in 2009, manages the country’s railway network—about 2,096 track route-kilometers (km). Most of ADY’s revenues come from freight; passenger services lose money but are socially important.

8 Railway infrastructure modernization on the 503 km East–West railway line is largely financed by the World Bank and the Česká exportní banka (Czech Export Bank). This forms part of the almost-completed Baku–Tbilisi–Kars corridor, which will provide a direct link from the Caspian countries to Turkey and on to Europe.

9 The unification of the railways of Azerbaijan, Iran, and the Russian Federation forms part of the International North–South Transport Corridor—a multimode network of ship, rail, and road routes for moving freight from Northern Europe to South and Southeast Asia.

10 Construction of this link is expected to be launched in 2018 with funding from the governments of Azerbaijan and Iran.

11 By September 2015, the government had appointed a new ADY chairperson and new members to the senior management team of ADY, empowered to have greater operational and managerial autonomy and report directly to the Cabinet of Ministers (COM).

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building blocks include a new port complex, free trade zones, the North–South and East–West railways, and a comprehensive set of legal-regulatory reforms in the warehousing and logistics operations. The roadmap sets out an integrated vision for how these building blocks can create synergies between the development of a logistics and trading hub in Azerbaijan and the country’s capacity to start attracting foreign direct investment in non-hydrocarbon processing activities. The development of the latter and their competitiveness is now a key priority in the government’s economic policy. The government has launched initiatives to reform several sectors of the economy, especially those with prominent state-owned enterprises like ADY. Also, as part of structural reform efforts to improve public financial management efficiency and develop a sound framework leading the country into a future of fiscal discipline,12 the government has started addressing financial management issues and operational and institutional inefficiency issues in state-owned enterprises.13 8. A sustained policy implementation effort to engineer a transition towards a less oil-dependent economy is an urgent priority, and railway development can be a crucial enabler of this alternative development path. With railway infrastructure installations in almost all strategic locations of Azerbaijan (border cross points, ports, oil production and agricultural regions), railways competitiveness can be essential to the country’s production, trade, and distribution of bulk materials such as agricultural products. However, reform challenges in the sector are urgent. 9. Need for a sector development program. The development problem summarized above urgently requires a comprehensive policy and fiscal response from the government that (i) promotes institutional, corporate, financial management and control, and labor and debt-restructuring reforms; and (ii) makes crucial financing available to upgrade ADY’s service capacity and/or competitiveness. The railway development challenges require properly sequenced institutional and corporate reform actions. These reforms are crucial so that a financially sustainable outlook for investment financing can help tackle the physical constraints to the freight and passenger businesses. The sector development program modality enables multiyear assistance to such a sector-focused reform and investment financing agenda.14 10. Value addition. The program, included in the Asian Development Bank’s (ADB) country operations business plan for Azerbaijan, 2018–2020, 15 will be ADB’s first intervention in Azerbaijan’s railways. Dialogue on the program’s design and the assistance began in late 2015.16

The program’s multiyear, programmatic policy loan component supports the government’s reform agenda for the railway sector and the currently-integrated main operator. Its project loan

12 Decree of the President of the Republic of Azerbaijan on approval of the “Roadmap on National Economy and Main

Sectors of the Economy” dated 9 December 2016. Priority reforms in the Strategic Roadmap of National Economy include strengthening public institutions, facilitating access to finance and efficient public financial management.

13 ADB. Forthcoming. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Azerbaijan Improving Governance and Public Sector Efficiency Program. Manila. There are complementarities between the forthcoming Improving Governance and Public Sector Efficiency Program (IGPSE) and the railway sector development program: while the IGPSE promotes appropriate corporate and financial governance standards across state-owned enterprises of different sectors, the proposed railways program represents a sector-focused package of sector, financial, governance, and corporate reforms in railways.

14 ADB has undertaken similar initiatives in the past. See for example the Rajasthan Urban Sector Development Program: ADB. 2014. Report and Recommendation of the President to the Board of Directors: Proposed Loan and Grant to the Republic of India for the Rajasthan Urban Sector Development Program. Manila.

15 ADB. 2017. Country Operations Business Plan: Azerbaijan, 2018–2020. Manila. 16 ADB approved the program’s concept paper in July 2016, and TA has supported the preparation of reforms and the

project design across all outputs. Key aspects of the program have also benefited from past advisory support from railway stakeholders, lessons from past ADB projects, and an ongoing World Bank railway project in Azerbaijan. ADB has ensured that the proposed program reforms complement past TA initiatives by other development partners (in some cases by providing critical leverage).

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component synergizes infrastructure improvement of Azerbaijan’s East–West and North–South railway corridors to maximize the country’s transit potential. In addition, since ADY’s capacity is significantly stretched by the wide range of pressing challenges, ADB will allocate TA to facilitate policy dialogue and support implementing further change. This will enhance the coordination with development partners, key ADY stakeholders and other policy makers regarding the challenging reform processes. B. Impact and Outcome

11. The impact will be railway development for Azerbaijan economically sustained. The outcome will be rail service delivery and financial viability of railway operations in Azerbaijan improved. C. Outputs

12. The program will have five outputs: the PBL will support reforms under outputs 1–4 with two tranches (tranche 1 includes 23 actions and tranche 2 includes 22 actions); the project loan will support output 5. A more detailed elaboration of the reform outputs summarized below is included in a dedicated supplementary linked document.17 13. Output 1: Enhanced governance, and management and financial autonomy. ADY’s new management team has brought a renewed reform drive to the sector, making the case for the need to enhance ADY’s financial autonomy.18 To strengthen its financial autonomy, ADY was given stronger authority in early 2016 to set railway service tariffs. Effective adjustments in the pricing of freight services still require the completion of key accounting and operational upgrades (discussed in outputs 3–4 below). ADY has undertaken key steps to start addressing the loss-making conditions in passenger services. Proposals were submitted to the Cabinet of Ministers (COM) to close profitability gaps through a combination of tariff adjustments, rationalization of service and introduction of public service obligation contracts.

14. As a PBL tranche 1 action, ADY’s legal department took leadership in drafting and submitting to COM a law for railways, introducing, inter alia, an openness to private sector participation. Approval of this law on railways is a condition for PBL tranche 2 release, as well as reforms on the pricing of ADY’s passenger services and the pilot introduction of (i) public service obligation contracts in case ADY is mandated to operate routes at a loss, and (ii) performance-based contractual solutions for operational maintenance subsidies. Establishment of a Supervisory Board for ADY and other key corporate governance upgrades are also part of the conditionality of PBL tranche 2. As covenanted in the program’s loan agreement, railway sector financing solutions will be mainstreamed from the piloting results before the program completion. 15. Output 2: Effective financial restructuring of ADY’s debt liabilities. The debt legacy on the books of ADY cannot be fully serviced by ADY. This over-indebtedness and the related constant financial distress and uncertainty that it produces make it extremely difficult for ADY management to plan reforms and implement a financial and business turnaround. The government has committed to shouldering the debt-service obligations connected with ADY’s state-guaranteed liabilities until term end. For its remaining debt liabilities, discussions on a three-phase financial restructuring plan began in late 2015 to enable ADY to avoid default. The three-phase plan was

17 Railway Sector Development Program Reform Outputs (accessible from the list of linked documents in Appendix 2). 18 Although the government established ADY’s operational and institutional autonomy in 2009, little subsequent reform

occurred until mid-2015.

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formalized in October 2017.19 MOF and ADY executed the first phase of financial restructuring in mid-2017, including restructuring of the debt from commercial creditors,20 and established a special escrow account (automatically credited with a proportion of ADY’s monthly revenues) for the sole purpose of servicing ADY’s main liabilities in a specific order of priority.21 16. Implementation of the second phase of the financial restructuring plan is a PBL tranche 2 condition, together with validation by a reputable third party of the assumptions and financing requirements considered in the original plan. The phased approach in the financial restructuring plan enables its implementation and the fiscal support for it to remain intertwined with the conditionality proposed.22 This provides an incentivized way of dealing with ADY’s debt legacy problem. As covenanted in the program’s loan agreement, the third phase of the financial restructuring plan is to be implemented before the program completion. 17. Output 3: Improved financial and management control and reporting. ADY’s accounting processes are mostly manual, and the financial reporting that is produced (e.g., quarterly management accounts) is not timely. This impairs management decisions. ADY’s current cost accounting systems are not useful for analytical purposes (e.g., proper pricing or planning of service provision levels) either. ADY is implementing a comprehensive set of financial management control and reporting changes (and system upgrades23) to address this fundamental handicap. To enhance financial control, ADY’s ongoing activities under tranche 1 include the revamping of its finance department, centralization of the registry for all contracts, consolidation of all bank accounts into a single-ledger bank account, and centralization of all payment-authorization responsibilities with the newly appointed chief financial officer. ADY also established effective internal audit functions. The continuation of these efforts in 2018 will fundamentally upgrade ADY’s financial management and reduce fiduciary concerns. 18. As conditions for tranche 2, ADY will have to establish a risk management system, and finalize the implementation of the integrated financial and management accounting and financial reporting and/or control system. This is expected to enable ADY’s financial governance and analytical cost-accounting capacity and cost-recovery pricing. ADY will also have to initiate the

19 With ADB TA support, ADY and MOF estimated the total required fiscal effort to bring ADY to a sustainable debt

service coverage ratio by 2020 at $600 million. The financial restructuring plan registers that these fiscal injections should at least be in the form of subordinated loans, with high levels of concessionality in terms (at least 3 years of grace period and 15 years of term). The plan, comprising $200 million for each phase, also articulated the benefits of executing these injections as new equity, and agreement was reached with ADB to revisit the issue during the implementation of phases 2 and 3, as elaborated in the Railway Sector Development Program Reform Outputs (accessible from the list of linked documents in Appendix 2). It is expected as a result of the compact of reform and investment interventions under the program, these improvements can be sustained further and a debt service coverage ratio of 1.2 can be achieved and maintained by 2022 (see related performance indicators in Appendix 1).

20 In each phase of the plan, ADY and MOF are expected to target the most expensive and short-term liabilities of ADY for either full debt retirement, or renegotiation of terms with the respective creditors (to include the stretching of maturities, lowering of terms, granting of grace periods, and/or waiver of loan covenants in case of loans already in arrears). Targeted creditors will see a reduction of their net present value and ADY will gradually push forward the time profile of its total debt servicing responsibilities. Ex-ante execution and evaluation of each phase is a policy condition under each tranche release of the PBL.

21 As a condition for PBL tranche 2, the arrangements of the special escrow account will need to be reviewed, to take ADY’s liquidity management challenges into account.

22 Debt restructuring per se will not have a sustainable impact on the underlying operational profitability of ADY. But the approval of a funding plan for the debt restructuring effort that is crucially needed will (a) avoid debt default, and (b) enable ADY management to focus on the actual reform agenda that can lift ADY’s business performance.

23 The implementation of an integrated financial and management accounting and financial reporting system is largely supported under the ongoing Rail Trade and Transport Facilitation Project financed by the World Bank. World Bank. 2008. Rail Trade and Transport Facilitation Project. http://projects.worldbank.org/P083108/rail-trade-transport-facilitation?lang=en

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procurement for a credit rating from an international rating agency as a tranche 2 condition. Preparation for such an in-depth assessment will generate additional momentum for improvements in ADY’s finance department. As covenanted in the program’s loan agreement, ADY is to obtain a credit rating before the program completion. 19. Output 4: Enhanced operational efficiency and effective corporate restructuring. ADY approved its organizational/corporate restructuring implementation plan in September 2017. In addition, from the establishment of a centralized procurement department, to the pilot introduction of outsourcing solutions and the elimination of 10 subsidiaries, ADY has started taking important steps to develop into a more focused, leaner and better performing corporate group. ADY has also initiated the establishment of effective human resource management functions to support the preparation and execution of a time-bound (with concrete targets), multi-optional (regular and corporate retirement, labor rationalization initiatives, etc.) labor restructuring plan. The latter was approved in October 2017. An open-ledger of operational and non-operational key performance indicators, to be monitored and reported regularly was set up in September 2017. This will set the stage for deeper operational efficiency efforts across the board. ADY’s property commercialization efforts have also made progress from 2016 to September 2017, with ADY’s property assets inventory and valuation program substantially completed. Submission to COM of a Business Plan to integrate these business and corporate restructuring efforts within an effective strategy will lock-in commitments going forward. 20. As a condition for tranche 2, and with support of expert advice, ADY will finalize a comprehensive review of its operational efficiency levels, and build on it to update relevant operational key performance indicator (KPI) targets going forward. ADY will also study the feasibility of establishing operational performance auditing requirements, as a condition for tranche 2. ADY will fully implement an infrastructure traffic planning system (i.e., for time-tabling freight and passenger services). A formal and strategic separation of core and non-core assets will take place during PBL tranche 2. ADY will submit commercialization and privatization plans for non-core assets to MOF and the Ministry of Economy, including a proposal to privatize non-core assets and expedite improvements in non-core revenue generation.24 21. Output 5: Infrastructure of the Sumgayit–Yalama rail line improved. Through this output, the project will rehabilitate about 166 kilometers (km) of double-line main track from Sumgayit to Yalama, including civil structures and level crossings. Other existing facilities, including signaling, telecommunications, and electrification systems, will continue as at present but with increased maintenance funding. This output will also comprise consulting services to develop future projects, including a phased strategy for the improvement of other key railway assets. This includes electrification, signaling, and telecommunications to complete the modernization of the North–South Railway Corridor from Yalama to Astara. D. Development Financing Needs and Investment and Financing Plans

22. The PBL will help the government bear the fiscal costs of the policy reforms outlined in the government’s development policy letter (Appendix 3) and the policy matrix (Appendix 4). The size of the PBL was determined on the basis of (i) the fiscal support required to prepare, implement, and monitor the proposed policy actions, including system capacity needs of ADY; and (ii) an

24 As covenanted in the program’s loan agreement, the implementation of the Operations Management System and

the labor restructuring plan, and the achievement of operational and non-operational KPI targets remains on schedule before the completion of the program.

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assessment of the government’s overall fiscal resources and allocation for the railway sector.25

The government has requested a PBL of $250 million from ADB’s ordinary capital resources and a policy loan of $75 million from AFD, which is not administered by ADB, in support of the PBL component of the program. 23. The project component of the program is estimated to cost $325 million (Table 1). The government has requested a loan of $150 million from ADB’s ordinary capital resources to help finance the project component. Government counterpart financing for the project component will be $75 million equivalent covering taxes and duties, maintenance of existing signaling and electrification on the project rail line, land acquisition and resettlement, and contingencies. The government will provide the loan proceeds and counterpart funds to ADY through a subsidiary agreement. AFD is expected to provide a loan of $100 million equivalent to jointly finance the project works contract, and ADB will partially administer the AFD loan by providing services on procurement, safeguards, and review of withdrawal applications.

Table 1: Project Investment Plan ($ million)

Item Amounta

A. Base Costb Infrastructure improvement for the Sumgayit–Yalama rail line 278.3 Subtotal (A) 278.3 B. Contingenciesc 37.9 C. Financing Charges During Implementationd 8.8 Total (A+B+C) 325.0 a Includes taxes and duties of $36.1 million to be financed from the Government of Azerbaijan’s resources. b In mid-2017 prices. Exchange rate of $1 = AZN1.686 is used. c Physical contingencies computed at 8.0% for civil works, equipment, and consulting services. Price contingencies

computed at 1.4%–1.5% on foreign exchange costs and 7.0%–9.0% on local currency costs; includes provision for potential exchange rate fluctuation under the assumption of a purchasing power parity exchange rate.

d Includes interest and commitment charges. Interest during construction for the Asian Development Bank (ADB) loan has been computed at the 5-year forward London interbank offered rate plus a spread of 0.6%. Commitment charges for an ADB loan are 0.15% per year to be charged on the undisbursed loan amount.

Source: Asian Development Bank estimates.

24. The financing plan is in Table 2. The ADB PBL will have a 15-year term, including a grace period of 3 years, an annual interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.15% per year, and such other terms and conditions set forth in the draft loan and project agreements. The ADB project loan will have a 25-year term, including a grace period of 5 years, straight-line repayment method, an annual interest rate determined in accordance with ADB’s LIBOR-based lending facility, a commitment charge of 0.15% per year (interest and other charges during construction to be capitalized in the loan), and such other terms and conditions as set forth in the draft loan and project agreements. Based on this, the average loan maturity is 15.25 years and the maturity premium payable to ADB is 0.10% per annum.

25 Railway reform adjustment costs—many of which relate to resolving legacy debt, staff rationalization, formalization

of subsidy solutions and other costs of corporate restructuring— are estimated in excess of $900 million over the duration of the program. The PBL will help fund part of these fiscal costs, taking into account the government’s general funding requirements. These issues are articulated in Financial (Fiscal) Impact Assessment of Railway Sector Reforms (accessible from the list of linked documents in Appendix 2).

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Table 2: Financing Plan Source Amount ($ million) Share of Total (%) Asian Development Bank Ordinary capital resources (policy loan) 250.0 38.5 Ordinary capital resources (project loan) 150.0 23.1 Agence Française de Développementa Policy loan 75.0 11.5 Project loan 100.0 15.4 Government of Azerbaijan (for project) 75.0 11.5

Total 650.0 100.0 a AFD involvement is subject to a positive outcome of its assessment process of the program, the negotiations of

terms and conditions of the financing documents, and the approval of the program by its internal corporate organs. In the event of AFD loan not being materialized, the government of Azerbaijan has agreed to fill in the funding gap either through an equivalent amount government counterpart funds or through alternative financing resources.

Source: Asian Development Bank estimates.

E. Implementation Arrangements

25. PBL tranche 1 policy actions have been completed by the borrower. Tranche 1 is expected to be released when loans become effective. Tranche 2 policy actions will be completed as a condition for Tranche 2 release (expected in 2019). ADY has established a program management office (PMO) for the program implementation. The PMO, consisting of a policy support unit and a project implementation unit, will be responsible for the day-to-day management of the program including procurement, financial management, loan covenant compliance, support with the implementation of the tranche release policy actions under the PBL, and liaison with ADB. Incremental operational expenses of the PMO will be financed out of the loan funds to attract competitive staff. 26. All procurement financed under the ADB loan and AFD loan partially administered by ADB will follow international competitive bidding procedures pursuant to ADB’s Procurement Guidelines (2015, as amended from time to time) and will be subject to ADB’s prior review. As AFD is expected to cofinance the program and ADB is expected to partially administer the AFD financing of the project component of the program, universal procurement will be applied.26 ADB will recruit the consultants—for the construction supervision and subsequent project development to be financed under the ADB loan—following ADB’s Guidelines on the Use of Consultants (2013, as amended from time to time). The implementation arrangements are summarized in Table 3 and described in detail in the project administration manual (PAM).27

Table 3: Implementation Arrangements Aspects Arrangements

Implementation period November 2017–December 2021

Estimated completion date 31 December 2021

Loan closing date 30 June 2022 Management

(i) Oversight body The government will establish the program steering committee, to be chaired by the minister of MOF and comprising concerned government agencies and ADY, within 3 months of the loan effectiveness. ADB and AFD will be observers.

(ii) Executing agencies MOF for the PBL component; ADY for the project loan component (iii) Implementing agency ADY for the PBL component

Procurement International competitive bidding 1 contract [This information was deemed confidential according to paragraph 97.5, of ADB’s Public Communications Policy.]

Consulting services QCBS (90:10) 343 person-months

QCBS (90:10) 95 person-months

26 ADB. 2015. Enhancing Operational Efficiency of the Asian Development Bank. Manila. 27 Project Administration Manual (accessible from the list of linked documents in Appendix 2).

9

Aspects Arrangements

Advance contracting Works and consulting services Disbursement The loan proceeds will be disbursed in accordance with ADB’s Loan Disbursement

Handbook (2017, as amended from time to time) and detailed arrangements agreed upon between the government and ADB. The $250 million PBL will be disbursed in two tranches, tranche 1 of $175 million and tranche 2 of $75 million.a

ADB = Asian Development Bank, ADY = Azerbaijan Railways Closed Joint Stock Company, AFD = Agence Française de Développement, MOF = Ministry of Finance, PBL = policy-based loan, QCBS = quality- and cost-based selection. a The front-loading of resources in ADB’s PBL is justified by two factors: (i) AFD's approval time line (expected in the

second quarter of 2018) does not allow its policy loan ($75 million) to be disbursed along ADB’s tranche 1; and (ii) MOF’s direct fiscal outlays in 2017 into ADY, as a result of tranche 1 conditionalities, have been substantial.

Source: Asian Development Bank.

III. TECHNICAL ASSISTANCE

27. The proposed transaction TA will support capacity development and reforms at ADY, focusing on outputs 1–4 with certain support for output 5. The TA is estimated to cost $1,100,000, of which $1,000,000 will be financed on a grant basis by ADB’s Technical Assistance Special Fund (TASF-other sources). The government through ADY will provide counterpart support in the form of counterpart staff, office space, workshop venues, and other in-kind contributions. ADY will be the executing agency for the TA, which will be implemented over 3 years during program implementation.28

IV. DUE DILIGENCE

A. Technical

28. The project design compared various rehabilitation options and considered track rehabilitation most appropriate given the traffic characteristics, service condition of railway systems, and competing demands for limited funds among railway assets. Comprehensive track renewal of the rail line will enable the commercial speed for freight to be restored from an average of 25 km per hour to 60 km per hour. 29. The project activity qualifies as climate mitigation as it promotes the reduction of greenhouse gas emissions by a modal shift to a low-carbon transport mode. Climate change risk factors in the project area include sea level rise, rising temperatures, and increased frequency and magnitude of flooding caused by increased intensity of single rainfall events. The project will incorporate climate-proofing design in the track rehabilitation, including continuous welded rails and improved drainages. B. Economic and Financial

30. Economic viability. ADB carried out an economic analysis of the project loan, comparing the incremental changes in costs and benefits arising from the project against a without-project scenario that assumes continued and gradual deterioration of the railway link between Sumgayit and Yalama.29 The current and forecast traffic with and without the project was assessed based on detailed data provided by ADY; an analysis of prospective flows on the North–South Transport Corridor; an analysis of international trade traffic data (from statistics provided by the United Nations, European Union, Commonwealth of Independent States, and other countries); and through the comparison of alternative routes. The main economic benefits are (i) time savings for freight traffic and passengers; (ii) vehicle operating cost savings; (iii) reduced externalities (carbon

28 Attached Technical Assistance Report (accessible from the list of linked documents in Appendix 2). 29 ADB conducted the analysis based on ADB. 1997. Guidelines for the Economic Analysis of Projects. Manila.

10

dioxide emissions and safety); and (iv) infrastructure maintenance cost savings. The project is economically viable, with an economic internal rate of return of 12.4% and a net present value of $118.6 million at a 9.0% discount rate. 31. Financial viability. To ascertain the project’s financial viability, ADB conducted a financial analysis of the project30 on an incremental basis to compare cash flow with and without the project. The financial internal rate of return is 6.7%, exceeding the calculated weighted average cost of capital of 2.3%. The project remains economically and financially viable against key variables, including a capital cost increase of 20% and traffic reduced by 20%.

32. Financial sustainability of ADY. The PBL component of the program will strengthen the financial capacity of ADY and the government to implement the project. Assuming a gradual phasing-in of the financial benefits to be realized from implementation of reform measures through delivery of 4 PBL outputs, ADY’s operating income will grow faster than that of the no-reform scenario, which will be critical for ADY to remain a going concern, averting default situation,31 and come back to a financially sustainable level of service delivery competitiveness.32 C. Governance

33. ADY’s financial management and reporting systems need strengthening. ADY is on track to begin operation of its integrated financial and management accounting, and financial reporting and control system, in early 2018. Under the project loan, direct payments for large contracts will be used. An advance account will be opened in a commercial bank acceptable to ADB, and all payments to contractors and consultants below a certain threshold will be made from the account with the endorsement of responsible senior staff in ADY and MOF. Overall financial management risk is considered substantial before the mitigation measures and moderate afterward.33 ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the government and ADY. The specific policy requirements and supplementary measures are described in the PAM (footnote 27). D. Poverty and Social

34. Azerbaijan has made significant progress in reducing poverty. But the developments in employment growth and poverty reduction have largely been skewed in favor of Baku instead of rural areas and non-Baku urban areas. The government’s various poverty reduction and development programs now emphasize, among others, inclusive growth, poverty reduction, and infrastructure development. The project will improve the rail network efficiency and reduce transport costs and travel time, bringing a positive impact on poverty alleviation for rural areas and non-Baku urban areas along the project railway. The primary beneficiaries will be passengers and freight transporters, including mobile vendors, shippers, freight transporters, and producers. 30 In accordance with ADB. 2005. Financial Management and Analysis of Projects. Manila. 31 Debt default would shut down ADY’s access to private credit markets—for formal finance and operational trade credit

— in the foreseeable future, and imply Government direct funding of every single capital replacement item going forward. The soft-budget constrains regime of the past would likely set in again, and the fiscal cost of this railway sector scenario would be augmented by such circumstances.

32 Financial (Fiscal) Impact Assessment of Railway Sector Reforms (accessible from the list of linked documents in Appendix 2).

33 The bidding documents for the works contract will include provisions specifying ADB’s right to audit all project records and accounts, as well as those of all contractors, suppliers, and other service providers as they relate to the project. Key measures to ensure proper governance are (i) independent external auditing of contracts, project accounts, and financial statements; (ii) transparent decision processes for all procurement matters; and (iii) verification of contractors’ payment claims by the supervision consultant and oversight by the project implementation agency.

11

35. Gender. The project loan is classified some gender elements. It is expected to bring certain benefits to women, including reduced travel time and easy access to public and business facilities, additional employment opportunities, and improved railway safety from the reconstruction of overpasses and bridges, installation of safety fences and lighting, rest areas with separate toilets for men and women, and a community safety awareness campaign. Advertisements for project-related jobs will include that women are encouraged to apply. ADY will implement a skills development program under the PBL, and ensure 30% participation by women. ADY will also design a new pricing strategy for passenger services that incorporates measures to mitigate any potential negative impact on the poor, women, children, and the elderly. E. Safeguards

36. Social safeguards. The project loan is classified category B for involuntary resettlement and category C for indigenous peoples. Meaningful public consultations were conducted and a draft land acquisition and resettlement plan (LARP)34 was prepared in accordance with ADB’s Safeguard Policy Statement (2009) and disclosed on ADB’s website on 5 October 2017. ADY has overall responsibility for LARP finalization and implementation. It has adequate institutional capacity and is committed to managing social safeguard compliance. The construction supervision consultant will monitor LARP implementation. The PMO will ensure the project complies with social safeguards loan covenants, including semiannual social safeguard monitoring reporting. No land acquisition and resettlement impact is expected for the PBL.35 37. Environmental safeguards. The project loan is classified category B for environmental safeguards. Meaningful public consultations were conducted and an initial environmental examination was prepared in accordance with the Safeguard Policy Statement and disclosed on ADB’s website on 7 November 2017. Project impacts during construction are expected to be site-specific, temporary, and related to the direct replacement of track, such as noise in residential areas, dust and exhaust emissions from equipment, impacts of bridge rehabilitation on the crossing rivers, and waste management. During operations, potential noise and vibration impacts are expected from the increased train speed and frequency after track improvement. The project will improve railway safety by fencing along the whole alignment. An environmental management plan provides mitigation and monitoring measures, as well as a capacity building plan for the PMO and ADY. Contractors will be responsible for implementing the mitigation measures. The loan has allocated funds for institutional strengthening, including safeguard compliance and railway safety improvement. The PMO will ensure the project complies with the environmental loan covenants, including semiannual environmental monitoring reporting. No environmental impact is expected for the PBL (footnote 35). F. Risks and Mitigating Measures

38. Risks and mitigating measures are described in detail in the risk assessment and risk management plan. This includes financial management risks. Table 4 summarizes major risks outside project control.36 Overall, risks are deemed manageable through mitigating measures. Benefits and impacts are expected to outweigh the costs of mitigation.

34 Five households (20 persons) will have land acquisition and resettlement impacts. All five affected households will

be severely impacted by losing more than 10% of their productive assets. No physical displacement will take place. One of the five affected households is deemed vulnerable.

35 Environmental and Social Assessment of the Policy Matrix (accessible from the list of linked documents in Appendix 2).

36 Risk Assessment and Risk Management Plan (accessible from the list of linked documents in Appendix 2).

12

Table 4: Summary of Major Risks and Mitigating Measures Risks Mitigating Measures

Regional geopolitical instability and reduced country growth affect ADY’s business prospects

Strong incentives exist to maintain oil flows to Western markets through the Caucasus region. Turkey and Georgia in particular benefit from improving transit conditions in Azerbaijan. Their railway sectors have invested significantly in upgrading their capacity. Iran is also prioritizing the development of rail connections to Azerbaijan to exploit potential transit connections from South and Southeast Asia to the Russian Federation. These factors mitigating the risk of regional instability to Azerbaijan’s transit potential, but are outside Azerbaijan’s control.

Potential political interference, with vested interests and lengthy government review procedure, affect procurement integrity and cause procurement delay

ADB’s prior reviews of the bidding documents will take full consideration of the feature of Azerbaijan railway sector, and its prior reviews of bid evaluation reports will assess any complaints received from bidders. International procurement and technical experts will adequately support the procurement activities. Program implementation consultants and ADB will provide capacity building activities for ADY. ADB will closely monitor procurement progress, identify the cause of any delays, and take prompt actions in consultation with the Azerbaijan Resident Mission through special review missions, country portfolio review meetings, and other effective dialogue channels with the government.

ADB = Asian Development Bank, ADY = Azerbaijan Railways Closed Joint Stock Company. Source: Asian Development Bank.

V. ASSURANCES AND CONDITIONS

39. The government and ADY have assured ADB that implementation of the program shall conform to all applicable ADB policies including those concerning anticorruption measures, safeguards, gender, procurement, consulting services, and disbursement as described in detail in the PAM and loan documents. The government and ADY have agreed with ADB on certain covenants for the program, which are set forth in the loan agreement and project agreement.

VI. RECOMMENDATION

40. I am satisfied that the proposed loans would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve

(i) the policy-based loan of $250,000,000 to the Republic of Azerbaijan for the Railway Sector Development Program, from ADB’s ordinary capital resources, in regular terms, with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; for a term of 15 years, including a grace period of 3 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft policy-based loan and program agreements presented to the Board; and

(ii) the project loan of $150,000,000 to the Republic of Azerbaijan for the Railway Sector Development Program, from ADB’s ordinary capital resources, in regular terms, with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; for a term of 25 years, including a grace period of 5 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft loan and project agreements presented to the Board.

Takehiko Nakao President

8 November 2017

Appendix 1 13

DESIGN AND MONITORING FRAMEWORK

Impact the Program is Aligned with

Railway development for Azerbaijan economically sustained (Azerbaijan Strategic Road Map, 2017–2020)a

Results Chain Performance Indicators with

Targets and Baselines

Data Sources and Reporting

Mechanisms Risks Outcome By 2022 Rail service delivery and financial viability of railway operations in Azerbaijan improved

a. ADY reached operational profitability (2016 baseline: negative)

a. Audited financial statements of ADY

Regional geopolitical instability and reduced country growth affect ADY’s business prospects.

b. Average freight speed on the Sumgayit–Yalama (border with the Russian Federation) rail line of the North–South Railway Corridor increased to 60 km/h (2016 baseline: 25 km/h) c. Debt service coverage ratio maintained above 1.2 (2016 baseline: negative)

b–c. Service delivery audit reports and annual key performance indicators reports of ADY

Outputs 1. Governance, and management and financial autonomy, of ADY enhanced

1a. Corporate governance requirements in Azerbaijan fully complied with by ADY by 2021 (2016 baseline: not applicable)

1a–1b. Program progress reports

ADY reform package still cannot improve financial performance, and chronic underinvestment in railway operation and maintenance will persist. Leadership and political will to complete the reforms is lacking because of vested interests.

1b. Tariff reforms completed, including public service obligation contracts introduced by 2021 (2016 baseline: not applicable) 1c. Outsourcing solutions mainstreamed at ADY by 2021 (2016 baseline: not applicable) 1d. Law on Railways approved by Parliament by 2019 (2016 baseline: not submitted)

1c–1d. Program progress reports and ADY annual reports

14 Appendix 1

Results Chain Performance Indicators with

Targets and Baselines

Data Sources and Reporting

Mechanisms Risks 2. Financial restructuring of ADY’s debt liabilities effectively conducted

2a. Debt service coverage ratio reached 1.1 by 2020 (2016 baseline: negative)

2a. ADY’s annual financial statements

2b. Credit rating from an international rating agency procured by 2019 (2016 baseline: no credit rating)

2b. Contract with a credit rating agency

3. Financial and management control, efficiency, and reporting at ADY enhanced

3a. IFRS–ERP system fully operationalized by 2018 (2016 baseline: not operationalized) 3b. Regular outreach efforts on annually reported key performance indicators undertaken by 2019 (2016 baseline: not undertaken)

3a. Program progress reports 3b. ADY website and annual reports

3c. Unqualified ADY’s annual audited financial statements achieved by 2019 (2016 baseline: two qualifications)

3c. ADY annual report

4. Operational efficiency enhanced and corporate restructuring effectively conducted

4a. Labor rationalization plan that includes a skills development program with at least 30% women participation fully implemented by 2020 (2016 baseline: not implemented) 4b. Corporate restructuring plan and asset management system fully implemented by 2019 (2016 baseline: not implemented)

4a. Program progress reports 4b. Program progress reports

4c. Full separation between core and non-core assets, and commercialization plan for non-core assets fully implemented by 2019 (2016 baseline: not implemented) 4d. Rating of operational efficiency, including energy efficiency, improved by 2019 (2016 baseline: rated low)

4c. Program progress reports and ADY annual reports 4d. Program progress reports

Appendix 1 15

Results Chain Performance Indicators with

Targets and Baselines

Data Sources and Reporting

Mechanisms Risks 5. Infrastructure of the Sumgayit–Yalama rail line improved

5a. 166 km of double track between Sumgayit and Yalama (border with the Russian Federation) rehabilitated and/or reconstructed with safety design features that benefit women, children, and the elderly by 2021 (2016 baseline: 0)

5a–5b. Program progress reports

Potential political interference with vested interests and lengthy government review procedure affect procurement integrity and cause procurement delay.

5b. At least two project proposals for improvement of key railway assets on the North–South Railway Corridor prepared by 2020 (2016 baseline: 0)

Key Activities with Milestones Outputs 1–4: Not applicable Output 5: Infrastructure of the Sumgayit–Yalama rail line improved 5.1 Establish program management office with necessary staff (March 2018) 5.2 Award engineering and supervision consulting service contract (June 2018) 5.3 Award design–build works contract (July 2018) 5.4 Award project development consulting service contract (June 2019) 5.5 Complete all construction and commission all facilities (December 2021) Inputs Loan ADB: $400 million (regular OCR loan; $250 million for policy component and $150 million for project component) Government: $75 million as counterpart financing of the project component and $900 million as fiscal costs of railway reforms AFD: $100 million (equivalent) for the project loan Transaction Technical Assistance Grant ADB: $1.0 million (TASF-other sources) Assumptions for Partner financing: AFD: $75 million (equivalent) for the policy loan

ADB = Asian Development Bank, ADY = Azerbaijan Railways Closed Joint Stock Company, AFD = Agence Française de Développement, ERP = Enterprise Resource Planning, IFRS = International Financial Reporting Standards, km = kilometer, km/h = kilometer per hour, OCR = ordinary capital resources, TASF = Technical Assistance Special Fund. a Government of Azerbaijan. 2016. Strategic Road Map on the development of logistics and trade of the Republic of

Azerbaijan. Baku. Source: Asian Development Bank.

16 Appendix 2

LIST OF LINKED DOCUMENTS http://www.adb.org/Documents/RRPs/?id=48386-004-3

1. Program Loan Agreement

2. Project Loan Agreement

3. Project Agreement

4. Sector Assessment (Summary): Rail Transport (Non-Urban)

5. Project Administration Manual

6. Contribution to the ADB Results Framework

7. Development Coordination

8. Attached Technical Assistance Report

9. Financial Analysis

10. Economic Analysis

11. Country Economic Indicators

12. International Monetary Fund Assessment Letter

13. Summary Poverty Reduction and Social Strategy

14. Initial Environmental Examination

15. Resettlement Plan

16. Risk Assessment and Risk Management Plan

17. List of Ineligible Items

Supplementary Documents

18. Railway Sector Development Program Reform Outputs

19. Climate Risk Assessment and Management Report

20. Environmental and Social Assessment of the Policy Matrix and Management Plan

21. Financial Management Assessment Report

22. Financial (Fiscal) Impact Assessment of Railway Sector Reforms

Appendix 3 17

DEVELOPMENT POLICY LETTER

18 Appendix 3

Appendix 3 19

20 Appendix 3

Appendix 3 21

22 Appendix 3

Appendix 3 23

24 Appendix 3

Appendix 3 25

26 Appendix 4

POLICY MATRIX

TRANCHE 1 TRANCHE 2 (November 2017–December 2019)

Reform Conditions

Reform Conditions

Necessary Documentary

Evidence Output 1 – Enhanced Governance, and Management and Financial Autonomy of ADY

1.1 Establishment of ADY’s operational and institutional autonomy,

including e.g. set-up of the management board, right to retain revenue generated from ADY property, and ADY’s autonomy to set railway service tariffs (freight and passenger, except for transit tariff).

1.2 Amendments to various normative acts to align these with the

Presidential Order of 18 September 2015; and approval of corresponding changes to ADY charter and organizational structure.

1.3 Submission to Cabinet of a draft law on Railways, including (inter alia) an institutional definition of functional and investment financing responsibilities, and openness to private operators.

President Executive Order dated 18 September 2015 amending President’s order #383 dated 20 July 2009

Cabinet of Ministers (COM) Resolution dated 7 February 2016. Cabinet of Ministers (COM) Resolution (133) dated 17 March 2016 Copy of ADY’s submission, with draft law proposed.

2.1 Parliament approval of a law on Railways, including (inter alia) an institutional definition of functional and investment financing responsibilities, and openness to private operators.

2.2 Establishment by Cabinet of a

Supervisory Board for ADY with full management oversight functions. Appointment of Board with appropriate number of independent members (non-government/non-railway affiliated). Establishment of the Risk and Audit Committee of the Supervisory Board, to which the Internal Audit Department will report directly, and compliance with other corporate governance requirements for state-owned enterprises.

1.4 ADY submits to the Cabinet a proposal (policy paper) for rail passenger service pricing that includes:

(i) Estimates of service provision costs and of current profitability gaps (meaningfully disaggregated by route/distance);

(ii) A gradual, time-bound increase in pricing aimed at closing routes' profitability gap or options for rationing (or rationalizing) loss-making services (already taking into account expectations regarding actions/improvements on operational KPIs);

Copy of ADY’s submission (i.e. cover letter and proposal).

2.3 Issuance of ADY’s Supervisory Board decisions on ADY’s pricing strategy for passenger services.1 2.4 Approval by Cabinet and ADY to introduce public service obligation contracts, on a pilot basis, for ex-ante determined subsidy solutions for the

1 The preparatory surveys and analysis for these decisions will need to estimate possible impacts on the ridership of women, men, children and elderly. Willingness-

to-pay analyses will be undertaken on the proposed changes to railway fares, and surveys will also attempt to gauge the composition of the potential ridership of the trains in response to possible rationalization measures. The resulting pricing strategy may include measures that mitigate potential negative impacts on the poor, women, children and elderly

Appendix 4

27

(iii) Public service obligation (PSO) contract solutions for any mandated passenger services provision below cost-recovery

passenger services that will still operate with profitability gaps.

1.5 ADY submits to the Cabinet a Railways Investment Plan, as an

element of its 5-year Business Plan, which includes segregation of investment financing responsibilities.

1.6 ADY submits a policy paper to Cabinet (based on international experience), setting-out options for an explicit policy direction on the long-term division of responsibilities for:

• financing Railways Investment, and

• a performance-based contractual solution for O&M cost sharing between ADY and Government.

Copy of ADY’s submission (i.e. cover letter and Railways Investment Plan, explicit on the terms of Action 1.5). Copy of ADY’s submission (i.e. cover letter and policy proposal).

2.5 Cabinet approval of the Railways Investment Plan, and its implementation by ADY remains on target.

2.6 ADY and Government introduce, on a pilot basis, performance-based contractual solutions for O&M cost sharing between ADY and Government.

Output 2 – Effective Financial Restructuring of ADY’s Debt Liabilities

1.7 Ministry of Finance and ADY implement the first phase of a three-

phase financial restructuring plan (approved between Ministry of Finance and ADY), with a combination of soft-loans and/or equity injections into ADY (to impact on about $200 million-equivalent of ADY’s non-publicly-guaranteed liabilities) that is calibrated to bring the debt-service coverage ratio (DSCR) to above 0.05 in 2017 (the calculation of these ratios exclude publicly-guaranteed liabilities). ADY approves annual targets going forward for: (i) debt-service coverage ratios, (ii) liquidity levels, and (iii) debt-equity ratio for ADY.

1.8 Ministry of Finance issues a commitment, regarding publicly-

guaranteed liabilities, to:

[1] service those liabilities till term end [or] [2] service those liabilities during phase two of the financial

restructuring plan, and transfer them out of ADY’s balance-sheet in phase three of the financial restructuring plan.

Copy of Three-Phase Financial Restructuring Plan approved by ADY and Ministry of Finance. Joint-letter on execution of 1st phase of debt restructuring. Ministry of Finance Decision [OR] Ministry of Finance confirmation (stand-alone letter).

2.7 Validation, by a reputable audit company, of the assumptions and financing requirements of the original financial restructuring plan.

2.8 Ministry of Finance and ADY implement the second phase of the three-phase financial restructuring plan, with a combination of soft-loans and/or equity injections into ADY (to impact on about $200 million-equivalent of ADY’s non-publicly-guaranteed liabilities) that is calibrated to bring ADY’s debt-service coverage ratio above 0.3 during 2018-2019 (the calculation of these ratios exclude publicly-guaranteed liabilities).

2.9 Ministry of Finance and ADY review (and revise as appropriate) the terms of the escrow account, considering financial restructuring efforts’ impact on debt-service projections and ADY’s liquidity management efficiency and challenges.

28 Appendix 4

1.9 Establishment of an escrow account by ADY and Ministry of Finance with large creditors (“passive signatories”) that are willing to restructure their loan terms. The escrow account agreement defines (i) the minimum transfers out of ADY’s monthly revenue that are to be deposited in the escrow account for the sole purpose of debt-servicing, and (ii) the priority of those large creditors in the proceeds of such account.

Copy of Escrow Account Agreement, with a cover letter from ADY explaining the objectives and main features of the account

Output 3 – Improved Financial Management Control and Reporting at ADY

1.10 ADY implements internal audit reforms, including the following: [a] new internal audit department established; [b] internal audit policy and methodology approved [c] new guidelines and routines established (including an Internal Audit Manual); and [d] key staffing with qualified professionals.

1.11 ADY to appoint a CFO to head the Finance Department (FD). ADY to issue an official order approving the restructuring of the Finance Department, incorporating Economic Analysis, Budget Planning and Expenditure Monitoring functions (previously under the Economic Analysis and Monitoring Department).

1.12 Establishment of a centralized registry for contracts in ADY’s legal

department.

1.13 Establishment of a centralized Procurement Department. Approval of Procurement Regulations establishing (i) value thresholds for the different levels of procurement-approving authority (head of department, deputy chairman, and chairman), (ii) requirements for clearance from the Procurement Department, and (iii) a prohibition of payments by the Finance Department related to contracts that are not reflected in the legal department’s registry.

1.14 Consolidation of all bank accounts into one single-ledger bank account (sub-accounts for different currencies; all payments authorized centrally). Finance Department to initiate production of monthly, forward-looking projections on cash-outlay obligations (for the following 2 months, with daily

ADY corresponding Executive Orders, including approvals for staffing requirements and the CVs of key IA team members. Copies of ADY Executive Orders (i) appointing a CFO and (ii) approving restructuring of Finance Department. Copies of ADY Executive Order approving the adoption of the procurement regulations dated 26 December 2016. Copy of the Procurement Regulations. Copies of (i) Cabinet Resolution #255s of 17 April 2017, (ii) ADY official order #47/S/A of May 1, 2017 to close bank accounts, attached to a cover letter by ADY

2.10 ADY approval of the shifting of the reporting line of Internal Audit to the Risk & Audit Committee of the Supervisory Board. 2.11 Procurement by ADY of a credit rating from an international rating agency, to serve as a benchmark for management efficiency going forward. 2.12 Appointment of CFOs for all corporate entities under ADY and chief accountants for all main departments, and establishes direct reporting lines to ADY’s CFO. Establishment by ADY of a risk management system (including a risk management manual, assessment guidelines and risk control functions). 2.13 Achievement by ADY of operating ratios below ‘1’.2 2.14 Public disclosure of information regarding ADY performance (quarterly reporting on selected KPIs) on ADY’s website.

2 Excluding depreciation costs.

Appendix 4

29

breakdown). Finance Department establishes a monthly cash budgeting and monitoring system.

1.15 ADY implements:

(i) A new Fixed Asset Register (FAR), and initiates its integration in the Enterprise Resource Planning (ERP) System,

(ii) On-line ticketing and automated ticketing for all commuter

services (with expansion of Automatic Points of Sale),

explaining what was achieved. ADY issuance of procedures regarding monthly cash forecast and management reporting. Copies of the letters from the banks confirming closure of accounts Letter from ADY Chairman with a statement of progress regarding the FAR integration with the ERP System. Letter from ADY to ADB with an explanation of the main results of automated ticketing (in terms of cash-less transactions)

1.16 ADY begins the implementation of an integrated financial and

management accounting, financial reporting and control system (Enterprise Resource Planning [ERP] system). The ERP system planned is to include all 19 functionalities/modules and IFRS reporting, and the following progress benchmarks are achieved:

(i) 4 out of 15 Financial Accounting Modules become functional

(‘Cash Balances’, ‘Bank Balances’, ‘Accounts Receivables’ and ‘Accounts Payables’). ‘Tax Accounting and Reporting’ and all 3 Management Accounting Modules (i.e. ‘Budgeting’, ‘Cost-Accounting’, and ‘Decision Support and Management Reporting) analytical reports) are operationally tested. All hardware procured and Oracle centers roll-out initiated.

(ii) 7 Oracle Centers established, with 113 qualified and trained new staff (as the first phase of plan to revamp the Finance Department), and data entry initiated. Submission to ADB of a time-bound implementation plan (indicating remaining 1 Oracle Center for Nakhchivan and the planned hiring of additional 11 qualified staff).

ADY cover letter making specific reference to this policy action, with copies of ERP system specifications, and the latest (i) implementer’s report, and (ii) E&Y monthly progress report (for end September).

2.15 Full-fledged commencement of the operation of ADY’s integrated financial and management accounting, and financial reporting and control system (ERP-IFRS). This is to include analytical cost accounting routines (activity-based cost accounting) that can serve as a basis for comprehensive financial modelling and average cost pricing (for freight and passenger services). ADY undertakes a review of all human resources working in the Finance Department (approx. 600) to put in place a performance appraisal system.

30 Appendix 4

Output 4: Enhanced Operational Efficiency and Effective Corporate Restructuring

1.17 Approval of a time-bound organizational/corporate restructuring plan, with explicit plans for internal pricing reforms, such as: (i) contractual systems for the services provided by selected corporate entities within the ADY group; (ii) approval of pilot Service Legal Agreement (SLA) solutions for services provided between operational departments of ADY.

1.18 Establishment of a Change Management Unit to (i) plan and monitor reforms, (ii) monitor Key Performance Indicators (KPIs), (iii) set operational and non-operational KPIs (open-ended ledger) explicitly calibrated to turn ADY into a break-even corporate group by 2020, to increase the quality of railway services (time, cost, etc.), and to improve energy efficiency, and (iv) undertake period operational performance benchmarking.

1.19 Introduction of outsourcing solutions on a Pilot basis (e.g. cleaning of

central station, ticket selling in the Central Station, property management in the Central Station, etc).

1.20 Elimination of at least 10 subsidiaries (corporate and non-corporate entities) of the ADY group. Merger of 6 depos for wagons into 3. Submission to ADB of a statement of intent regarding the remaining subsidiaries.

1.21 Submission to the Cabinet, by ADY, of a Railways Business Plan,

covering the next 5 years, including: (i) The establishment of operational and non-operational KPIs,

explicitly integrating investment financing options and business development efforts, marketing plans, operational and human resources strategies, etc.

(ii) Corporate/organizational restructuring plan (e.g. unbundling of

freight operations, passenger operations, depots and rolling stock services, and infrastructure/holding management services).

Copy of ADY Executive Order for organizational restructuring. Copy of ADY Executive Order establishing the Change Management Unit. Copy of the new ledger of main operational KPIs. Copies of respective commercial agreements Copy of ADY Executive Order. ADY letter to ADB with a plan regarding remaining subsidiaries. Copy of ADY submissions, including attachments.

2.16 Implementation by ADY of an infrastructure traffic planning system (time-tabling). Adoption by ADY of a detailed plan to establish an Operations Management System with customized MIS features (e.g. a Freight Management System with RFIDs and GPS-based monitoring of rolling stock), and commence procurement. 2.17 ADY undertakes a comprehensive review to its operational efficiency levels, and on its basis updates the relevant operational KPI targets going forward (by revising the KPI ledger). ADY undertakes a study of industry operational standards and the feasibility of establishing Operational Performance Auditing requirements. ADY commissions a: (1) review of the implementation of outsourcing pilot solutions to assess future potential for outsourcing (on the basis of market capacity), and a (2) cost-benefit study to assess the feasibility of establishing depots for wagons in joint-venture with a private partner. 2.18 Approval by Cabinet/Supervisory Board of ADY’s Business Plan, with its Executive Summary disclosed on ADY website. Issuance by the Change Management Unit of internal quarterly reports on achievement of KPIs and on the implementation of reforms across ADY. 2.19 ADY (i) establishes an electricity commercialization unit (or subsidiary) to reduce potential commercial leakages, and (ii) integrates warehousing inventory

Appendix 4

31

records to reduce instances of wasteful procurement. 2.20 ADY’s implementation of the time-bound organization/corporate restructuring plan remains on track. ADY reduces the number of wagon depos and locomotive depos.

1.22 Establishment of HR/Labor restructuring Commission, and approval of an HR/Labor restructuring strategy that includes a human resource management program and a time-bound, multi-optional labor rationalization plan (e.g. regular retirement, VSS, outsourcing of non-core activities, retraining program and relocation program), with the objective of reducing ADY’s labor force by 5,000 staff between 2017 and 2020 (from 21,000 at the beginning of 2017).

Copy of ADY Executive Order approving a HR Strategy comprising a human resource management program and a time-bound, multi-optional labor rationalization plan. ADY cover letter to ADB with the quantification of objectives restated.

2.21 ADY to (i) keep implementation of the time-bound, multi-optional labor rationalization plan according to schedule, (ii) implement human resource management initiatives (e.g. grading and performance-based assessments), and (iii) commence the implementation of a skills development program with at least 30% women participation.

1.23 Completion of the following steps of ADY’s property commercialization reforms:

(i) Property Management System is established and all non-performing property-related lease agreements are terminated.

(ii) ADY contracts the services of a professional valuation companies. Completion, by ADY, of the property inventory (and valuation program for selected assets) in the Absheron region (>60% of total ADY properties), (with full clearance of their legal ownership).

(iii) ADY’s Property Department is transformed into a specialized subsidiary (ADY Property), led by a RICS-certified professional3, to implement the commercialization and privatization plans for non-core assets (in line with ADY-approved plans), under a fee-based Service Level Agreement (SLA, formalized though an ADY official order).

Copies of ADY Official instructions. Copy of ADY’s contract for valuation services. Copy of ADY letter to ADB describing progress on property inventory and valuation. Copy of ADY Executive Order

2.22 Completion of the following steps of ADY’s property commercialization reforms: (i) ADY approves an Asset Management Policy (with a full set of guidance instructions), and completes the property assets’ inventory (and valuation program in selected assets) across the country (with full clearance of their legal ownership). (ii) ADY approves and starts implementing a time-bound plan for a comprehensive asset management strategy, which shall include separate formal plans for core (i.e. railways administration and operations property) and non-core property assets.

3 RICS stands for Royal Institution of Chartered Surveyors.

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(iii) ADY Supervisor Board approves commercialization proposals for the non-core assets that are not identified for outright sales (e.g. stations and warehouses), and initiates its implementation.

(iv) ADY submits to Cabinet a proposal for outright sales of non-core assets that are not identified for commercialization (e.g. lands and old buildings), and initiates its implementation (conditional on Cabinet endorsement).

Covenants and Assurances

• Ministry of Finance shall vet any new commercial borrowing by ADY that is incompatible with the debt-equity and debt-service

coverage ratio targets set under the railway sector development program (RSDP). • ADY shall ensure that all new capital investment plans above a critical threshold will undergo key steps in investment analysis and

appraisal of project finance alternatives, and implementation of such plans will require approval by ADY’s Supervisory Board. • The borrower and ADY shall ensure that the following steps are undertaken prior to completion of the entire RSDP (which is

expected by mid-2021): o Cabinet takes decisions on mainstreaming railway sector financing solutions, on the basis of lessons learned during the

implementation of the pilots under policy actions 2.4 and 2.6. o ADY and Ministry of Finance implement the third phase of the financial restructuring plan, and ADY obtains a credit rating. o ADY’s implementation Operations Management System remains on target. o ADY’s achievement of operational and non-operational KPI targets remains on schedule. o ADY publicly discloses annual KPI reports and annual audited financial statements, and regularly communicates to the

public on ongoing reform progress. o ADY continues to implement the HR/Labor restructuring plan as scheduled.

• Within 12 months of release of completion of Tranche 2 policy actions, a joint review mission shall be fielded to monitor progress towards the above listed covenants and identify any possible corrective measures.